By Elmer L. (Al) Meszaros, CFA, Partner
Let’s say an investor hears about a chance to buy shares of stock worth $40 each for only $20 each. Sounds good, right?
But five years later if those shares are still selling at that same $20. That’s not so good.
So how can this outcome be avoided?
The investor needs to judge if the company will be able to steadily grow the intrinsic value of its business over the years, creating upward pressure on the stock price.
Attractive characteristics
A tangible expression of a company’s ability to increase profits and business value is “dividend growth.” Typically, companies that are able to increase dividends steadily have other attractive characteristics, including:
- A solid business franchise with strong profitability;
- Management’s ability to generate a growing level of profit and cash flow.
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Meeting these criteria would suggest that a company can both invest for future growth and pay increasing dividends. In addition, an attractive business is one that is stable enough to avoid wide fluctuations in profits that may endanger the dividend.
Dividend increases
Good managements are loathe to cut dividends. Therefore, they take care to ensure that increased dividends are sustainable. At Midwest Investment Management, the median dividend increase for stocks in our Large-Cap Core Value Portfolio was 11% annually over the last 5 years. This compares to a median dividend increase of only 2% for stocks in the S&P 500 Index. I am pleased to report that nearly 60% of the companies whose stocks are currently in our Large-Cap Core Value Portfolio raised their dividends each year for the last five years!
Growth of a stock’s price may not immediately keep pace with rising intrinsic values or higher dividends, but eventually, the gap closes, as history shows. Over the past 20 years, of 17 companies in our portfolio that increased dividends each year, only 2 failed to outperform the S&P 500 benchmark. Of course, it’s not easy to figure out which companies have the business franchise and managerial skills to increase dividends in the future. Yet, that is the judgement an investor must make!
Significant advantage
For the entire 76-year period from 1929 to 2005, dividend-paying stocks returned 9.8% annually, versus only 5.5% for non-dividend-paying stocks—a difference that can provide a handsome advantage for long-term investors. For example, a $100 investment in dividend-paying stocks listed in the S&P 500 in 1972 would have grown to $2,629 by the end of 2005, while the same amount invested in S&P stocks that did not pay dividends would have grown to only $392 (see chart below).
Today, the stocks of many large, quality, dividend-paying companies have lagged their smaller, lower-quality rivals. The result is that many stocks are available at 10% to 30% discounts to historical relationships, thereby creating opportunity for our clients invested in our Large-Cap Core Value Portfolio.
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If you are not a Midwest Investment Management client, consider the long-term growth potential of your portfolio using Al Meszaros’ methods for identifying quality, dividend-paying stocks. He can be contacted at (216) 830-1133 or elm@mimllc.com
