It has been a rough start in the markets for 2016, and in particular for commodity investors.
Interest rates remain low, industrial utilization rates remain below capacity and, while employment remains strong, wage growth remains stubbornly flat. We live in a world where market-linked GICs from banks promising maximum annual rates of return of 3% are exciting and are one of the top investment products recommended by fee-for-service investment managers. While market-linked GICs might not be bad products to hold for the fixed income component of a core investment portfolio, it will be difficult to get ahead if you’re earning at most 3% a year on your capital.
When it comes to investing in stocks for income, we look for companies that:
- Are well established, have strong sustainable competitive advantages and have produced stable cash flows for a long period of time.
- Have not rejected or reduced their dividends at any point in time over the last few economic cycles.
- Have a history of repeatedly raising dividends.
- Are liquid and have easily manageable short-term and long-term debt loads.
- Earn high returns on invested capital.
- Pay out an acceptable percentage of earnings and free cash flows as dividends, cushioning the firms against economic downturns.
- Are approximately fairly priced or moderately underpriced.
- Are in, or are entering, a horizontal or upward sloping trend channel.
We try to avoid companies that do not have strong sustainable competitive advantages or that offer dividend yields below 2%. We also tend to avoid companies offering yields above 8% as many of these firms are in serious trouble and will likely have to cut their dividends in the near future.
Unfortunately, finding great dividend-paying stocks that meet these criteria isn’t that simple. Sure, there are lots of companies offering high yields with long dividend track records, but many of these companies are still unsafe poor investments. Just consider all the supposedly “safe” dividend-paying energy stocks that got hammered over the last year. If you’re going to invest in stocks for dividends, you’ve got to target those stocks that pay nice dividends of more than 2% but that are still selling at or below fair value. Thanks to the recent market drop, there are many more attractive dividend-paying stocks selling at appropriate valuations.
Let’s take a look at three of our top dividend-paying stocks for 2016.
Automatic Data Processing
Automatic Data Processing (ADP, Financial) is a provider of business outsourcing solutions. It offers a range of human resource, payroll, tax and benefits administration solutions. The company is also a provider of integrated computing solutions to auto, truck, motorcycle, marine, recreational vehicle and heavy equipment retailers and manufacturers.
Shares have traded down 6% over the last year on fears that worldwide new business bookings could slow and lead to short-term pressure on margins and earnings. The current dividend is $2.00 per share annually, making the current yield 2.44%. In 2016, analysts predict Automatic Data Processing will earn $3.39 in diluted earnings per share and $3.69 in 2017, which puts the payout ratio at a modest 65%. Relative to free cash flows, Automatic Data Processing’s payout ratio is 58%. This means that Automatic Data Processing could suffer an approximate 40% drop in earnings and still be able to make its dividend payments.
Over the long term, Automatic Data Processing’s dividends are well intact and will continue uninterrupted. Its shares are approximately fairly valued and will offer investors an approximate 3% to 6% annual rate of capital appreciation.
Colgate-Palmolive Co.
Colgate-Palmolive Co. (CL, Financial) is a consumer products company. It sells its products in more than 200 countries and territories throughout the world and operates in two product segments: Oral, Personal and Home Care and Pet Nutrition. The company's oral care products include Colgate Total; Colgate Sensitive Pro-Relief; Colgate Max Fresh; Colgate Optic White and Colgate Luminous White toothpastes, among others. The company sells its personal care products under the Palmolive, Protex and Softsoap brands. The company, through its Hill's Pet Nutrition segment, manufactures pet nutrition products for dogs and cats.
Colgate-Palmolive is another company with a nice stable dividend stream. Shares of Colgate-Palmolive yield about 2.3% annually. Dividends have grown at an annual rate of about 7.8% per year over the last three years. This is ranked higher than 66% of the 646 companies operating in the Global Household & Personal Products industry.
Colgate-Palmolive is a well diversified company and is largely insensitive to major economic swings. The company has taken on a bit of debt over the last few years, but this debt is easily manageable and could be paid off with about three years of annual earnings. It also has a current ratio of 1.3 and a quick ratio of 1. Colgate-Palmolive's low debt position and recapitalization strength combined with its moderate payout ratio of 59% of free cash flows should reassure investors that the dividend is safe. Trading at 21x forward earnings per share, Colgate-Palmolive is approximately fairly valued and should offer investors about 2.5% to 5% per year in capital gains.
Diageo PLC
Diageo PLC (DEO, Financial) is engaged in alcohol beverage business. It is engaged in the production, marketing and selling of alcoholic beverages with brands in spirits, beer and wine. Its brands include Johnnie Walker, Crown Royal, J&B, Buchanan's, Windsor and Bushmills whiskeys, Smirnoff and Ketel One vodkas, Baileys, Captain Morgan, Jose Cuervo, Tanqueray and Guinness. It also owns the distribution rights to Ketel One vodka products in perpetuity. The company sells its products in 180 countries. Diageo offers a dividend yield of 3.3%. This is better than 81% of the 294 companies in the Global Beverages - Wineries & Distilleries industry.
Like many firms in the industry over the last year, shares of Diageo have suffered a pullback, falling by 11%. But the company continues to generate solid sales and earnings, producing a return on invested capital of 14.5% versus a weighted average cost of capital of 6.2% – signaling continued value creation. The company’s stock currently trades at $103.30.
Free cash flows are even more impressive. The company produced almost $3 billion, or $4.74 per share, in free cash flows for 2015, while only paying out $2.2 billion in dividends. This leaves the company substantial wiggle room and is exactly what we like to see to feel comfortable that its dividend is safe.
Disclosure:Ă‚ SEENSCO does not currently hold any positions in Automatic Data Processing, Colgate-Palmolive or Diageo.
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