Dividend Aristocrats & The Sharpe Ratio: Part 4 of 4 - Sure Dividend Sure Dividend

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Dividend Aristocrats & The Sharpe Ratio: Part 4 of 4

Published March 21st, 2015

In the final article of the 4 part Dividend Aristocrats & The Sharpe Ratio series, I examine the 5 highest ranked stocks using the value-adjusted Sharpe Ratio discussed in part 2. The 5 highest ranked stocks are: PepsiCo (PEP), Coca-Cola (KO), AT&T (T), Clorox (CLX), and Abbott Laboratories (ABT). Each of these stocks has been ranked in the Top 10 over the last year using The 8 Rules of Dividend Investing.

The 5 stocks below are all examples of extremely high quality businesses. In addition, each of these 5 stocks are Dividend Aristocrats; they have paid increasing dividends every year for 25 or more years.

Abbott Laboratories Analysis

Abbott Laboratories is the 5th highest ranked stock using the value-adjusted Sharpe ratio using data over the last decade. Abbott Laboratories has a market cap of over $70 billion. The company’s stock has seen solid returns this year, up about 23%. Abbott Laboratories’ has positioned itself for rapid growth in emerging markets. The company currently generates 50% of sales in emerging markets, and 70% outside the U.S.

Abbott Laboratories sells nutritional products under the: Ensure, Pedialyte, Similac, Zone Perfect, and Elecare brands, among others. The company also sells diagnostic health equipment, medical devices, and generic pharmaceuticals (pharmaceutical sales are exclusively in emerging markets). The company’s operations are divided into 4 segments. Percentage of total revenue generated by each segment is shown below to give an idea of the relative size of each segment:

Abbott Laboratories spun-off the bulk of its pharmaceutical business on January 1st, 2013 when it created AbbVie (ABBV). Since the spin-off, Abbott Laboratories has steadily grown its business. Dividends in particular have surged, up over 70% since the spin-off.

Abbott Laboratories has showed strong growth recently. The company grew adjusted earnings per share over 22% in the 4th quarter of 2014 versus the same quarter a year ago. The company’s growth is coming unequally from emerging markets. Abbott Laboratories will benefit from rising per-capita GDP in emerging markets. As GDP rises, so too does life expectancy and demand for health care services. Health care is one of the fastest growing sectors in the world; Abbott Laboratories gives investors the safety and management expertise of a blue-chip U.S. company, with the growth prospects of an emerging market stock.

Clorox Analysis

Clorox manufactures and sells branded consumer products. Unlike Abbott Laboratories, about 75% of Clorox’ sales come from the U.S. Clorox portfolio of high quality brands includes: Clorox, Pine-Sol, Liquid Plumr, Glad, Fresh Step, Kingsford, Hidden Valley, Brita, and Burt’s Bees. I must admit it is a little disturbing that the same company that makes bleach, charcoal, and cat litter also makes ranch dressing. Regardless, Clorox has built a portfolio of premium brands that have large market shares in their respective categories. 80% of Clorox’s sales come from brands with the number 1 or number 2 market share position in their respective categories.

Clorox is not an overly fast growing stock. Management expects constant-currency revenue growth of 3% to 5% going forward. In addition, the company repurchases about 1.5% of shares outstanding and currently has a dividend yield of 2.7%. The company may also be able to add to growth through margin enhancement and greater efficiency, which could boost earnings-per-share by 0% to 1% a year. In total, Clorox shareholders can expect total returns of 7.2% to 10.2% from revenue growth (3% to 5%), dividends (2.7%), share repurchases (1.5%), and margin improvement (0% to 1%).

Clorox stock has seen strong gains over the last year, gaining nearly 30% versus about 15% for the S&P 500. Because of its share price gains, Clorox looks somewhat overvalued at this time. The company currently has a price-to-earnings ratio of 24.8 which is not fully justified considering the company’s fairly low expected growth rate. Clorox is a high quality company however, and should trade at a premium price to other stocks with similar growth metrics. A price-to-earnings ratio of 18 to 20 more appropriately reflects the company’s mediocre growth prospects and high safety.

AT&T Analysis

AT&T is the second largest publicly traded wireless telecom, behind only Verizon (VZ). AT&T and Verizon alone control about 65% of the wireless telecom industry in the U.S. If you add in Sprint (S) and T-Mobile (TMUS), those 4 companies alone account for over 90% market share. Clearly, the U.S. telecommunications industry is an oligopoly. This is bad for consumers (less competition means less innovation and higher prices), but good for investors.

The telecommunications industry has extremely high barriers to entry. High fixed costs and government regulation make the telecom industry a good place to look for durable competitive advantages. AT&T has increased its dividend payments for over 30 consecutive years; it has a strong competitive advantage.

AT&T currently trades for a forward price-to-earnings ratio of under 13. The company’s stock has an extremely high 5.7% dividend yield. AT&T is not a fast growing stock. AT&T is certainly not a fast growing stock; it had higher earnings-per-share in 2007 than in 2014, but the company makes up for it with its high dividend.

AT&T has taken steps to increase its growth rate, however. The company is acquiring DirecTV (DTV). The move gives AT&T a better position in Latin American markets as DirecTV has a solid presence in the region. Additionally, AT&T recently announced it is acquiring Nextel Mexico as well. Taken together, AT&T’s growth plan is clear – the company is planning to gain market share in the Latin American telecommunications market. AT&T faces strong competition from Carlos Slim’s America Movil and Telefonica telecommunications companies in Mexico which together have a 90% market share. Still, the move into Latin America should boost AT&T’s growth over the next several years.

Coca-Cola Analysis

Coca-Cola is one of Warren Buffett’s largest holdings. The stock qualified to be a Dividend Aristocrat in 1989, when Warren Buffett purchased it. Since that time, Coca-Cola has produced fantastic returns. It is clear what the Oracle of Omaha saw (and presumably still sees) in Coca-Cola.

Coca-Cola operates in the slow changing beverage industry. It is very unlikely that changing technology will dramatically impact Coca-Cola’s operations. As a result, the company is shielded from the creative destruction of innovation. The company derives its competitive advantage from its host of strong brands. In total, Coca-Cola now has 20 beverage brands that generate over $1 billion a year in sales.

When we think of Coca-Cola, we think of soda. Coca-Cola sells a wide variety of non-carbonated beverages as well; these beverages are driving growth. Coca-Cola’s non-carbonated portfolio includes: Simply (juices), Dasani, Powerade, Honest Tea, Hubert’s Lemonade, Gold Peak Tea, Fuze tea, and many more. A slow shift in consumer preference from carbonated to ‘healthier’ un-carbonated beverages will not end Coca-Cola’s reign as the largest beverage company in the world.

Coca-Cola currently trades at a forward price-to-earnings ratio of 18.7. The stock has a solid 3.3% dividend yield as well. Coca-Cola has underperformed the market over the last year, gaining around 8% versus 15% for the S&P 500. Over the long run, the company should continue to grow earnings-per-share at 7% to 9% a year. This growth combined with the company’s 3%+ dividend yield gives investors an expected total return of 10% to 12% a year.

PepsiCo Analysis

When one thinks of low standard deviation stocks, utilities come to mind. Surprisingly, PepsiCo has one of the lowest stock price standard deviations of any company. PepsiCo’s low stock price volatility comes from its extremely stable cash flows. PepsiCo generates significantly more of its operating income from its snack portfolio (primarily Frito-Lay brands) than from its beverage portfolio.

In total, PepsiCo has 22 brands that generate over $1 billion a year in sales (2 more than Coca-Cola, if you want to compare the two). Some of PepsiCo’s well known billion dollar brands include: Pepsi, Mountain Dew, Cheetos, Fritos, Doritos, Lay’s, Walker’s, Aquafina, and Gatorade.

In fiscal 2014, PepsiCo grew constant-currency adjusted earnings-per-share by 9% (2 percentage points higher than Coca-Cola). The company has increased its dividend payments for 43 consecutive years, giving it a very long history of rewarding shareholders with rising dividends.

PepsiCo ‘s growth is coming disproportionately from snacks and emerging markets. The company is the global leader in chips, and number 2 in beverages (behind Coca-Cola). PepsiCo’s combination of high quality brands in both beverages and snacks make it a safe bet for investors with low risk tolerances. The company is a long-time favorite of The 8 Rules of Dividend Investing thanks to its low stock price volatility and solid growth prospects and dividend yield (discussed below).

Like Coca-Cola, PepsiCo shareholders should expect 7% to 9% constant-currency earnings-per-share growth going forward. The company currently has a 2.8% dividend yield and a forward price-to-earnings ratio of 18.6. PepsiCo shareholders should expect total returns of around 10% to 12% a year from both dividends and earnings-per-share growth.

Final Thoughts

Thanks for reading the 4 part series on Dividend Aristocrats & the Sharpe Ratio. The Sharpe Ratio did not prove to be a reliable tool at forecasting future returns. On the other hand, the Sharpe Ratio does a good job of showing historical risk adjusted returns. The 5 companies examined in this article are among the most reliable in the Dividend Aristocrats Index in specific, and the stock market in general.

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