Dividends First and Foremost
Avoid the Wild Gyrations of the Stock Market
The Best Dividend Stock to Own
The best indication that a company is prospering is its history of dividend payments. Sales provide more than a hint of how a company is doing, but sales alone do not prove that a company is profitable now or that it will become profitable in the future.
Earnings can also be a good barometer of the condition of any company, but companies can include or exclude so many "extraordinary" items of income, expense and balance sheet items, that investors need to dig into most companies' financial statements to determine whether earnings are really and truly growing or not.
In my view, dividends are the most reliable indication of a company's growth and stability. Dividends are the payments of a company's hard-earned profits. A company's ability to continually pay dividends provides concrete evidence that the company is performing well.
The Advantages of Dividends
Accounting malfeasance is harder, or impossible, if a large transfer of cash is going to shareholders on a regular basis. I exclude companies paying really low dividends; I am referring to companies paying dividends yielding more than 1% per year. This figure is called the dividend yield and is calculated by dividing the annual dividend by the current stock price.
When evaluating dividends and yields, beware of a common pitfall: dividend coverage. You can evaluate dividend coverage by dividing the annual dividends per share (latest quarter times four) by the last four quarters of earnings per share (DPS divided by EPS). The dividend coverage ratio indicates if earnings can support the dividend.
As a general rule of thumb, most successful dividend investors avoid companies with a dividend payout ratio above 50%. Anything above that mark means the company may not be investing enough capital back into the organization. Even though a company's growth has slowed, it is critical for the company to reinvest a portion of earnings back into the organization.
Rising dividends indicate that the management and board of directors of a company are reasonably sure the company is performing very well now and will continue to perform well during the foreseeable future.
SPDR S&P Dividend ETF (SDY)
Nine years ago, State Street Global Advisors created an ETF (exchange-traded fund) to track all the companies in the S&P (Standard & Poor's) 1500 Index that have raised their dividends every year for the past 20 years. The objective of the ETF is to include companies that have increased their dividends consistently. Out of the 1,500 companies in the index, only 96 qualify!
SPDR S&P Dividend ETF (SDY) is well diversified with risk spread out over 96 holdings. The largest position consumes only 2.81% of the total portfolio. The 10 largest holdings in order of size are: HCP, AT&T, Consolidated Edison, People's United Financial, National Retail Properties, Target, Procter & Gamble, Clorox, Sysco and PepsiCo.
The five largest sectors are: Financials, Consumer Staples, Industrials, Utilities and Materials. SDY is a great substitute for bonds because of its 2.4% yield and steady performance. The price to earnings ratio, based on current EPS (earnings per share) of the stocks contained in the ETF is 17.7, and the price to book value ratio is 2.54. Both ratios are reasonable, and the beta (a measure of stock price volatility) is below average at 0.77. Management fees total 0.35%.
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The Best Dividend Stock to Own
I scanned the list of 96 stocks contained in the SPDR S&P Dividend ETF to find the best undervalued companies with better-than-average dividend growth prospects for the future. United Technologies (UTX) made the list because the blue chip company currently sells at an attractive price.
United Technologies is a large defense contractor and defense contractors have been out of favor since the wind-down of the wars in Afghanistan and Iraq. Now, though, the U.S. military has become more involved in Syria and Iraq and will once again build its weapons arsenal. Beaten down stocks in the defense sector are now selling at bargain prices and will likely become leaders as the stock market recovers.
United Technologies (UTX)
United Technologies is a multi-industry holding company that conducts business through five divisions: Otis Elevator; UTC Climate, Controls & Security; Pratt & Whitney; UTC Aerospace Systems and Sikorsky Helicopters.
Otis Elevator (20% of 2013 sales) is the world's largest manufacturer of elevators, escalators and moving walkways. International revenues were 82% of the division's revenues in 2013.
UTC Climate, Controls & Security (27% of sales) is the world's leading provider of HVAC (heating, ventilating, and air conditioning) and refrigeration equipment. Products and services are sold under the Carrier and other brand names. The division also makes and services security and fire safety products, including intruder alarms, video surveillance systems, and fire detection alarms. International sales were 61% of total Climate, Controls & Security revenues in 2013.
Pratt & Whitney (23% of sales) is a leading supplier of aircraft engines for large commercial aircraft, business jets, and military fighter and transport aircraft.
UTC Aerospace Systems (21% of sales), which was formed from the purchases of Hamilton Sundstrand and Goodrich, is a leading supplier of a wide array of technologically advanced aerospace products and services. Sales to Boeing and Airbus, which are UTC Aerospace Systems' two largest non- governmental customers by sales, were 20% of the division's sales in 2013. Sales to the U.S. Government were 21% of division sales in 2013.
Sikorsky (9% of sales) is the world's largest manufacturer of military and commercial helicopters, including the world-famous Black Hawk helicopter. International revenues were 30% of division revenues in 2013 and U.S. government sales were 58%.
Sales increased 4% to $65 billion during the 12 months ended 9/30/14 while EPS rose 16%. Strong demand for many of United Technologies' products and services was partially offset by divestitures of slower growing, less profitable segments. Management's cost-cutting programs bolstered earnings. Sales will likely climb 5% and EPS will advance 13% in the next 12 months to 7.50. The company's broad product mix, and substantial and steady parts and service business will provide dependable growth in future years.
UTX has paid dividends consecutively since 1975 and has increased its dividend every year for 20 years. Another dividend hike is expected by the end of 2014. The company's payout ratio (dividend divided by earnings) is 36%, well below my 50% upper limit. United Technologies is a blue-chip company that is well worth buying for long-term investment.
Until next time, be kind and friendly to everyone you meet.
J. Royden Ward
Analyst, Cabot Benjamin Graham Value Investor
Editor's Note: You'll find additional dividend-paying, high-performing stocks selling at bargain prices in the Cabot Benjamin Graham Value Investor. In every issue, you'll find my legendary Maximum Buy and Minimum Sell Prices for over 275 stocks.