The Dilemma With Slow Growth

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Constructing an attractive yet sustainable dividend growth portfolio is no easy feat, especially one that meets your expectations. As much as you try, you will eventually invest in a company whose dividend growth rate doesn't meet your expectations. For us, we want to attain a dividend growth rate of at least 6% a year on average, and ideally faster than that. Every investor needs a process for evaluating whether a company is a net positive on their portfolio, or if it’s weighing it down. 

But it’s not black and white. If the dividend growth hasn’t been there, but the stock price has done well and you've owned it for a long time, reaching a decision can be complicated. The dilemma is: do you sell the company and move on, or can you see a clear path for the company to get back on track? 

For our 17th episode, Greg looks at Emerson Electric (EMR), a company we have owned for over 10 years. While the stock has returned over 150%, the dividend growth rate has not met our expectations. Faced with the dilemma of selling the company, he takes you through our process of how we figure out what to expect going forward. Later he contrasts this story with Hanes Brands, a company that we eventually sold.

Within the show, we use a simple dividend growth model as a starting point. If you would like to follow along, it is linked below:

EMR Simple Dividend Growth Model

Notes & Resources:

DCM Investment Reports & Models

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Transcript

00:22 Greg Denewiler

This is Greg Denewiler, and you are 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.

Welcome to the 17th episode of the Dividend Mailbox. In this episode, we're going to go through a dilemma, and it's one of our positions that we currently own, and we've owned it for a long time. So, the dilemma becomes what happens when things aren't going quite as planned. And then we're going to look at one that we actually sold. You know, they're all different. The situations are constantly evolving. There's no clear answer, right or wrong, just to exactly how you deal with something. So, what I hope you get from this episode is just a look into our process, and how we evaluate whether a company is still a potential candidate as a dividend growth story that meets our hurdle rate. Or at what point is it just time to let it go?

So now to our dilemma. In June of 2012, we purchased Emerson Electric, and we bought it at $44.64. This is a position that actually went into our model portfolio, one that we've brought up in the past, it is a live portfolio. It clicked all the boxes back then, or as much as any stock potentially can. Emerson Electric, if you don't know what it is, it's not a real common name, but it's a company that's been around for more than a hundred years. It is a Dividend Aristocrat. In fact, it's a Dividend King, which means it's grown its dividend by at least 50 years. And in this case, Emerson has had dividend increases for over 60 years. So at first glance, it fits the profile of a dividend grower. It had management that had proven they could maintain profitability and for the previous few decades, they grew the dividend by 8% a year. 

Emerson is an industrial conglomerate. They have a portfolio of services and products that largely consist of measurement equipment, process, monitors, automation software. They have manufactured valves that control or measure pipeline flows. They've concentrated in the oil and gas, power, renewable, chemical, commercial, and residential spaces. They also, up until just recently, they owned InSinkErator, which is a pretty popular garbage disposal, but they've just divested that. We like to try to keep the portfolios diversified as much as we can, having presence in the major sectors, so it checked the industrial box. Since we've owned Emerson in the last 10 years, the company has struggled with growth. So they started to look at ways where they could kind of reinvent themselves to become a little bit more of a growth story going forward. They've divested some businesses, they've made some acquisitions, and what they're focusing on now is industrial data collection automation- more of a software or high-tech-oriented company, which they hope is going to give them a higher growth rate. 

So now let's go back to kind of the story here and our dilemma. We purchased the stock at $44, and now it's at $95. So the stock has actually performed relatively well. It's doubled and the dividend has grown. It has brought our total return on our original purchase. Up to a little over 150%. So, you may be thinking, well, that doesn't sound like much of a dilemma to me. Well, going back to what we do and what we tell clients we do, and the whole purpose of this podcast, what we are about is dividend growth. In 2012, when we bought this, the dividend yield was 3.6%, so that was pretty attractive.

If you go back to the decade before that from 2002, the dividend had grown by 7.7% a year. You go back to the decade of ‘92 to ‘02, the dividend had grown by 8.10% per year. When we first went into the stock, our target rate was pretty much there. But you know, that has changed. If you look at the dividend growth rate over the last 10 years, Emerson's dividend was $1.60. Currently, it's $2.08. It's only grown by 2.5% a year. Going forward, we don't want another decade of 2.5% dividend growth. That's not our hurdle rate. And then you may remember that the dividend growth rate of the S&P 500, long term, has been 6% per year. So we want to at least have a target to match that. We really want a dividend growth rate that's a little bit higher than that, and we don't want a company that potentially, you know, that's all it can deliver. We have to figure out, you know, what can we reasonably expect going forward. So now we have to decide, is this a company that is going to continue to give us dividend growth? Or maybe a better way to put it is, is it going to resume the dividend growth that we thought we were going to get when we first bought it? We have a dilemma of: do we continue to hold it or do we look to move into something else? 

So now we have to go back and look and say, okay, what was the cause and what potentially is going to help get this company back on track. And one of the things that you look at to see if there's a problem potentially going forward is the dividend payout ratio. And historically, they have averaged about 50% since 1990. And currently the dividend payout ratio is 51%. If you, uh, don't recall, if company earns a dollar and they pay out 50 cents, then they have a 50% payout. So right now, the payout ratio is basically within the norm, so, we don't really need anything to change much there. Just to kind of give you a perspective, the payout ratio of the S&P 500 is 30%, so it is lower, but you have to remember a lot of those companies are either higher growth or some of them don't even pay dividends, so that pulls down the average. But you can't just take one number. You have to take the individual company and look at what it's historically done and what you think it's going to do in the future, and every situation has a little bit different twist to it. In regard to Emerson, they're basically about where they've been for the last several decades, and more mature companies do tend to pay out a little bit more, so we don't really have a problem.

On the earnings per share front, where we're looking at earnings growth, ultimately you have to have earnings growth if you're going to get dividend growth, that's always the story. You know, these companies, we're not buying dividends, we're really buying earnings growth, and then they pay you a dividend. Well, in the last 10 years, earnings have grown by about 5% a year. In the last 37 years, they've grown by 6.1%. Earnings growth has slowed down, but this company's gone through two transitions where they really moved their portfolio around trying to get growth back into their portfolio, and it's to the point where since 2016, they have acquired 19 different businesses and sold off six different businesses. Some of the stuff that they have liquidated, or at least sold major portions of, represent a fairly substantial part of revenue. In some cases, 25% or more, and they've made another acquisition to replace it. So what they're trying to do now is to get their earnings rate up so that if they grow earnings by more than 5% a year and their payout ratio stays at roughly 50%, then that means their dividend is going to grow by more than 5% a year. So that's the target of what Emerson's trying to do as far as restructuring their portfolio. Because of all these acquisitions, debt to equity is on the high side. Right now, it's up to 110%, debt is a little bit more than what their equity is. Looking at the long-term average of 60%, at first glance, that looks like a possible warning flag. But since they do have some businesses that they're going to sell that have closed after the balance sheet of 9/30/2022, they're going to end up with net cash, and right now it's about 8 billion. And we just have to see what acquisitions they make going forward. It's yet to be determined how that number shakes out, but right now we're just on hold and we don't see a problem here.

The important thing, and especially for companies that are in transition as far as acquiring or selling off businesses, you have to look at the quality of earnings. Companies can grow earnings, but the big issue is how do they do it. What's the quality of those earnings? And in order to have sustainability, you don't want a company using a lot of financial engineering. You want good, solid, just organic earnings growth. So let's take a look at Emerson's earnings quality. In this case, operating profits since 1984 have averaged about 16% of revenue, and currently they're 16.9%, so the company is profitable and they don't really have an issue there. If you look at profitability from a standpoint of their asset base, return on invested capital since 1990 has averaged, not quite 14%, a little less than that. In the last 10 years, It's averaged 13.75%. Currently return on invested capital is 13% - down slightly, but on an incremental basis since 2005, return on invested capital has been not quite 13%. And a simple description for that, this gets kind of technical, but the short version is you've got the core business and then you've got what the business grows by and how many assets they have to put on the balance sheet to grow the business. So basically it's just that the growth part of the business has also earned roughly the same as what the core business has done. The incremental return on invested capital is a little bit lower than the long-term average or the current rate, but it's close enough. That's what we look for here. I have to say, management has been relatively disciplined in how they've allocated their resources. They've been able to maintain their profitability on their balance sheet, even in light of the transition that they've gone through, which is a really key point to get growth going forward, because you don't want your asset base to get diluted. 

Lik

So we've looked at the company. You know, they're profitable, they're maintaining a lot of the ratios that we've looked at. There's nothing that really sticks out that would indicate that, “Hey, we have an issue here. Can management fix this or are they addressing it?” Everything seems to be relatively in line here, but the dividend growth just hasn't been there.

So now we look at the quarter that was just released and the company has openly stated they're going to buy back roughly $2 billion worth of shares and they're going to pay out $1.2 billion in a dividend. Well, all we have to do simple math. If you use $90 a share, slightly below where it is, and you divide 2 billion by that, they can buy back about 22 million shares. They have 594 million shares out, so that would leave them with 572 million shares. So, at that point, if you divide $1.2 billion by the number of shares outstanding after the buybacks, that leaves you with a dividend of $2.10 cents based on the company's guidance. We already know that next year's dividend isn't going to grow much, probably only about one percent. We have a problem. Unfortunately, that keeps them on the dividend aristocrat list, but it doesn't give us the growth that we're looking for. You know, we're not going to own a stock just because it's on the dividend aristocrat list. So the dilemma is: is this company going to catch up and get back on at least a 5% dividend growth rate? And we really want it higher than that. And we don't really want to see this: if all of a sudden, they started dramatically raising the dividend, but they're using debt to do it, because that's not sustainable and that happens frequently.

One of the things that really helps to find out: “Okay, how much does this thing need to transition?” in order to get that into perspective and to see if they can give us the 10-year growth, we go back to our simple 10-year dividend growth model, where we look at the dividend growing over the next 10 years by 5, 6, 7%, and then that gives us an easy backdoor into what does earnings have to be to get us where we want to go. For those of you who want to see our 10-year simple dividend model, we have included it in the show notes, so it's a little easier to track. We take the current dividend and we grow it by an assumed growth rate. In this case, we're going to use 5%. And if you grow the dividend for Emerson Electric from $2.08, which is what they're currently paying, that means in 2032, this company needs to pay a dividend of $3.23 to get 5% growth. If you assume that happens - and one thing I want to say is that these numbers are not always smooth. They don't grow it at a consistent 5% a year because we already know that the dividend next year is pretty much not going to be $2.18s, which is 5% higher. But going back to our example, the dividend grows to $3.23. This gets to be actually relatively simple. If the dividend yield at that point, 10 years from now is 2.5%, that means the stock will be trading at $129. We do a simple total return, adding up all the dividends, and then the gain from $95 to $129, that is roughly a 65% return over 10 years. And that does not account compounding, but we want to just keep this simple. That number right there is not- does not meet our threshold of what we really want to see. Our real goal, our target on all of our investments, especially when we go in, and even in this case where we're looking at it for the next 10 years, our target return is a minimum of a 100%. Now you might say: “Well, okay, the current dividend yield on the company is 2.2%, so why do you use 2.5%? Well, we try to build in a little bit of margin of error. If you use 2.2%, it would actually give you an 80% return over that period of time. The expected return of what we want is still a little bit low. So we already pretty much know just based on what management has told us, that we're not going to get to the dividend growth that we want in 2023. We're really now out looking at 2024 to get them back on track. If you look at 2024, earnings estimates are $4.64. If they execute on their strategy and they get the growth they're looking for, and analysts are correct, and Emerson maintains a payout of 50%, then we've got a dividend that's up over $2.30. And that gets us back on track and we're still running at a 6% or more dividend growth.

And one thing you have to remember, companies tend to beat expectations. They tend to give you guidance that they eventually exceed, and the number tends to run at around 70%. So from quarter to quarter as companies announce, 70% of the time they beat expectations. Now it does get a little more complicated longer term. Analysts tend to overestimate on a longer-term basis. But companies guide analysts down so they can beat and look good later. If Emerson does that, we're in great shape. But our dilemma is: how long do we let this go? I think for us, what we're really going to be looking for is, these guys need to earn $4.64, and if they do, that means they've successfully transitioned the portfolio and quite likely are going to be back on track. 

From what I take from this and what I hope you get, number one, management matters. Ultimately, that's what you're investing in. It looks like management may be transitioning this company to a higher growth story, which is what gives us dividend growth. Number two, know your end result. You know, the reality is the stock has done reasonably well. But don't get caught up in the stock price. Focus on dividend growth, if in fact, that's what your main goal is long term. And finally, it's know the story and be patient. Everything has a hiccup. Things are constantly evolving. They virtually never play out in a quarter or two. Sometimes it takes a year, sometimes even longer than that. But if you have discipline and you have patience, it can work out. So, to wrap up the Emerson dilemma, we've waited 10 years and we have not gotten the dividend growth that we want. It's been way below target. From our total portfolio perspective, we have actually exceeded our goal by a few percent, but Emerson has been one of the ones that has been dragging it. We think it has the probability of getting back on track, but it's going to come down to management executing on what they've done here recently, and we're really going to be paying attention to 2024 when the earnings estimates are up where they need to be. Can they actually come through? If the dividend growth is not there, we need to sell it and move on.

So you may be thinking you never sell anything. Well, what I'm going to do now is tell you about a company that we did sell and we sold it last year. In 2005, which was actually before I had officially started doing a dividend strategy, I bought Sara Lee. It was a good dividend story at that point, and the reason I purchased it was really off of a CEO that they brought in to try to turn the company around. It was Brenda Barnes. She was an executive out of PepsiCo and she had a strong reputation for being able to go in and execute. So, it was a company that I thought it was relatively cheap, it was a dividend payer, and It looked like a great opportunity. But then in September of 2006, Sara Lee spins off Hanes Brands.

Well, I acquired shares of Hanes Brands and the stock starts trading around $5, but it doesn't pay a dividend. However, the stock is performing well, and actually over the next few years, it's on its way to- it ended up over $30. But I originally held the stock because it was a spinoff and it was performing well.

One of the things that is not uncommon is these spinoffs, once they get their own dedicated management, they get potentially more access to capital when they're on their own. They just have a lot more options where they're able to move around and sometimes these things, they perform really well. Hanes brands fit into that category.

So my new company, if you look at 2007, the earnings were $0.48, and by 2017 they had grown to $1.60. So, I'm sitting on a position that I inherited, and these guys are growing relatively rapidly. Revenue in 2007 goes from $4.25 billion to $7 billion by 2019. In 2013, they start paying a $0.20 dividend, and by 2017 the dividend was up to $0.60. That's a triple in four years. They were growing it extremely fast, and at that point, they had a dividend yield of about 3%. Just from that observation, this is looking like a great dividend story. That's not how it continues. 

So everything in the first decade that I own this stock, it's doing well. But then we get to 2019 and things start to change. Earnings peak in 2017 at a $1.60, but as we continue on in, in 2019, revenue peaked at $7 billion. Well, between 2017 and 2019, the underlying business is just not doing quite as well even though revenue continues to grow for another few years, and I'm trying to figure out what's going on with this company. Why have things started to slow down? It was becoming obvious that the story was changing. They had a line champion that Target stopped carrying, but then they were making some acquisitions. They were going into - actually they did something over in Europe and Australia. But the thing that was even more challenging is through all this, revenue's not really changing much, they're putting debt on, inventories are bouncing around. Even as a CFA, which doesn't guarantee anything, it was really getting difficult to track what was causing what or where the real issue was. So that became the big red flag. This is something that when you're looking for dividend growth, you want predictability, and it was not in this story.

By 2021, revenue had actually declined a little bit, it was down to 6.6 billion. That was in light of the fact that the company was out making acquisitions. It just didn't seem to translate down to earnings because earnings had peaked at $1.60 in 2017. In 2013, their debt to equity was about 1.7 times. By the time 2021 rolled around debt had increased over six times equity. Again, they weren't getting revenue growth to benefit from it. I'm really starting to question, “is this a sustainable dividend?” To make the story a little bit more complicated, return on invested capital, which is a number I use a lot - in 2013, the company had about a 9% return. In 2020, they were still holding it around 9%. So the business was profitable, but the story just wasn't all adding up. It became very clear that the dividend was at the very best, they were just going to maintain the dividend. Where it was going to grow from was not clear at all. Just didn't see it here, didn't feel comfortable holding it anymore. Definitely better places where we could put the money where we feel like we had predictability. 

By 2021, the stock started to, uh, started to flounder. The stock was trading around $20. It had come down somewhat, and with the 60-cent dividend, that was a dividend yield of 3%. I'm looking at it thinking: “okay, it's got an attractive yield, but I want dividend growth and it's not here.” So, in February 2021, I decided to sell the stock. It was trading at around $19. Really, the biggest motivation was I just didn't have good clarity going forward.

And here I would just emphasize that the difference between something like this and an Emerson, Emerson's got a lot of pieces of the puzzle that all fit together. It's just that management needs to execute. We do see a path toward dividend growth. Well, in Hanes, the promises kind of kept coming, and the execution never showed up. The proof is, and trust me, this is far from a perfect science, but in this case, it's a good thing I sold it because now the stock is down around $8. After 2017, the dividend was never increased again, but they still are paying that 60-cent dividend. So, this thing has become a very high-yielding company, but I would not buy Hanes now expecting to get 8% going forward. 

So to wrap up the podcast, Emerson is a story that has a dividend, they've been growing it but didn't meet the expectations. But we have tightened up our timeline as far as how much leeway are we willing to give these guys to make this a successful piece of our portfolio. 

You know, selling… another thing that's tough to do, especially when the stocks do go up and you've owned a company for a long time, for a decade or more, in one small way it sort of becomes part of your identity. Sort of like watching your kid grow up. You watch these companies grow their dividends, grow earnings, and you look on your statement and you see a value that's 2, 3, 4, and you hope you get to a point where it's 10 times what it was. It's kind of like a kid that grows into an adult. It's hard to get rid of a kid, but every story eventually changes. You always have to stay rational about these things. In order to grow wealth, we need cash flow, and we want that cash flow to grow. So, if you have one that's not working and you don't have clarity, there is a time when you have to sell one and move on to something else.

If you enjoy 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 growmydollar.com. 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 ethan@growmydollar.com. 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.