The Formula for Dividend Growth Investing

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Do you ever find yourself looking for that one crucial piece that would make you a better investor?  Being active in the market naturally drives investors to want to compare notes. When you look at the impressive track record of great investors, it can feel as though they know something you don’t. Is there a formula? What’s the silver bullet? 

In this episode, Greg reveals seven key factors that he looks for in a good dividend growth story. He explains what they are and why they are important to achieving 7% dividend growth per year. Later on, he applies them to Dover Corporation ($DOV) which is a company that appears to check all the boxes. But before you go out and buy stock in it, you may want to listen to the whole episode.

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Transcript

This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.

Welcome to episode 26 of The Dividend Mailbox. In this episode, we're going to go through the magic formula for dividend growth investing. We're going to take seven points, in some detail, that we think it takes to make a good dividend growth investment. Then we're actually going to apply it to a situation, to a company that we've had some interest in in the past, to see how we actually apply this to determine if a company is a good dividend growth story or not.

So now let's get right into what are the requirements for a good dividend growth story. Now these are the things we look for. It is not an exhaustive list but these are the key points that we really need, if we feel like we're going to have some predictability as far as getting our dividend to at least double in the next 10 years. And we found that it's been a pretty good guide, so that's how we've come up with this list. I will tell you that as I go through each one of them, I am not going to say that one's more important than the other. They all have a, have an impact. 

So to start with, point number one. We look for at least a 10% return on invested capital. The simple explanation for return on invested capital is it's basically their return on their balance sheet, what kind of profitability they have on their asset base. The big reason why we want 10% or higher is because long term, the stock market returns 10%. The theory goes, if you’re getting at least 10% or a little bit more on the capital you're probably going to build shareholder wealth over time because they're earning a higher return than what the market returns are for just the average S&P 500 stock. 

Number two, the next thing is you look for is steady gross margins and profit margins. Or if they're down, you're looking for a catalyst that's going to get them back to the mean. You want a business that is profitable and that tends to indicate that there's some form of a moat in the business. If their margins are steady over time, that helps to maintain the value of the stock, and investors are willing to pay a decent price for it. Gross margins are the profits a company makes just after their cost of goods sold— profit margins are farther down the income statement. What you look for there is a consistent business, one that management has a good handle on what their business is, and they're able to raise prices. They're able to compete in the marketplace. A company that has pretty stable margins tends to have a much more predictable business. What you have to be careful with is different companies have different levels of exposure to the economy as far as recessions. Lower margin businesses tend to be more price competitive and they tend to have less of a moat. But then when you get into cyclical companies, that can be extremely profitable but when the economy weakens, they actually may shortly move into a loss situation. You know there, you're looking for a balance of a company. If it's going to be more cyclical, you definitely want a company that has more margin of error, that has lower debt, and they've shown the ability to manage through and stay consistent on their dividend policy. So what we look for is a good track record of stable margins. 

After margins, we look for a dividend payout ratio that's consistent with their historical average. And here, you're just trying to look at sustainability. What's the likelihood that they're going to continue to meet that dividend growth? Because if a company earns $1 and they pay out 50 cents of their earnings in a dividend, that's a 50% payout ratio. Well, if you look at the last decade the company's averaged let's just say 30%, they've paid out 30 cents of every dollar in a dividend, and the last few years you start to see that number creep up. The dividend's been growing, but now they're paying out, let's say 60%. Well, what you have to look at there is if nothing else changes, at some point they're going to run out of room, and they are not going to be able to grow the dividend as fast. Companies tend to, there are exceptions on some really high-yielding situations, but they tend not to pay out all their earnings and dividends. The payout ratio that we like to see typically is below 50% because it does leave a little bit of margin of error, but it does vary from company to company and depends on the industry that a company is in. However, we want something that, at the very least, is kind of at its long-term mean. So, if you have that stable number of, let's just say 30%, whatever the number is, 50%, if that's what they've done for the last decade or more, and the earnings continue to grow at 5%, 8%, 10%, that sort of implies that the dividend is going to grow by the same amount. That is where we get dividend growth.

And then we like, we try to find at least a narrow moat in a business. I believe Warren Buffet is the one that came up with the term moat, but way back when they used to have castles, they would put a moat around it, and that just made the castle harder to invade. That concept is it's just harder for competition to compete because either they have great brands or they have something that is somewhat unique about their business and it's hard to replicate, or it takes a lot of money to replicate it. That tends to lead to a little bit more stable margins, so we look for at least a narrow moat. 

Then we move on to debt. This is a big one because obviously, leverage can be both a good and a bad thing. Virtually all companies use debt, and in some ways, debt can be a good thing because if you have 3% or 4% debt on your balance sheet right now, and it doesn't come due for 10 years, in this environment, I would consider that to be an asset. That is if they don't have debt that is at levels that the next downturn in the economy can put real stress on the business. This is a part where I think you really have to pay attention because companies leverage up to pay a bigger dividend. Companies will leverage up to buy stock back. That becomes an unsustainable situation if they don't have good earnings growth, and the slightest hiccup can really change the whole dynamic of the business. We don't really like to see leverage build over time. All things equal, what we like to see as a rule, we want it to be less than one times debt to equity, meaning for every dollar of equity they have a dollar of debt or less. Now, a lot of times there's more work behind this. You have to look at why the debt's up and kind of what the long-term goal of the business is. Is there a catalyst that's going to bring the debt back down? You just can't continue to build debt indefinitely, and that is going to impact how much cash is left over to pay out to investors. We want a company that has used discipline and that is not aggressively using debt to create an empire. This is where you get into problems with acquisitions, and that will be my point number six. 

We like to see historical discipline in management and how they manage the balance sheet because one of the big problems is you can have great, consistent return on capital and good margins, but if you go out and you pay too much for a company, then that starts to dilute your core business profitability. It can take a long time to recover from that, and in some cases, some companies never do. Some companies are better at acquisitions than others. The quick way to tell is if they continue to have a pretty consistent return on invested capital, that means when they go out and they add leverage or equity to go out and buy something, and they're able to maintain the profitability of their business, that actually becomes a positive. But it's hard to do, and historically, all the research regarding finance pretty much shows that acquisitions are just a tough game to create shareholder wealth with. However, looking at management, it does go beyond just companies acquiring other companies. You have to look at how management has handled debt, how they handled their balance sheet, their assets, and how they reinvest their profits. In the end, you want management that is building shareholder wealth. 

Finally, our last point is that we do want a track record of dividend growth. We like to see at least 6% a year because that is what the S&P 500 as a whole has grown its dividend by over the last 100-plus years. We have a target slightly higher than that. In order for it to double its dividend in 10 years, we like to see 7% growth. We feel that that is attainable when you consider in the S&P 500, you've got companies in there that don't even pay a dividend. By us focusing on dividends, we can amp that growth up at the minimum just by a little bit. Here's the hard part, defining a track record can be very subjective. It could be one year, it could be five years, it could be 20 years. But it depends on the company, and what the catalyst is, and you have to take each case individually and determine we've got dividend growth going forward. We pick a sweet spot of 2-3.5% on the dividend yield, but we do have exceptions. We do do things outside of that, but that's the core of what we really try to target. The reason why we do that is— actually, this is a somewhat complicated answer, but the best way I'm going to describe it is we want a little bit higher yield than what the S&P500 pays, which right now is about 1.5% because we want to potentially live off the income. If you want a hundred dollars of income and you have the dividend yield of the S&P500, you need $6.6 million in your portfolio. Now you're going to have the growth of the S&P 500, which is attractive, but let's just go to 3%. $100,000 requirement, you need $3.3 million if you have a 3% dividend yield. Well that number's half, and that's a pretty significant difference. Can you potentially expect all the growth of the S&P500? No, but here's a key point that you need to remember. You don't need all the growth because part of it has been transferred over to the dividend yield, and that's the part that we really try to focus on. We still have pretty much the same total return, but we've just transferred part of the performance from the price of the stock going up to a little bit higher yield.

Now you may ask, well, why not just keep going up the dividend curve? Well, if you have a 5% dividend and if you have that same $100,000 requirement, you only need $2 million. Here's the problem. Those companies as a rule tend to be more leveraged, slower-growth companies that are more concentrated on just paying out most —And in some cases, like real estate investment trusts— they're paying out pretty much all their income and dividends. It can still work, but in order to have that goal of doubling your income in 10 years, really what you're relying on at that point is you're just reinvesting and continuing to just try to compound the cash flow. The core dividend is not going to grow much.

If we have a 2.5%, 3% dividend grower that grows its dividend by 7% a year, we really don't have to do anything. And that's one of the beauties of the sweet spot, at least from our standpoint. 

This is part of why I'm bringing these whole points up again, because we have had some questions regarding some higher-yielding situations. Well, exactly how do you do what you do? A lot of times these companies will yield 6%, 7%, 8% because people, when they think of dividends, they think of, well, I want a yield that's attractive. Obviously, it's a whole lot easier to live on 6% than it is 3%. 

So here's another way that I'm going to try to illustrate the difference and what you really have to focus on because there are different sectors in just the dividend space alone. S&P Global puts out an update once a month and they show how several different investment strategies have performed. They look at roughly 40 different indexes, and one of the things they do is break up some of the dividends into different sectors. So the S&P 500 through the end of July was up about 20% on a total return basis. 

If you look at the Dow Jones US Select Dividend Index, that is a dividend index that does invest in some mid-cap companies, they have utilities in that index, and it tends to be a little bit higher dividend yield. It is a little slower growth. It is actually down slightly for the year. It was off a little less than not quite 1%. 

Well, then you go to the low volatility high dividend. Here, people in the past, several years ago, it became popular because the perception was, oh, you get a great dividend yield, but stocks don't move around so much. It's like, “yeah, I get the income without the risk. Maybe there's a free lunch out there.” Well, guess what? That index is down slightly too, not quite 1%. 

The S&P high dividend aristocrats, here, you may remember we've mentioned it several times, but the aristocrats are the companies that have raised dividends every year for 25 years. It doesn't necessarily mean they've risen them by how much, but they have grown the dividend every year for at least the last 25 years. When you look at the high-yield portion of that, obviously you're just taking the higher-yielding part of that index. Well, it's up 2.1%. It's doing a little bit better than the other high-yield indexes because it has a little bit of a growth component to it.

If you just look at the whole dividend aristocrat index, which this is, if you had to take a general approach, this is kind of where we live. That index is up 8.7%. It's still less than 20%, but it has growth built into it. And again, you're always trading something. What we try to do by focusing on the 2.5%-3% area of the dividend market, we're trying to balance and we're trying to get growth and yield at the same time.

So kind of a takeaway on this part of the podcast— you really need to focus on what your end game is and what you're trying to achieve because as you can see from these different indexes, you get different results. If you want a high dividend, a high dividend index is going to give it to you, but it's just not going to have the growth part of it. You're shifting the return over to almost all income. 

There is no simple right answer to any of this. It all has its place depending on what your goals are and what you're trying to achieve. I think a great way to think about this is when you look at the market return, dividend yield makes part of it, and then stock appreciation makes the other part of it. The market has been roughly split long-term between dividend and stock appreciation. What we're trying to focus on is by just slightly tweaking the dividend yield up from what the S&P 500 pays, we may not even be changing much of anything from the S&P 500. All we've done, to a degree, is eliminated the part of the index that doesn't pay anything. So by asking for another percent or two of dividend yield, we’re not really changing much at all.

Well, I go all through that to now talk about a company that checks all the boxes. From a standpoint of the seven points that we just went through, it pretty much hits them all. It is a dividend aristocrat stock and in fact, it's been on the list for 67 years, so they definitely have a long-term track record of growing the dividend. What I'm going to do right now is just kind of hit each of the points real quick and what you're first going to see is, “Wow, okay, this is, uh, this is obvious and it's simple.” You have a formula, and you follow it, and voila, you get great dividend growth and you get a great total return. Well, as you're about to find out, it's not that simple. Yes, I am going to tell you the name of the company, but I'm going to hold off for a little bit, that way you're not going to have any preconceived ideas as to why this should or should not be a dividend growth story. 

So first of all, return on invested capital— this company earns 13%. That is higher than 10%, so that's what you really like to see. But here's what you really want as an investor. I call it incremental return on invested capital, and basically what that means is, okay, you have a company that has its core business, they have earnings, and they reinvest those earnings. Are they reinvesting at the same levels of profitability? And in this case, the 10-year-plus track record of their incremental return on invested capital is 23%. That is a number that you dream about. They've been able to reinvest their profits at higher rates of return than just the core business. So that's a key point. 

The second thing is profit margins. Well, here again for the last 20 years, gross profit margins have averaged about 32% to the mid-thirties. Lately, in the last quarter, their gross profit margin was almost 36%. So they've been consistent and they've actually grown slightly. If you look at just their profit margin, which is getting down towards the net income line, there, you're at 12%. Once again, the last 10 years’ average has been 12%. It has been slightly lower than that in the last five years, but part of that comes through 2020. So you've got good stable margins, box number two is checked. 

Then you look at the payout ratio. If you look at the last 20 years, the average was about 42%. Last 10 years, they paid out about 25% of profits. Currently, they're paying out 28%, so they're actually on a little bit the lower side of what they normally pay out of their earnings in dividends. Right there, you've got room for the dividend to go up 50% if they just go back to 42%. That's a number that you'll really like to see. We've got box number three checked. 

Is it a narrow moat business at least? Well, this company operates in the industrial space. It basically operates in five segments: engineered systems, clean energy and fueling solutions, imaging and identification, pumps and process solutions, and climate and sustainability technologies. So just the broad descriptions show you that they are in some growth-oriented businesses. You know, with the engineered piece, I would argue that there's at least a narrow moat there. It's not a wide mode, but these are not sectors that are easily copied and this type of company usually has somewhat high switching costs. They've maintained a product base for customers, they have data, and they've got a lot of experience delivering a solution, so it's usually a little harder to switch. That's why we call this, at the very minimum, a narrow moat. 

Reasonable debt to equity. Here again, right now they're at running at about 70% debt to equity, so for every dollar of equity, they have $0.70 of debt. 20 years ago, they had about a 40% debt-to-equity ratio, so they use leverage, but they don't use a lot. Five years ago they had bumped up to 95%, but now they're bringing it back down. Now it's 0.7, so there's nothing that's too dramatic or out of line there. And this is where you should take the time to look at how your company has allocated its capital. This number is up a little bit, but again, coming out of the low-interest rate environment, if they've got low-interest-rate debt, I'm going to go as far as to say that becomes an asset. So we've checked box number five, debt is not really a problem here. 

Box number six is a historical discipline of management and how they've managed the balance sheet. Well, one of the things that they've done is in the last 20 years, they've bought back 30% of their stock. In this case, debt has been relatively well managed. They haven't issued very much additional equity. The shareholder count has gone down, they haven't diluted shareholders. They've been able to maintain their profitability in their business and even grow it a little bit. They've made some acquisitions in the past, but they've executed well by the fact that their profitability has remained attractive. So we're going to call box number six checked. 

Now we get to box number seven. Basically, we want dividend growth. This company has grown the dividend for 67 years, so clearly it checks box seven. It's a dividend aristocrat, and the revenues of this company in the last five years, revenues are up 40%. The earnings are up 121% in the last five years. If you go back 20 years, to 2002, which was in a recession, but earnings were $0.30 and now they're $7. The estimate for next year are that they're going to earn $9. So they've had a strong trend of earnings growth. The dividend has grown by 17%, and in the last 10 years, it's grown by 70%. It hasn't quite doubled, but in the last 20 years, the dividend's grown by 286%. You know here, that box was definitely checked. They've been raising the dividend, their growing earnings, and they're buying back stock. That is all of the ingredients that you're going to get dividend growth. 

We've clicked all the boxes and you're thinking, “Well, tell me what this is so I can go out and buy it.”

This mystery company is Dover Corporation and the symbol is DOV. The reason why we follow this is that we have a small position in it, it is one of the smaller positions in all of our accounts. It's not in the model portfolio that we talk about and I bought it more than a decade ago. One of the reasons why we don't own very much of this is because the stock has never really been cheap, or it was just cheap for a very short period of time, and the dividend yield is a little below where our sweet spot is. But again, not everything has to be in the sweet spot. The stock, you know, has done fairly well. However, even when all the boxes are checked, it's still not easy. 

Here's one thing that comes up. So this has been a dividend growth story, but if you look at the dividends, they grew them really fast up until about five years ago. They went from $0.52 back in 2002 to $1.72. But if you go from five years ago to today, the dividend has only grown by 17%. With the way they've had earnings growth double in the past five years, why are they not growing the dividend? Here's where dividend growth and this whole concept of, “Oh, it's easy, just buy a good dividend stock and sit back and don't worry about it.” Well, you've always got to look at what's going on. What's management doing? Do they have the discipline and is there a priority to pay you? Here was the big disappointment: they announced their June quarter and they announced that they raised the dividend by one-half of 1 cent. So now they're paying $2.04 cents with current earnings of $7 and an estimate for next year of $9.78. At first, you would think, what in the world are these guy’s problems? Why are they not paying me? 

There has to be a reason here. The answer comes, if you dig into their investor presentation on page 61 of their presentation, they get into capital allocation priorities. Their number one priority is to invest organically, and basically, that means taking R&D and coming up with new products, expanding what they've got. Priority number two is to grow through acquisitions. So here they're just looking for new markets to go into. They want to stay competitive, or if they haven't developed the R&D in a specific product line where they want to go, companies do this all the time, they just go out and buy something that's in that space. So there they have an immediate presence, but the problem is it usually never goes quite that smoothly. Priority number three, last on the list, is they want the dividend to continue to grow and they want to repurchase shares if they don't have any good investment opportunities out there. What this company is telling you is that you getting paid is last on our list.

Well, this company may have a great total return, and in fact, they have done well in the last five years. The stock is up 83% on a total return basis versus the S&P at 73%. If you go back 10 years, they've lagged, they're up 140%, the market's up 218%. But if you go all the way back to 1989, they're up 3700% and the S&P is up 2500%. So depending on the period you look at, overall, this company has done a pretty good job of creating wealth for shareholders. The problem is we're looking to double our income and we want an income stream. So now we don't have box seven checked. Dover is starting to deviate from that stronger dividend growth. They're doing everything that would make it easy for them to check that box, but for whatever reason, and they have their own, we can't depend on this dividend doubling in the next 10 years. So, therefore, Dover just doesn't give us that confidence because management appears to be shifting its focus to something else. Not that it's right or wrong, that's just what they're doing, and that doesn't fit what we try to do and deliver to our clients.

So, in conclusion, not every company is going to check every box. A lot of times that's where some of the opportunities come from, a little faster growth or greater total return. And even if they did check all the boxes, then you have a problem of you're probably going to pay way too much for it. That then kills your total return outlook for the next 10 years. 

I know people listen to podcasts, read, watch the financial media, and listen to what some of these quote gurus are saying. People evaluate Warren Buffet's portfolio, frontwards, backward, and upside down. People are looking for the silver bullet, or what's the magic formula? I'm even guilty of it on some level myself. You're trying to get ideas, you're trying to get opinions, and you're trying to pick up something that you haven't recognized before where maybe it's like, “Hmm, well if I just knew this, this could really help me out.” Well, I hope you see by just looking at Dover, there is no magic formula and there is no silver bullet because all of these situations are a little different. If you want dividend growth, you have to look at all the variables that are at play. They're all going to be different from time to time. You're going to give and take, and that's part of what makes this anything but easy.

You just try to follow discipline and have a framework. That's what our seven points do. It's a great starting point and it helps keep us centered so that we try to stay down the middle of the road. Our personal checklist is kind of our way of determining whether these things fit close enough into what we're trying to achieve, that we have enough confidence that when we have a portfolio of them, and you're going to have a few of them, maybe even more, that don't for some reason or another, don't end up checking all the boxes and don't perform as well. But you're going to have a few that may end up really kind of hitting the ball out of the park. Part of this is just mindset and just trying to make sure you get from point A to point B. There is a little bit of a magic formula from the standpoint that if you use discipline and you're willing to be patient and you're willing to make some mistakes, I t's quite possible to be relatively successful at this.

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you'll find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com.

Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies