A Dividend Growth Buy, Watch, and Sell

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In today's episode, Greg dives into a practical application of our dividend growth strategy by discussing a recent buy, a watch, and a sell. 

He starts the episode with Hershey (HSY), exploring why this classic chocolate maker made it into our portfolio despite soaring cocoa prices. Although it may sound like a boring name,  companies like this can generate outsized long-term returns. 

For the watch candidate, Greg turns his attention to CVS Health (CVS). Despite its financial strength and attractive valuation, he discusses CVS's coming headwinds. Sometimes when there is a lot of negative sentiment surrounding a company, there is potential to make a lot of money. 

Lastly, Greg explains his decision to trim our position in Emerson Electric (EMR). Even though it is a long-time dividend growth stalwart and has seen strong price performance recently, it no longer meets our dividend growth criteria.

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Transcript

Greg 00:11

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 35 of the Dividend Mailbox, and today I think it's a little bit of a treat, but of course, my perspective is: “Drank the entire Kool-Aid of the dividend growth story.” But since I know some of you are probably looking for ideas, and I'll listen to a few podcasts myself — you're always looking for things that maybe you didn't recognize or that you weren't aware of — what we're going to do is go through a buy, a watch, and a sell. So, in one episode I hope that you can see, ““Okay, how in each situation do we apply what we're trying to achieve here, how it impacts our decision of why we buy something or hold something or sell something.”

So we do have a new buy, it is a position that we took a few weeks ago. As is usually the case, we started with a half position. We'll see if we're going to repeat our Williams Sonoma mistake because the stock has already moved, but we started buying Hershey. This was brought to our attention. I hadn't looked at it in a few years. The stock usually trades at a fairly substantial premium to the S&P 500, partly because consistent predictable earnings growers tend to trade at premiums. Just a year ago, in 2023, the stock had a high of $276. Since then, Cocoa prices have spiked dramatically. They were up somewhat last year, but they really took a big move up at the beginning of this year. They actually moved a little above 10, 000 per ton, which is more than double where they normally trade. Obviously, one of the big ingredients that Hershey uses for their chocolate is cocoa, so, there's a real fear there that Hershey's going to have a real problem with the cost of goods sold. Therefore, the stock really has started to come down and we took our position at just under $185 a share. 

It's a dividend grower, as you're going to see, it's got very predictable earnings, and the company is just extremely well managed. It may sound like kind of a boring name. In the last five years, they've grown sales by 5. 5% a year. Your first reaction may be, “Well, I'm looking for more growth than that,” but these boring cash flow companies can create some outsized returns. 

Well, let's first start with simple valuations. We paid, we're just going to call it 185, so all of these numbers are based on that stock price, although it has moved back up to about $200 now. The 10-year average P/E ratio on Hershey is 28x. As I mentioned at the beginning, it does trade at a premium to the market. The P/E at $185 was 21x, so we were able to buy it at a market multiple. The average price-to-sales ratio was 3.5x. Currently, that number is still 3.5x. The average price-to-free-cash-flow in the last 10 years is 26x, right now it's 25x, and the average price-to-book in the last 10 years is 18x, right now it's down to 9x. One of the reasons why you might ask, “Well, why has price-to-sales or price-to-free cash flow not changed that much recently?” Well, it's because they've made some acquisitions of about a billion and a half, which is a little above their normal pace, so their capital structure has changed. But anyway, I'm going to go through the reasons why we took a position in it. 

First, it's probably going to be a little surprising just how big a portfolio Hershey has. Everybody knows the Hershey candy bar, and you're probably well aware of Hershey Kisses, but, they also make Heath, Ice Breakers, Good and Plenty, Skinny Pop (which is an acquisition they made just in the last few years), Twizzlers, Whoppers, Payday, York, Almond Joy (one of my favorites growing up), Milk Duds, Breath Savers, Bubble Yum, and Cadbury (that's a fairly significant name). Another big one is Reese's, that's one of the more popular brands out there. Pirate's Booty is one that they bought recently. I mean, the list really goes on and on. They have close to a hundred brands in total. It does give you some real confidence when you can say, “Look, these brands 10 years from now, there's going to be some competition out there and there can be companies that come in and take market share, maybe a few of them are not the number one brand anymore, but overall, this is a business that isn't going to change much.” That is one reason why it's been around for almost a century and why 10 years from now, you don't have to worry about technology or AI or what may or may not happen. People are still going to eat chocolate and it's got a nice consistent revenue base.

As a rule, we tend to be a little leery of companies that do a lot of acquisitions, which is something that Hershey's has done over the years. Historically they have acquired a lot of these different brands. In fact, a lot of them that I named don't have Hershey in the name because Hershey didn't come up with the product. These are all brands that were created by somebody else that they purchased. Just last year, they bought Skinny Pop. They paid $165 million for it in 2021. They bought Pretzels Inc., Dot’s pretzels, and Lily's Sweets, which is another chocolate brand. For all of those acquisitions together they spent about a billion and a half dollars. But here is how we judge whether they've managed these acquisitions well and it is return on invested capital. The really short conclusion here is going all the way back to 2006 return on invested capital has run close to 20%. In fact, they've actually grown it slightly into 2023. It was actually up to 22%, but it runs relatively consistent. As a rule, when you're able to earn more than 10% long-term on your capital, you tend to be growing shareholder equity. Another big piece is we look at the incremental gain on return on invested capital. The simple explanation for that is: What is the size of assets they've acquired and has operating income grown by at least that amount? In this case, the incremental return on invested capital is 23%. So, they've been able to reinvest it and they've integrated relatively well. We're not really too worried about a big risk that they dilute the company over time because they just haven't done it historically. 

So, looking at revenue, historically they've grown fairly consistently. In the last 10 years, it has grown from $7.4 billion to $11.1 billion. That's up 50%, and in the last 20 years, revenue is up slightly over 150%. 

Earnings per share were $2.24 20 years ago. 10 years ago, they were up to $3.77, and now at the conclusion of 2023, they're at $9.06. So, earnings have grown by 140% in the last 10 years. 

Now, the piece that we're really interested in is the dividend was $0.84 20 years ago, $2.04 10 years ago, and currently, it's at a rate of $5.48. So that represents dividend growth of almost 10.5% per year for the last 10 years. We'll look at our 10 year simple dividend model here in a little bit, but you may remember if you've listened to very many of these at all, our target is 7.2% dividend growth over a 10 year period— which means it doubles. In the past, they've done this relatively easily. Over a decade, Hershey's dividend has grown by 170%. They have well surpassed our hurdle rate there.

 Another gauge of “Okay, is the company at a position right now where they've been a little bit more aggressive?” They've had some pretty good dividend increases. The dividend has grown at a fairly aggressive pace. Well, the payout ratio has remained relatively consistent. In fact, 20 years ago it was 75%, 10 years ago it was 48%, and currently, it's 48%. So, they basically pay out half of their profits to shareholders in a dividend. 

If you look at pre-tax income minus capital expenditures and the dividend that is paid out, the free cash flow that's left, they've grown it from 1 billion dollars of free cash flow after the dividend in 2011 up to now they're at 2 billion dollars. So, even including the $890 million dividend payout and CapEx of $770 million, they still have free cash flow of $2 billion. If you just think about the simple concept that once you develop a brand, you don't really have to put a whole lot of money into it, I think it's pretty easy to assume that this is a sustainable dividend grower. 

So going on to margins. Their gross profit margins, they've done a really good job of managing those. The 20 year average is 42%, the 10 year average is 45%, and currently, they're at 45%. So, they've actually grown their gross margin slightly. I have to tell you, currently, with their cost of goods sold, and cocoa prices spiking as dramatically as they have, the fact that they're holding margins is a pretty strong, I think, statement in and of itself. They've got long-term contracts with their suppliers set up. They've done some hedging, but mainly, they manage their suppliers well so that they have some protection against this. 

Now moving on to debt, this is a huge factor. We've had some strong dividend growth and earnings growth in the last 10 years, faster than what revenue has grown by. One of the red flags you look for is: Are they using financial engineering to get much faster earnings growth? Well, in this case, the answer is no. 20 years ago, debt was about 1.2x equity. 10 years ago, it had increased a little bit to 1.5x. Currently, they have their debt-to-equity ratio back down to 1. 2x. So, the key point here is— I think it says a lot for the discipline of management— is that they've been able to make a lot of acquisitions in the past and they've done it without increasing leverage and keeping the balance sheet at the same level of risk for the last several decades. This is one point that a lot of companies struggle with. They use leverage, and they tend to leverage it up because that can impact their returns in the short term. But debt we're not worried about because they generate plenty of cash flow. As long as a company uses discipline, a little debt is not necessarily a negative. It can even be a positive.

When you look at the shares outstanding, they've actually reduced those too. In the last 20 years, they reduced their shares outstanding by about 20%, and in the last 10 years, the shares outstanding have declined by 10%. That's not a big number, but I actually view this as a positive because normally the stock trades at a premium to the market and it's usually not that cheap. So they do buy some stock back, but they don't aggressively go in and overpay for it. 

So just a quick summary here, because I'm throwing a lot of numbers out there. They've just managed their balance sheet well, debt has declined versus equity, their profit margins have remained consistent or actually improved slightly, they have attractive returns, and they don't really use financial engineering in their balance sheet. It's just very consistent and predictable, and that flows into a fairly aggressive dividend strategy. At first look, you might consider it as a boring company, but of course, it really is anything but that. 

Now we're going to turn to what some of those numbers actually look like and how it's actually performed. So, one of the things that I think is kind of fun is, let's just say that you're an older person— not that I am, I just had my 25th birthday last week. If you had put $500 into Hershey on May 1st, 1975, as of May 6th, that $500 would have grown to $302,000. I think it's kind of hard to wrap your head around this, especially when you're thinking about Hershey's chocolate bars, but you would now own 1,530 shares. With the $5.48 dividend, you would now be getting $8,384 a year in dividends. So, if you graduated in 1975 and you just would have convinced somebody to give you $500 of Hershey stock and you didn't touch it, it starts to fund a little piece of your retirement. Its more than what a lot of people have, more than what most of the country retires on in just that alone. Well, bringing it a little closer to home, if you would have put $10,000 in Hershey's in 1989, currently, you'd have $523,000 vs. $305,000 in the S&P 500. That's on a total return basis. You came close to doubling what the overall market has done, and you have to think back to what I mentioned earlier, the stock has come down from $275. So it's well off of its high, right now it's right around $200. Just on a price basis alone, taking the dividend out— which a lot of times is part of the game changer on these dividend stories— if you put 10, 000 into Hershey in May of 2008, it's now worth $51,000 and the S&P 500 on just a price basis is worth $36,000. So it's clear in the long-term performance since 1975 and 1989 that the dividend plays a significant factor in total return. But even just looking at 2008 moving forward, just on a price basis alone, it is still beat the S&P 500. I think one of the big challenges with dividend growth investing is people tend to say, “Well, I don't want to wait two or three decades to get a nice total return. I want something that's going to move in a shorter period of time.” Well, Hershey has shown that it has the capability of doing that. 

It is not a dividend aristocrat because even though this thing has paid a dividend going all the way back to 1986, from September of 2007 to December of 2009, they actually left the dividend at, not quite 30 cents on a quarterly basis. So, they lost their dividend aristocrat status, but in the end, just because a company is a dividend aristocrat, in and of itself, doesn't guarantee you anything. This is the kind of company that we look for if we can buy it at a reasonable price. 

So now we're going to go to our infamous 10-year simple dividend model, where we kind of reverse engineer. If we start this year at $5.48 and we take 7% dividend growth, that would imply that we have to get to $10.07 in 2033 to have 7% dividend growth over that period of time. If you look at the current earnings estimates, they are $10 for next year. Of course, they're not going to pay out a hundred percent, but they've already met that. They could theoretically already pay that dividend out just in the next year. So I think it's a very attainable goal, and if you look at a 3% dividend yield in 10 years, out in 2033, if the dividend is in fact $10, that would put the stock at $335. That is a total return, not counting reinvestment of dividends, of 115% over 10 years. On the simple metrics, I think our simple little dividend model becomes extremely realistic, especially when you account that they've grown the dividend much more aggressively than that. Actually, if you look at ValueLine, they do an estimated dividend growth rate— they look at sales, earnings, dividends— They've got an estimated dividend growth rate going out to 2028 of 7% for earnings, and actually 11% for dividends. So we've got some pretty good margin of error. 

We're looking at a company that doesn't seem to have a lot of pizazz to it, but let's look at this in another way of a potential upside surprise. If we actually have a $10 dividend in 2033, and they're paying out 50%, that's a $20 earnings number. If they go back to really what their long-term premium has been, and they have a PE of 28x, if you take a price-earnings ratio of 28x times $20 of earnings, you've now got a stock trading at $560. You've captured $75 of dividends that you add to the price of $560, and you're now up to well over $600, and you've got $200 in it. 

Well, here's another thing that we've started to do— it's our recession scenario. Just because this is how it happened in the past, doesn't guarantee anything in the future, but, history has a way of repeating itself on some level. If you go back to the recession of ‘73 to ‘75, Hershey actually went up 3%. If you look at January ‘80 to July ‘80, Hershey declined by 1%. July of ‘81 to November ‘82, the stock actually went up 35%. July ‘90 to ‘91, the stock went up 6.4%. In March of ‘01 to November ‘01—  you may be able to start to remember some of these numbers where the S&P 500 was down almost 50%— Hershey actually went up 12%. If you've been around very long at all, you definitely remember December ‘07 to June ‘09, and Hershey declined only by 10%. Finally, in February of ‘20 to April ‘20, those few months where the whole world literally fell apart, fortunately, consumption of chocolate apparently was not too affected because the stock only declined by 15%. It's got a pretty good track record of protecting capital through down markets. Even when the economy gets hit, people want to treat themselves on some level. It's just more evidence that this is a fairly predictable company. 

So finally, in concluding with Hershey, you do have a lot of margin of error here. However, the company has openly stated they are changing an inventory management program that they have. They did do a little pre-selling into the marketplace to stock up with their end users and they are expecting a little bit of a dip in sales going forward in the short term. I mean, that's out in the marketplace, it's public knowledge. So, in these companies where they're fairly consistent, you look for some bump in the road that'll make the stock a little bit more attractive. On one level, I hope the stock comes back down. We're not really interested in chasing it right now, but we definitely want to accumulate more. Or the other way you can get a good value is if earnings continue to grow, but the stock doesn't move. That creates a better value, but we do try to use discipline on our price entry because in the end, price is going to be part of the return. You're not going to make it all on the dividend. 

So that's our perspective on Hershey, but now we're going to move on to a company that we are watching. This one is an interesting story, because first of all, at the beginning of the year ValueLine had this rated as a number one for timeliness, and at that point, this stock was trading at $79, and now it's down to $56. It's CVS Health and I've seen it recommended several times. ValueLine, as I said, had it rated a timeliness of a one. They had it at a safety rating of two. The company's financial strength was an A, and they've actually got the stock's price stability rated at a 90 out of 100. They actually had a pretty strong opinion on it, but if you've followed it at all, you know that they've had a couple of big disappointments. In their last earnings report last week, the stock got hit hard again and brought it all the way down into the mid-50s. Well, what makes this a watch for us is there is some pretty good financial strength there and it's trading extremely cheap. The earnings estimates for this year are $7, so one of the things you may be asking is, “Okay, why is the stock trading at about eight times earnings?” Usually, you don't get anything that cheap unless there's a real problem. 

Well, they really have three problems, CVS operates in three major markets. They are the stores that are similar to Walgreens, you've probably seen one because they've got over 9,000 of them. They also have a pharmacy benefit manager where they fill and manage over 5 billion prescriptions a year. And then the third piece of their business is insurance. They focus in the Medicare and Medicaid supplemental insurance space. This has been where they've had an issue. The government, in its effort to try to save money— one of the big targets because it's a huge part of our economy— they've been cutting how they reimburse Medicare and Medicaid. So it's cut into the growth of their business. The reason why we have it on a watch and we're not buying it is because one of the things that we really try to look at is, “Okay, five years from now, what is this business going to look like? When you're not sure of how the government is going to reimburse in the future, and then you have a question mark on how well their stores are performing because they have had some issues there, and then on top of that, these pharmacy benefits, there's a lot of pressure on trying to cut drug pricing— I will admit, we don't know the story well enough to really have a good handle on that. But apparently neither does ValueLine or pretty much anybody else out there because that's why the stock's trading at eight times earnings. There's a lot of unknowns. 

I will tell you one of the positives is it's probably not going to be a disaster because I don't think there's too much of a long-term liability piece to their insurance business, which basically means life insurance, or like long-term care, where they get trapped into something for just a multiple of years and they can't really reprice it.

But anyway, you know, finally, I would say the other reason why we're going to be hesitant to do anything on this is their return on invested capital is below 10% and it's basically stayed down there sfr most of the last decade. Right now they're earning like 5.7%, which barely earns their cost of capital, like on their debt and their equity. It really should be up closer to 10%. Long-term that does tend to help you create shareholder value when they earn more than their cost of capital. That's a red flag there.

But I will tell you that the positive to this and why we're even mentioning it is CVS has been a good dividend growth story. They did pause the dividend for a few years back in 2017 to 2021, but they have since grown the dividend fairly aggressively again. It was $2.05 in 2021, and now they're up to $2.66, but because the stock has declined so much, now, the dividend yield is up to almost 5%. With a $2.60 dividend and you have earnings estimates this year of $7 and next year they're $8, you could go all the way down to $5 and still have a 50% payout. So, the dividend appears to be probably safe, but normally we don't start a position at that yield. That higher dividend actually becomes a little bit of a red flag, and in CVS's story, there's several moving parts in here, and it's hard to figure out exactly what the company has control over, what they don't have control over, and what they may be able to do. But they have compounded the dividend at almost 10% a year for the last decade. So, it does meet that hurdle. One way to get on these— I'm going to go back and call them “boring dividend stories” where you can do really well— is when nobody has real confidence in the story. When a company has that much negative sentiment hanging over it, it can potentially be an opportunity to make a lot of money. So we are watching it because it does potentially fit the dividend growth, there’s value, and there's a little bit of a turnaround story in it. So we'll see what, we'll see what happens with CVS, 

Finally, we're going to move to the sell: it's Emerson Electric. We've owned it for more than a decade, but we decided to sell a third of it. This is one that we've actually mentioned in several podcasts in the past. We were questioning whether the dividend growth story is really there. We have even less faith now that the stock is going to continue to meet our dividend growth threshold. This is one where it gets a little more complicated because the stock has actually performed reasonably well recently and it's because they do have a growth component to the story. We just haven't been getting dividend growth out of it. They basically have just been bumping the dividend for the last several years by only a half or one cent a quarter on an annual basis. But when we originally bought it, it was a dividend grower and it was in the 6-7% category. This is actually one of the ones on the New York Stock Exchange, which has one of the longer records of dividend growth. This thing goes back about 60 years or more. So, the company has definitely been a dividend-oriented company. However, we're getting a hint that that's changing a little bit and I’ll just go through it real quick. 

Our 10 year dividend model for Emerson is actually on our website. We first put it together originally in 2021. We had said that this thing by 2031 has to get up to $3.20 to be at least a 6% dividend grower a year. We had a target for this year of $2.29, and for next year we needed to get up to $2.41. Well, here's where the challenge is. The company just made their quarterly announcement a few days ago. One of the reasons why we were a little nervous about it is in the past, they've sold some businesses off, and brought in some new ones. Margins have improved dramatically, but a big reason for that is they've just bought higher-margin businesses. They're focusing more on software, data management, their measurement systems, and software is just a higher margin business. So the fact their margins have improved doesn't say a whole lot yet. Their earnings estimates for ‘24 are $5.40 and they are paying $2.10 in dividends. So, their payout is down around 40%. They have room to bump this dividend, but the reason why we decided to sell a third of it is they made in their quarterly earnings presentation a few days ago, one of the things they put in there is that they plan to buy back about $500 million worth of stock and their target is to pay $1.2 billion of dividends. If you do a little bit of reverse engineering, in order for this thing to pay $2.40 in a dividend for next year, they have to pay out almost $1.4 billion to pay that dividend. However, they have paid $1.2 billion out for the last three years, and this year their target again is $1. 2 billion. So, you might be asking, well, “Okay, if they continue to pay out $1.2 billion for the last several years, how can the dividend have grown by half a cent per quarter?” Well, most all of the explanation for that is because they had 598 million shares out in 2020 and now they're down to 572 million shares out. They've been buying back stock. That is really the reason why the actual dividends per share have been growing slightly. They're buying back stock, but now they're starting to buy it at a much higher P/E because the stock has moved up. I have to wonder why, “Well, why not just bump the dividend? Why not pay $1.3 billion out? Just take a hundred million, bump the dividend up and keep this thing in the dividend growth category instead of just bumping it up by a half of one cent.” It is disappointing to us, especially when you see the fact that they do have the earnings, the cash flow, and they have the balance sheet to support a higher dividend. Why not put more of that to a dividend? Well, they've got a new CEO that came in a few years ago. It appears that he's more acquisition-oriented. He's trying to move this into a higher growth type of company. One of the big differences between a stock buyback and growing the dividend is, if you buy back the stock then they can turn around and reissue it if they go out and they want to do another acquisition. They don't have to totally issue debt. They can either use part of their cash or they can just use shares of Emerson Electric. If you pay a dividend, once that check clears the bank, it's gone. Shareholders have it, we want it so that we can use the cash flow to either reinvest or to live on. But for a company, they can use a stock buyback to manage its balance sheet and they can turn around and get access to it later on. 

Another thing that we see happening, and we mentioned this, acquisitions are a dangerous place to go. A lot of companies have trouble maintaining profitability. We just went through a big explanation of Hershey and how they've actually done a pretty good job with acquisitions. But one of our big models that we use to figure out how efficient they are is If you look at the return on invested capital for Emerson Electric, you go back a few years, they were up in the low to mid-teens. They've had a big restructuring in the last few years and right now their return on invested capital is down around 8%. It has come down and part of that is just because of the dilution. They issued some debt and they issued stock, but they turned around and bought it back aggressively last year. All of that costs money. 

So just a quick summary, the stock is up, the stock has just hit a new all-time high, and we sold a third of it a few days ago, a few dollars lower. But you know, with a dividend below 2%, this is a great example of how to manage your cashflow. We can turn around and take that money that we sold and turn around and buy a 3% yielding stock, which we bought Hershey a few weeks ago at a yield of 3%. That really makes it easier to grow our income by at least 7% a year. It's one of the levers that we've mentioned in the past that we can pull and this is what we're doing with Emerson. Then finally, you might ask, “Well, why don't you just sell it all?” Well, we've owned it for a long time. Next year, they may start to get a little bit more aggressive on the dividend. I mean, it's an open question right now, but kind of reading between the lines, it's just our interpretation, it just doesn't appear that's where their mindset is now. From a total return standpoint, if the stock keeps moving up, we are probably going to sell more of it. In the end, we want both a reasonably attractive dividend, we target 3% plus or minus, and we want that growth. Right now, the stock price is helping us, but we don't see the dividend growth. 

So that's what we have for you for today's episode. I know it did run a little bit long, but you know, we did show you what we're looking at as far as when we're buying, what's important to us and why, what a hold looks like and the reason why it is still on the watch list and what we may or may not do with it, and finally, why we've started to sell something even though the stock itself is performing relatively well. So, what it is, these are three companies that have all been growing in one form or another. But, I hope you found something out of this that helps you as far as how you look at your own situation and how we take that growth story and apply it to what we're trying to do. 

We do plan to put out a report on Hershey. It's a situation that this is going to be one of our long-term holds and I would love to have the chance to buy more of it. Hopefully, we'll have that out here in the next several weeks, and in the meantime, we look forward to meeting with you again next month. I think we're going to have a special treat. We don't have it totally confirmed yet, but you'll just have to stay tuned. It's going to be a great episode on why the dividend story should continue well into the future.

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 will 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 mentioned herein.