Thursday, December 05, 2013

The ABCs of Dividend Investing, Part IV: Who Are the ABCs?

After our series of posts titled "The ABC's of Dividend Investing", we received many requests from people asking us to show some specific examples of A, B and C stocks.  We don't typically talk about individual securities on our blog, but we decided to identify a few companies that we own and discuss their dividend characteristics and why we own each of them.

We chose three stocks – one each from our A,B,C sub-portfolios.  For those who have read our posts on the ABC's of Dividend Investing, the features of these sub-portfolios are probably familiar to you.  For those of you that have not, here is a brief summary:
What Are the A, B, Cs?

In the early 1990s, we restructured our main dividend investment strategy away from a portfolio focused primarily on high dividend yielding stocks with modest dividend growth into a portfolio comprised of three distinct types of dividend stocks.

As a result of this shift, we have been able to create a portfolio whose combination of dividend yield and dividend growth performs well regardless of market conditions.  The table below is an illustration of each of the three sub-portfolios: A, B and C.

A Stocks

Sub-portfolio A is comprised of stocks with average dividend yields and above-average dividend growth. 

Given enough time, it is clear that investors are willing to pay for a faster growing dividend, as long as that dividend is consistently paid and growth is visible.  As a result, companies with the lowest dividend yields and highest dividend growth have been the top performers over the long-term (5+ years).  A stocks also tend to outperform the average stock when the markets are trending sideways or in bull markets (like the one we are currently in).

A Stock: Prudential Financial (PRU)

The chart above is our proprietary 10-year multiple regression model.  This model is influenced by several different variables, but the primary driver is the dividend.  The blue bars represents the model’s predicted prices in each of the last ten years, whereas the red line indicates actual market prices during this time.

As you can see from the model chart above, Prudential was overvalued from 2005 to 2007 before falling below fair value in 2008 and 2009 and then flattening out.  In 2013, the blue bar representing fundamental value jumps significantly from below $55 to over $85.  Price followed right along with it.

Why the sudden increase in value and stock price?  In 2013, Prudential raised their dividend by over 32% and was rewarded for it with a significant increase in value both in our regression model and in actual stock price. 

Prudential is modestly undervalued at the moment, yet it is significantly undervalued when looking ahead 12 months. With a current dividend yield of 2.4% projected to grow 12% annually over the next 3-5 years, Prudential is primed for more future price growth.

B Stocks

Sub-portfolio B is just the opposite of sub-portfolio A.  B stocks are those with an above-average dividend-yield and with a dividend growth rate at about the rate of inflation. 

These stocks tend to underperform the market over the long-term and usually don't do as well as the average stock in a bull market.  Why hold them in a portfolio?  B stocks do two things: (1) provide good income and (2) protect the portfolio in bear markets.

B Stock: Kinder Morgan Energy Partners (KMP)

KMP is exactly what we like to see in a B stock.  

(1) The stock price and dividend are highly correlated.  Using the same 10-year regression model discussed above, Kinder Morgan’s predicted value (blue bars) follows remarkably close to the market price (red line).

(2) With a dividend yield of 6.8% and a projected 3-5 year dividend growth of around 5%, it provides good total return potential.

(3) Kinder Morgan provides stability in bad markets.  In 2008, the S&P 500 fell by over 40% between December 2007 and December 2008.  During the same time period, KMP was down less than 12%.  KMP and other B stocks provide generous and growing income and much less volatility than the average stock.

In addition to dividends, Kinder Morgan’s stock price is impacted by other variables – especially interest rates.  The approximate 20% rise in rates from 2012 to 2013 negatively impacted the stock’s predicted value.  Today, KMP is fairly valued.  However, it is undervalued by about 8% when looking ahead to the next 12 months.

C Stocks

Sub-portfolio C is full of the crown jewels.  The companies in this portfolio have a higher-than-average dividend yield in combination with average or above average dividend growth rate.  These are the companies that stand out most in our statistical models.  Their above-average dividend yields combined with a history of superior dividend growth often means these stocks offer the best opportunity for price appreciation in the next six to 18 months.  

These companies are often undervalued for a reason.  Usually, the attractiveness of C stocks has been clouded by some recent news or concerns about future growth.  Portfolio C stocks can do well in any market - especially if headwinds are temporary.  It is our Investment Strategists' job to dig deeply and judge how long the headwinds are likely to blow.

C Stock: McDonald’s

Like Kinder Morgan, McDonald’s price is highly predictable in our 10-year multiple regression model.  It became slightly overvalued in 2007, but price flattened out starting in 2008.  McDonald’s was undervalued in December 2009 and then both predicted value (blue bars) and stock price (red line) soared through 2011 when MCD became overvalued again.

McDonald’s is fairly valued today, yet more than 10% undervalued when projected into 2014.  With a 3.4% dividend yield and 3-5 year dividend growth over 8%, McDonald’s has both above average dividend yield and potential for above average dividend growth.

Just like with many C stocks, however, MCD is what we call “vexed”.  In other words, its future is somewhat clouded by uncertainties.  Another “vexed” C stock that we have been buying recently is JP Morgan (JPM).  In McDonald’s case, the problem is that sales and earnings growth have softened over the past couple of years to below historic standards. 

It is the job of our investment strategists to look ahead 3-5 years and determine whether or not the company can overcome the short-term difficulties.  In the case of both McDonald’s and JP Morgan, we believe that they will.

Dividend Investing: The All-Weather Investment Strategy

The market has seen a lot of changes since we began following our Rising Dividend Investing strategy nearly 20 years ago.  Dividend-paying companies have waxed and waned in their popularity, but we have preached dividend investing throughout it all. 

We continue to believe that consistent and persistent dividend growth provides stability and market-beating performance over the long-run.  By owning high-quality companies in each sub-category, the Cornerstone portfolio has been able to perform well in all different types of market conditions while still providing our clients with a consistently growing income stream.

DISCLAIMER: Clients and employees of Donaldson Capital Management own KMP, MCD, JPM and PRU.