The Dividend Mailbox

Dirty vs. Clean Opportunities

February 10, 2022 Greg Denewiler Season 1 Episode 8
The Dividend Mailbox
Dirty vs. Clean Opportunities
Show Notes Transcript

Normally, finding investments that fit the sustainable dividend growth strategy is challenging on its own. With the high valuations in this current market, it becomes even more difficult to find those companies at an attractive price. In this episode, we explore the future of the energy sector (dirty) and recent developments with Clorox (clean) while Greg shares why he thinks both could be great opportunities.

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Greg Denewiler  0:11  
This is Greg Denewiler. And you're listening to another episode of the dividend mailbox, a 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.

Greg Denewiler  0:36  
In this episode, I want to break it into two parts. The first one is going to be about the oil and gas story we mentioned in the last episode. And then the second one, we're actually going to look at a specific investment idea, and how we apply our dividend growth strategy and looking at making an actual investment. 

Greg Denewiler  0:58  
So now, as we look at the oil story, everybody knows that oil and gas is probably one of the more politically incorrect places to invest. Well, that goes over to foundations and pensions, a lot of them no longer invest in oil. So what does that do, it takes one of the major buyers of equity out of the market, that helps create lower prices, because there's just less demand for the stocks. So it makes a stock like Chevron, Exxon, or any of the other oil stocks just a little cheaper in price. Well, the political incorrectness also bleeds over into the fact that it is getting harder for oil and gas companies to access the capital markets, the debt markets, their debt is more expensive, or the market doesn't even want to loan them any more money. It's not only political, but investors have been burned in the past because the returns have not been as good. Well, that also goes over into banks, there's political pressure to even let the banks make loans to oil and gas companies. One of the big issues now that affects the price of oil is there just are not as many rigs out there looking for oil and gas. When you look at 2014, when oil was up to $100 a barrel, there were 1800 rigs that were working in the US. Normally, when you have oil that's up around $70 or higher, which currently it's at 90, if you look historically, it's not uncommon to see more than 2000 rigs working when you've got oil up at these prices. Well, currently, we only have 613 rigs working. And even though oil has recovered, the price of oil has recovered from last year, you just don't have as many rigs looking for reserves. So therefore, it's kind of simple economics, you're not going to have as much supply coming onto the market, but demand continues to remain fairly stable. So this supply and demand balance is really more towards higher prices here going out into the future. And it all comes back to the fact that capital is harder to come by. So oil and gas companies don't have the resources to spend to go out there and look for new resources. This also ties into offshore, which is where in the past, has accounted for 30% of our reserves in our production. Now, it is becoming harder to drill offshore. And it's much harder for these big companies like the big international oils to get leases offshore. And even though they're very expensive wells to drill, one of the big advantages to offshore drilling is that those wells a lot of times will have production lives that may go 40 years. That's just another piece of the puzzle and supply is just not going to be there near as much. Well, then you look at shale, it was really the big turning point for oil production and for the oil and gas markets a few decades ago. Well, there's a theory now that the best reserves the best shale reserves have basically been found and that there may be only another decade or so of high quality reserves. And after, say 10 years, the drilling just will not be as productive as it was before. It's the theory that we may be reaching peak oil again. We've been through this before, you know 30-40 years ago when Peak Oil became a big topic. And then new technology came along the whole fracking revolution created new reserves. But now it looks like shale may be peaking relatively soon. And that just goes to the supply story. Another piece to the oil story is also the Saudis and OPEC. One of the things that's been happening is there's been political pressure to try to get Saudi Arabia to increase their production, which would help drive down oil prices. One of the problems is the breakeven for Saudi Arabian oil is $55, according to the IMF. So when you're putting pressure on a country to increase their production, it's pretty hard to get them to go below $55, which would mean they'd be selling it for less than it cost them to produce it. And then you also look at that Saudi has higher debt, now, their population has entitlements built around their oil revenue. It just seems to be a real challenge to think that Saudi Arabia is going to do too much to lower the price much below probably $60 at the most, and it's really in their self interest to keep it up here. Why would they want to sell production and not make much money on it? So now, let's turn to the ESG side of the oil story. Well, one of the problems is, oil is pretty much in about 90% of the economy in one in one form or fashion. So you have an electric car, when you go to drive that electric car, guess what- you have asphalt, you have concrete, both of these take a lot of petroleum. In fact, when you look at these wind turbines, people don't realize that these things are massive, it takes a huge anchor to keep these things from falling over. And that anchor is cement, is concrete. Most people probably don't know that cement is the most energy intensive of all manufacturing industries. You know, it's not a free lunch, putting up one of those wind turbines. And then you've got the fact that there's all the copper that goes, one, connecting the grid and connecting the wind turbines, and then what goes into an electric car. If you take a look at how copper is mined, it's very destructive of the earth. Then you've got mining for the lithium for the batteries. It's just not a simple story, and the point is, it's not whether electric cars are good or bad- whether they're going to help or not. The point is, there's still going to be a need for energy. Petroleum is going to be with us for decades. And even though at some point, you'll have lower demand for oil, it's just not going to go away. And you're going to have companies that will do well, even though the industry may shrink. You look at some of the well capitalized companies that have access to capital, some of the big internationals, and I'll specifically just relate to Chevron, where it's well capitalized, it's had management that has done a relatively good job of allocating capital, they've got a an excellent track record, one of the better ones of all the international oils, they've got reserves around the world, they're in a position that as long as there's an oil industry, they stand a chance to be one of the better companies involved in it. It may continue to do well, even though the industry itself struggles. And when you have a company like Chevron who has a 4% dividend and it only trades at 13 times earnings, it creates opportunities. And that just seems to be what the oil story is. And another way to look at it is, a decade ago oil or energy represented about 10% or more of the S&P 500. A month ago, before or oil rallied and some of the energy stocks have had some pretty significant moves, energy only represented about 2% of the S&P 500. You know, oil is just out of favor, it's that simple, and it creates opportunity. So based on the present circumstances, we think something like a Chevron has a great dividend and it's got dividend growth built into it. You know, going forward, Chevron is something that we own. However, I will say when you look at December 30 of 2021, the stock was at 117. Right now we're not putting any new money in it, because the stock has moved up 20% plus. You know, oil up at around $90, at some point will probably still go higher, but I'm just a little hesitant to buy something that has moved relatively-It's performed relatively well here in a short period of time. So we're going to, we're going to look for an opportunity to add any more new money in it. You know, any weakness in the economy, if it shows up or some news headline, you know, at some point you always usually get something, hopefully we'll have an opportunity to enter it a little better price than where it is.

Greg Denewiler  10:21  
So we've heard the dirty story. Now we're going to hear the clean story. And this leads us to the second part of the podcast. 

Greg Denewiler  10:31  
So one of the things that we've done is, I'm going to just call it the back of the envelope approach, we've come up with a simple concept that helps guide us and helps us to look for companies that we think do have the ability to grow their dividends long term. So let's look at one example to see basically how we apply this concept. I hate to use the term, but our clean story is going to be Clorox. Now, one thing you have to remember, it's easy to find dividend growth, all you have to do is do a quick search look for companies that have raised their dividends in the last few months, and there you have dividend growth. But it's a whole other situation if you want to compound dividend growth over the next several decades. It requires a whole lot more discipline, and it requires looking at companies that have the ability to grow earnings, that have a disciplined approach to capital allocation, so that they could continue to raise those dividends 5, 10, 15 years out. But there's one more piece to this equation, you don't want to pay too much. You want to try to get the best total return you can. As we've mentioned in previous podcast, half that return is probably going to come from dividend growth and compounding, but the other piece of it is you're going to hopefully get some price appreciation. So back to our back of the envelope. Let's just say a company pays a dividend of $1. At the very minimum, we want that company 10 years from now, to pay $1.50. You know, we want it to at least go up 50%. Another piece of the equation is, sure there are a lot of great dividend growers that, you know the dividend is only a quarter, one half of a percent. There's this gray area where we don't want just dividend growth, but we want enough dividend yield that you potentially at some point are going to live off of your dividend income. That implies we target a dividend yield of at least 2%, which is higher than the S&P 500 right now. But then we also don't want to go too high because then you get into a situation like AT&T. Not to beat a dead horse, but you had a great dividend there, but it just looked like it was going to be hard for them to continue to grow it due to their capex spending, a relatively low return on capital, and they just had a lot of debt. So using the back of the envelope concept on Clorox, if you start with their current dividend of $4.64, which is what they're currently paying, and at the current stock price, which is about $143 At the moment, that gives you a dividend yield of about 3.2%, which is which is very attractive in this in this environment. In order to get at least 50% growth over 10 years, that implies we need a $7 dividend 10 years from now. That's our goal. That's our hurdle rate. Then we start to go backwards, kind of what I'm going to call reverse engineer and we look at okay: "so how much does the company have to earn 10 years from now to pay that $7 dividend?" But one of the things I want to do first is give you just a little bit of background on Clorox. First of all the brands, pretty much everybody has heard of Clorox bleach, that's been their main product since 1913, when the company was- first came into existence. Well, they own Clorox wipes. They own Kingsford, the charcoal. They own glad trash bags. They own Brita water filters, Pine Sol, Hidden Valley Ranch. Most of the brands that they own are leaders in their field. And one of the great things about Clorox is that it is a dividend aristocrat, which is a company that's raised its dividend for at least 25 years. So what would be one of the first things you would want to look at if you want dividend growth over at least the next decade? Well, where I would start is first of all, you're going to have to have some revenue growth. So one of the things, let's just look at Clorox, and you look at their revenue over the last several decades, going all the way back to 1984, they had a little over- just slightly over $1 billion in revenue. You go out to 1991, they had about 1.7 billion in revenue. 2001, 3.9 billion, and not to bore you here, but just ending last year, they had slightly more than $7 billion. So they had decades where they grew 7%, 8%, 3%, a year as far as their revenue growth. So then the question becomes, you know, what's the probability that I'm going to get revenue growth in the future? You know, what's my risk here? Has something changed? Well, when you've got brands that are as strong as what Clorox has, it becomes what I'm going to call a GDP plus company. And what that means is, they're probably going to grow by at least what GDP grows, you've probably got a minimum of 3% a year plus some inflation. So you know, they don't have to sell too much more, they just have to get the rate of inflation, which is probably going to run by two or 3% for the next decade. When you go to the grocery store, do you think one year from now there's going to be a price cut on Clorox bleach, or glad trash bags are Kingsford charcoal? You're probably going to pay more. And when you've got major brands, prices just continue to climb higher. And the other great thing is the brands that Clorox owns, they've been market leaders for years, so there's probably not an immediate threat to any of their brands. And one thing I can tell you is that two years ago, when this whole pandemic started, people wanted Clorox wipes. And if you're looking at your health, you probably don't want to save a few dollars. The brand names tend to be associated with higher quality. And I'm going to give you another quick example- Kingsford charcoal. You know, it's been a while personally, since I've used a barbecue with actual charcoal. But one thing I can tell you is, in my past experience, when you buy cheaper charcoal, it just tends to not light as well and burn as evenly. So brands have their premium pricing for a reason. Now, another thing that you probably want is a company that's profitable. And not only just profitable, but they earn more than what their cost of capital is. And just as a quick side note to cost of capital, the basic definition of it is their interest rates on their bonds, or bank debt and their stock. And what that means is, the long term return of the stock market is around 10% when you go back 100 years. What you really want to see, or what you like to see, is a company that earns more than at least 10% on their asset base, because that means they're earning more than their debt and also just the value of what the stock market goes up. So if a company earns 20%, which happens to be about what Clorox has returned has been for the last 20 years on their balance sheet. If you're earning 20% plus, if you hold that company long enough, and they don't do something stupid like a crazy acquisition where they spend a huge premium for something, and they don't start to dilute their profitability, you're going to build shareholder wealth. And that's why you see a lot of these somewhat boring companies that have great returns, just because of the compounding of their balance sheet. So now let's go back to that back of the envelope of Clorox and what needs to happen to get that dividend at least up to $7 in the next 10 years. And this is looking- now we're reverse engineering here- if we take the current revenue of about 7 billion, and let's just say you grow that at 4% for the next 10 years, that means you're going to have $9.5 billion of revenue 10 years from now. I think as we mentioned earlier, I mean, that's a reasonable expectation. That's a number that they could potentially hit. They've managed their expenses well, they've been very consistent in it, and the numbers have been very stable for the last several decades. If the revenue grows to 9.5 billion, and at least 13% of that ends up on their net profit line, which is what it's been in the past, that means 13% of 9.5 billion is $1.2 billion. Divided by their shares outstanding, and there you have $10 of earnings. $10 is a bigger number than seven, at least last I checked. Well, why has Clorox become an attractive investment here, just in the last week or so? Well, it just seems to be a real challenge to find attractive prices, when you've got a stock market that has performed so well in the last several years. So usually, you have to find something that hasn't gone quite right to bring the price down. And that is Clorox's a story, because the stock has declined a little more than 20% just in the last few weeks. And it's kind of fascinating, and I think this is what makes this one really, really attractive is the assumptions are just very basic as far as what we need for this situation to improve again. But let me just give you a quick overview of what happened recently to Clorox. Clorox was one of the big beneficiaries of the recent pandemic. And it's kind of obvious one of the one of the products they have is Clorox wipes. Well, in a space of about two or three weeks, literally, their sales volume just exploded. Well, the good news for Clorox, but short term, it's a negative right now, they sort of knew that well not everybody was going to stockpile Clorox wipes for the rest of their lifetime. And it was probably somewhat of a short term situation, and they would at some point, probably normalize. So instead of going out and buying another manufacturing plant, or building another one, they went to third parties to increase production for their wipes. Well, when you do that, your cost structure is higher, but it's variable, and at some point, you can pull it back which is what's happening right now. So they have higher expenses over the short term. But as they go back to more of a normal environment, over the next probably 12 to 24 months, their expenses should get back into line. Well right now in the last quarter, they announced gross margin, it had declined to 33%, which has been very consistent over the last 20 years, it's been about 44%. But you've got a simple solution to the problem- part of the problem to get it back to the norm. They're going to end probably here in the next 12 months, most if not all of these third party arrangements and go back to their manufacturing process themselves. The second part of the equation here, and a lot of companies are struggling with this right now, inflation has really taken off, and commodity prices have moved up dramatically. And it's just taken them a little more time to adjust pricing to get back to a point where their profit margins are stable. But in the next 12 to 24 months, they've got pricing power, they've had it for really the entire existence of the company, and they're in the process of raising their prices back up. And the company is actually stated that they expect their gross margins to return to 44% within the next 24 months, and then you'll have earnings back to normal, you'll be on the track of getting that dividend of at least 50% growth over the next 10 years. We have a catalyst, it's created an opportunity for us to buy it at a reasonable price. We've got a good dividend, 3.2% is about two and a half times what the S&P 500 yields right now. So that's our starting point and we can see where that dividend is probably going to be up 50% in the next 10 years. But one of the things that you have to keep in mind, and I think this is one reason why a lot of people don't succeed at this long term, is it takes discipline. And one of the things that very well may happen is Clorox may only raise their dividend by one cent here in the next 12 months. These companies that have long term track records of dividend growth, they don't want to interrupt that because then they have to start all over on the 25 year timeline. So they may just raise it one penny in the next year to continue to have that track record of dividend growth. But what you'll see probably happen, is over the next two or three years, then you'll get a big catch up to where they go back to that normal. Usually they pay about 65% of their profits in dividends. And if they earn $10, that dividend is probably going to be, you know, right around $7 when you look at 10 years from now, or possibly higher. They've got a lot of levers that they can pull, they can buy back shares, they can pay down debt, they can make acquisitions, there's just a lot of ways that they can get growth. You know, Morningstar has them rated as a wide moat company. That's what you really want to see, and they go as far as to say that they expect for the next 10 years that Clorox's return on their invested capital basically return on their balance sheet, they'll average 32%. So if these guys earn 32% on their capital over the next 10 years, and they're disciplined, and they don't do anything stupid, then this is just a great candidate for not only dividend growth, but you're going to have a great stock return also. Now, I do want to say, you know, we are currently buying this, we are- it is one of our positions that we're putting in our portfolios. But you have to remember that this is one of several positions. You know, this is not a recommendation that you should go out and put all your money in Clorox. Part of this is just to help to give you a feel of okay: "how do I actually apply this concept?" And it takes years for this strategy to really work well.

Greg Denewiler  26:40  
If you enjoyed today's podcast, please leave us a review and follow us on LinkedIn, Instagram, and Facebook. If you would like more information regarding dividend growth, or just our style of investing, go to There you will find some of our previous podcasts and also our monthly newsletter. If you have any questions or anything to add regarding today's podcast, email Past performance does not guarantee future results. Each investor should consider whether a strategy is right for them and all the risk involved. Dividend Stocks are volatile and can lose money.