A Warning Sign Of High Dividend Growth Stocks – Seeking Alpha

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Which of the following seems like the most logical choice to grow your dividends the most by retirement?

  • Buy stocks with slow to moderate dividend growth
  • Buy stocks with high dividend growth

Obviously, with all other factors being equal, you would want high dividend growth. But all factors are not equal. Consider the following scenario.

Two men are each filling up a bucket of water with a hose. One-man comments that his bucket is filling up twice as fast as the other bucket. Which bucket will hold more water in 10 minutes from now? That is a deceivingly hard question. You would need to know more information such as the following:

  • How big is each bucket?
  • How much total water volume does each bucket currently hold?
  • What is the total current volume output of each water hose?
  • How might the variable water pressure change for each hose?

Stocks with high dividend growth are in a similar situation. The dividend bucket appears to be filling up fast. But will that ensure that you receive a larger pile of dividends 10 or 20 years from now? There is simply not enough information to say based on this simple metric. There are many other considerations.

One consideration that many investors overlook relates to sales growth. You would assume that in order to ensure a high sustainable dividend growth rate, you would also look for a high sales growth rate. I assumed this logical conclusion as well. There is good reason to believe, however, that you should be wary of, or even avoid, stocks with very high trailing sales growth. More on that a little later in the article.

Challenging Our High Dividend Growth Assumptions

Before we talk about the pitfalls of high dividend growth stocks with high sales growth – I first want to run my own analysis on a group of 267 dividend growth stocks which have at least 10-years of consecutive annual dividend increases. I only include stocks which have fiscal year dividend increases – not calendar year jumps.

Below is a comparison of the average dividend growth stock with a sub-set which has at least 15% annualized trailing dividend growth over the past 5 years.

  • Average market-cap $30bn – High dividend growth market-cap $44bn
  • Average payout ratio 65% – High dividend growth payout ratio 46%
  • Average dividend yield 2.5% – High dividend growth dividend yield 2.0%
  • Average 5-year earnings growth 6.6% – High dividend growth 5-year earnings growth 8%
  • Average 5-year sales growth 3.5% – High dividend growth 5-year sales growth 5.2%
  • Average 10-year sales growth 4.6% – High dividend growth 10-year sales growth 6.4%
  • Average PE ratio of 27 – High dividend growth PE ratio of 27.7

There are a couple of surprising numbers in the mix. I find it interesting that the high dividend growth stocks have a higher market-cap. I would have expected these high dividend growth stocks to be smaller in size. The other oddity is that there is very little difference in the PE ratio. I would also have expected that stocks with high dividend growth have higher PE ratios which is indicative of stocks with high expected future growth. But this is not necessarily the case.

One of the lessons I get from this test is that the profile of stocks exhibiting high dividend growth is not what I had imagined. I envisioned small and fast-growing companies which had more cash coming in then re-investment opportunities, perhaps because the growth was organic. Not so.

The other surprise relates to the PE ratio. Growth stocks generally have higher PE ratios. You generally either get more value now or more potential growth later. But this did not appear to significantly be the case. The following chart tracks dividend growth stocks with a minimum 10-year winning streak. It shows the net difference in the price-to-earnings ratio of stocks with a high dividend growth rate of at least 15% (trailing 5-years) vs. those with less than 15% average dividend growth. The excess PE ratio of high dividend growth stocks is not constant or positive throughout time.

High Minus Low PE Ratio of Dividend Growth Stocks

What I surmise from these numbers is that high dividend growth stocks (at least in this sub-set of stocks with at least 10 years of consecutive dividend growth) are not that much different than those with lower dividend growth. What I do notice is that stocks with high dividend growth have a smaller payout ratio and dividend yield – despite the similar dividend potential as shown by the price-to-earnings ratio (I know – I know, dividends come from cashflows and not earnings). This implies that much of the dividend growth is coming from an increase in payout ratio. This type of dividend growth feels more artificial and does not represent a true sustainable growth rate.

When I look at the extreme ends of the payout ratios, I find this to be true. Very high dividend growth stocks with at least 20% trailing dividend growth (5-year average) have roughly half the payout ratio of stocks with less than 5% trailing divided growth. So, while the growth numbers look high at first glance, it isn’t as impressive when we see where the growth is coming from. Most of the growth comes from simply allocating more existing cashflows to shareholders over time. The cashflow growth rate is not the same as the dividend growth rate.

So where does this take us? Should we focus on stocks with very high sales growth to provide the backbone of our dividend growth strategy? You would assume so.

The Danger of High Sales Growth

If you desire sustainable and increasing dividend growth – it would be logical to want a large increase in earnings… which should be based on a large growth in sales in order to be sustainable. This seems like common sense. But once again, what seems to make sense does not always make a good practice.

The 2002 academic white paper, Growth, Corporate Profitability, and Shareholder Value Creation, highlights the double-edged sword of growth. What did they discover? We often equate success with growth. But focusing too heavily on growth and forcing it can often lead to a waste of resources and a destruction of shareholder value. What might be good for the CEO and the company is not always what is best for the shareholder.

Imagine that your only mandate was to grow a company. You have $1 bn to spend. Perhaps there are few opportunities to invest in and the ones that do exist are expensive. But remember, you are focused on growth and not value. The person paying your salary demands growth. Which of the following would you do?

  1. Sit on the cash and wait for a good opportunity to arise – even if it takes years
  2. Return more cash to the shareholder and forget about growth
  3. Spend the cash even if the opportunity is expensive so that you can report an increase in growth

If you were under a lot of pressure to grow the company, you would likely take the third option – which is not necessarily going to increase shareholder value. You probably paid way too much for the growth. But you don’t care because everyone is demanding growth and your paycheck is dependent on it. Mission accomplished at the shareholder’s expense.

The bottom line is that while high sales growth is good in theory, it often comes with too high a price tag in practice. This leaves you with one of two options:

  1. Look at each company on a case by case basis to determine the main drivers behind the sales growth and whether the company paid a good price or not for that growth
  2. Stay away from dividend growth stocks with very high sales growth

Testing The Relationship Between Sales and Dividend Growth

I realize that this is not an intuitive conclusion. So I ran my own battery of tests based on the above white paper. While I find an proof for their main thesis statement, I could not find any proof for some of their other observations. High sales growth in this group of dividend growth stocks was not related to small companies with high PE ratios. Keep in mind that their paper was written in 2002 and it was not specific to dividend growth stocks.

  • What I did find was that high trailing sales growth stocks were linked to a decrease in shareholder value when compared to their peers.

Just look at the importance of trailing sales growth and future subsequent performance within our group of dividend growth stocks. We start with our group of dividend growth stocks which have at least 10 years of winning streaks. We are specifically analyzing stocks which have a 5-year trailing dividend growth rate of at least 10%. We also want the stocks to have a positive trailing 10-year sales growth rate.

Next, we sort our stocks into 10 equal portfolios based on the 10-year trailing sales growth rate. The lowest sales growth portfolio is the tall blue bar on the left. The red bar on the furthest left is our benchmark (VIG). The green bar on the right is our highest sales growth portfolio. We re-sort our portfolios every month starting in January 2001 up until today. This is our annualized performance.

Sales Growth and Dividend Growth

Stocks in the highest sales growth portfolio under-perform stocks in the lowest sales growth portfolio by a factor of 2.5! Do you think this to be some oddity that would look different if tested over more recent history? This is the same test ran over the past 5 years.

The difference is even more pronounced.

Will history continue to repeat itself or will it change? That is something I cannot answer. It is altogether possible that everything will change. Investors might begin to pressure management to focus more heavily on increasing shareholder value and less on increasing future growth. Is it possible? Yes. Do I think it will happen? No.

My bias is that the pressure to scale bigger will continue. Investors, like those on Shark Tank, only want deals where the potential of fast growth is present. Because of that, I feel that available resources may, at times, be wasted to achieve high growth. Below is a chart showing 10 dividend growth companies with very high trailing sales growth and 10 companies with very low trailing sales growth. All of these companies have high dividend growth.

My recommendation would be to more carefully look at those companies in the bottom rather than the top.

Ticker

Name

MktCap

Sales10YCGr%

(BEN)

Franklin Resources Inc

24009.01

0.25

(BBY)

Best Buy Co Inc

20820.64

0.93

(TRV)

Travelers Companies Inc (The)

36158.51

0.94

(ES)

Eversource Energy

19431.45

1.06

(PH)

Parker-Hannifin Corp

27525.82

1.16

(ALB)

Albemarle Corp

14691.42

1.23

(LECO)

Lincoln Electric Holdings Inc

6294.16

1.44

(CSX)

CSX Corp

52264.92

1.47

(TGT)

Target Corp

38470.97

1.57

(HP)

Helmerich & Payne Inc.

7414.39

1.85

(PRGO)

Perrigo Co Plc

12683.26

15.1

(OZRK)

Bank of the Ozarks

6522.77

15.66

(ETE)

Energy Transfer Equity LP

18679.22

15.78

(WHG)

Westwood Holdings Group Inc.

593.18

16.86

(V)

Visa Inc

270560.53

17.73

(SHPG)

Shire PLC

45154.18

20.29

(EVR)

Evercore Inc

3604.77

21

(HDB)

H D F C Bank Ltd

86289.46

21.01

(RGLD)

Royal Gold Inc

5483.09

24.73

(AFSI)

AmTrust Financial Services Inc

2487.19

30.39

What is your take? Do you strongly disagree with these conclusions? Can you pick a high dividend growth winner out of the ‘high sales growth’ pile? Please comment below.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.