Many dividend investors naturally have a big portfolio allocation for large-cap stocks. Large-cap stocks are generally corporations that have been around for a long time, have huge revenue streams, and have an established and impressive record of dividend payments to shareholders, so it’s only normal that dividend investors (including me) will be attracted to them.
When looking for companies with very long records of increasing dividend payments, the list will include many large companies. With decades of dividend growth, how could they not be large? And yet, when we look at one of these large companies, and in particular large companies that provided above-average total returns to shareholders for several decades in a row, what we’re really looking at is the history of a transition from a great mid-cap stock into a large-cap stock. If they have several decades of impressive growth, then chances are, they were not very large so many decades ago.
Johnson and Johnson, for example, is one of the most recognizable blue-chip investments today, and has an impressive record of dividend increases and overall shareholder returns spanning decades, but in 1970 the company only had $664 million in revenue. Even when adjusting for inflation, that’s not very large. These past several decades were a transition from a mid-cap to a large-cap.
As a company grows larger and larger, it becomes more difficult to maintain a high level of growth. Their markets become saturated, their economy of scale becomes maxed out, organic growth becomes strained, and significant acquisition opportunities become rarer. Many of the large-cap stocks of today might provide fairly good total returns well into the future, but only a smaller subset of them are likely to continue providing outstanding returns.
Many of the large-cap companies that exist decades from now will be future versions of some well-run mid-caps today, and shareholders of those companies will have built an enviable amount of wealth from their mid-cap investment along the way. But great dividend records are harder to come by in these smaller companies. So, how do we find a good investment? The benefit of large-cap dividend payers is that they have proven histories. If we’re looking for decades of dividend growth into the future, how can we pick out the right mid-cap companies? There are two main ways:
Old Shareholder-Friendly Mid-Caps
Earlier in this post I mentioned that if we’re looking at a company with several decades of increasing dividends, chances are that we’re looking at a company that is now a large cap. Well, the Old Shareholder-Friendly Mid-Cap type of company is the exception. There exists a strategy that a company can follow to provide decent returns and consistent dividend growth to shareholders without growing very much. This strategy is to offer a solid dividend yield while spending a lot of the remaining earnings on share repurchases. By doing this, a company can avoid growing too much while they still continually increase earnings-per-share and dividends-per-share due to the share repurchases. Instead of maintaining a significant chunk of earnings for growing the business, this type of company shovels back as much of their returns as they can to shareholders. Share repurchases are often performed poorly by other companies, but by doing it every year, this type of company is essentially dollar-cost-averaging with its own shares.
An example of this is Harleysville Group Inc. Harleysville (HGIC) is an insurer with a market capitalization of less than $1 billion despite having a record of increasing its dividends for 23 consecutive years. Over the last five years, their revenue has grown by less than 1% per year while per-share book value has grown by 7% and the dividend has grown by 13% The most recent dividend increase was 9% and now the company offers a 4.50% yield. How does the company do this? They use most of their annual earnings to pay the large dividend and to buy back their own shares, which spreads their fairly static book value and earnings over an increasingly smaller number of shares. Over the past three years, the company has repurchased over 17% of its current market capitalization.
These types of boring companies can keep chugging along under the radar for years building shareholder wealth along the way. They don’t need to even do much- they just need to maintain their status quo, or try to grow a little, and shovel all of their earnings back to shareholders.
Premium Growing Mid-Caps
Unlike the previous group, Premium Growth Mid-Caps aim to grow considerably over the next several decades. They might not have a huge record of dividend increases at the current time, but years from now, they will. But without a consistent history of dividend increases, how can an investor spot this type of company now? That’s where the “premium” comes into play. In order for a company to outpace its peers and provide excellent shareholder returns for decades, it usually requires a large competitive advantage to separate itself from the competitors. Maybe it’s a company that has strong brand recognition, or high switching costs, or innovative patents, or a local monopoly (like a pipeline). These are the types of companies that today’s large-caps were decades ago.
A possible example of this sort of company is Smuckers. Smuckers (SJM), with a market capitalization in the range of $7 billion, is not exactly small, but definitely not huge either. With a portfolio of top-selling brand foods and recent aggressive growth, Smuckers has been providing shareholders with market-crushing returns over the last decade. The company currently offers a 2.60% dividend yield and several years of an increasing dividend. Only time will tell if this turns into a large-cap with an astounding dividend history, but I think this is the sort of company that has a great chance. It’s still run by the Smuckers family after more than 100 years of operation, has a well-known brand name, and operates in a recession-resistant but highly competitive industry.
Dividend-paying companies on the smaller end of the scale, in the mid-cap or even small-cap range, can be a boon for a dividend-growth investor’s portfolio.
Full Disclosure: At the time of this writing, I own shares of HGIC and SJM.
You can see my full list of individual holdings here.