Quick Ideas

There seems to be a general misconception, especially among non-investors but even among some supposed investors, that stock performance is directly related to company performance.

In a rational world, stock prices would reflect company performance and future expectations, adjusted for risk. In this world, stock prices reflect human psychology, and are only indirectly related to actual company performance.

Some people who are inexperienced with investing may view a rising stock price as direct evidence that the company is performing well. Similarly, they may conclude that if a stock price is falling, the company has performed poorly.

In reality, a company can perform quite well while its stock does not. Consider the following five examples:

Wal-Mart

Have a look at the long-term Wal-Mart stock performance.

Wal-Mart must have performed pretty poorly to have 10 years of no stock growth, right?

Apparently not. Wal-Mart grew its net income from approximately $6.3 billion in 2001 to $14.3 billion in 2010. That represents earnings growth of nearly 10% compounded annually. Earnings-per-share grew even faster due to share repurchases, and the company paid a dividend for the whole period as well.

Coca Cola

Have a look at the long-term Coca-Cola stock performance.

Coke’s chart is even more depressing than that of Wal-Mart. The company must have made some huge mistakes.

As it turns out, Coke grew its income from approximately $2.2 billion in 2000 to $6.8 billion in 2009. That’s more than 13% annualized earnings growth. And Coke paid dividends the entire time as well.

Microsoft

Have a look at the long-term Microsoft stock performance.

That poor stock trend must be well-deserved. Throughout this decade, Microsoft has failed to stop Google and Apple from attacking its moat and market dominance.

Turns out that Microsoft didn’t perform so badly. Microsoft grew net income from approximately $7.3 billion in 2001 to nearly $18.7 billion in 2010. That’s a growth rate of 11% annually, plus dividends for part of that time. EPS actually grew at a rate of 14% due to share repurchases.

Johnson and Johnson

Have a look at the long-term Johnson and Johnson stock performance.

That’s a little better, but still pretty flat. By the appearance of it, Johnson and Johnson must have had fairly mediocre company performance.

Actually, the health care juggernaut performed exceptionally well. JNJ managed to turn 2000 earnings of $4.8 billion into nearly $12.3 billion in 2009. This represents 11% annualized earnings growth. In addition, they of course paid dividends to shareholders each year.

Medtronic

Have a look at the long-term Medtronic stock performance.

I’ll skip the sarcasm this time: They did great.

Medtronic grew net income from a little over $1 billion in 2001 to nearly $3.1 billion in 2010. That’s more than 13% annualized growth, and they paid dividends as well.

What happened?

What do these five companies have in common? They were all drastically overvalued 10 years ago. These companies have all performed very well financially over the past 10 years, and yet their stocks have gone nowhere. This illustrates perfectly the “lost decade” of investing.

Investors a decade ago saw the bright futures of these five remarkable companies, and they paid a premium for shares of them. Unfortunately, they drastically overpaid, and therefore their returns were lackluster. Value investors, on the other hand, wisely understand that regardless of how well a company is performing, their stocks must be purchased at a reasonable price.

People claim buy-and-hold is dead. It’s not dead. You simply have to do it correctly by buying great companies at reasonable prices.

All of these companies have great valuations right now. Some of them have some pretty big obstacles ahead, so it’s important to investigate them thoroughly, but in general the values now are much more reasonable than they were in years past.

Company	Current P/E
WMT	14.1
KO	19.3
MSFT	11.5
JNJ	13.2
MDT	11.2

Full Disclosure: I own shares of KO and JNJ. I have no position in any of the others, but MDT is on my buy list and MSFT and WMT are on my watch list.

Everyone loves a good value. In search for one, it makes sense for most investors to be looking for high quality companies trading for a good price rather than mediocre companies trading at bargain prices. Dividend stocks on this list each face certain risks and are not necessarily recommendations, but they may not be a bad place to look for some solid dividend investments. So, without further delay, here’s five high-quality names currently on the discount rack:

Chevron (CVX)

Chevron is the second largest oil company in the United States. Although the company experienced a decline in revenue and earnings in 2009 due to falling oil prices, the company remained profitable, continued to grow its dividend and assets, and now is in a period of recovery with an exceptionally strong balance sheet. The company managed to increase its shareholder equity by an average of 10% per year over the past five years, straight through the recession.

Through a combination of increased worldwide energy demand, core production growth, dividends, and share repurchases, Chevron may be poised to outperform over the long-term.

Dividend Yield: 3.40%
Trailing P/E: 10.0
Full Analysis

Texas Instruments (TXN)

Texas Instruments is one of the country’s largest semiconductor companies. Although they’re quite well-known for their calculators, the company focuses on analog, embedded, and wireless products, and has a large market share in all of those categories. Texas Instruments benefits from increased usage of smart phones, and has an excellent balance sheet with a current ratio of 4 and zero debt. Unlike Intel which has been diversifying its business, Texas Instruments has been streamlining and focusing its business into the few primary segments listed above.

The company has high dividend growth, and recently announced a $7.5 billion share repurchase program which, at the current low valuation, is a better bargain than previous share repurchases. The company has been making small acquisitions within its areas of focus, and has increased its manufacturing ability during the market downturn.

Dividend Yield: 1.80%
Trailing P/E: 12.4

Novartis (NVS)

Novartis is a huge global health care company based in Switzerland. The company is incredibly diversified, offering a variety of pharmaceuticals, consumer health products, and animal health products. With a strong balance sheet and quickly growing revenue, the company appears to be in a position to offer great long-term returns. Due to their strong pipeline, the company’s valuation is a bit higher than many other health care companies, but lower than the market in general (and comparable to JNJ).

Dividend Yield: 3.40%
Trailing P/E: 13.3

Exelon (EXC)

Exelon is the largest nuclear energy producer in the United States. With 17 nuclear reactors, Exelon produces energy for millions of people.

Unfortunately, Exelon also has some unfunded pension accounts, and is facing a likely future earnings decline due to low natural gas prices. Low natural gas prices mean that utilities that generate electricity via natural gas are very competitive with Exelon’s nuclear power, and therefore the company’s moat has been temporarily breached.

The low stock price seems to currently be factoring these things in. I wouldn’t look for the dividend to grow much, if at all, until Exelon can increase its earnings. The CEO, however, recently stated that maintaining the dividend is extremely important, and Exelon expects to maintain it even with gas prices staying low for quite a while.

Exelon recently agreed to acquire John Deere Renewables, paying $860 million for over 700 MW of wind power and additional wind power under development.

Dividend Yield: 5.10%
Trailing P/E: 10.4
Full Analysis

Chubb Corporation (CB)

A leading multi-national property and casualty insurer, Chubb is exceedingly skillful and efficient in underwriting, achieving a combined ratio of 86%.

The company’s written premiums have been decreasing somewhat during this recession, but the company’s underwriting has been very profitable. The company has a policy of not sacrificing underwriting quality to chase premium growth. Shareholder returns will be largely driven by dividends and share repurchases, which at the current stock valuation are an excellent value.

Dividend Yield: 2.50%
Current P/E ratio: 8.6
Full Analysis

Full Disclosure: I own shares of CVX, TXN, CB, and JNJ. I have no positions in EXC, NVS, or INTC.
You can see my full list of individual holdings here.

An important aspect of long-term dividend investing is identifying companies that have durable economic advantages that allow them to remain profitable for the foreseeable future. For the dividend growth strategy to work, time is needed, and lots of it.

Company economic advantages are often called “economic moats”, because they act as a durable defense to separate the company from its competitors. Companies that do not have moats face a lot more pressure from competitors, while companies with large moats have better chances for higher margins and bigger profits along with consistent growth. This article highlights 7 companies with superior moats.

Canadian National Railway (CNI)

Canadian National Railway is the largest railway in Canada and has significant operations in the United States. The rail network extends from the Atlantic Ocean to the Pacific Ocean through Canada, and also extends southward to the Gulf of Mexico through the United States.

Railways have big economic advantages because once track is put down, there’s little reason for a competitor to put down track in the same area to serve the same routes. A railway’s biggest concern is the economic trends in the areas it serves, rather than fierce competition from other railways. Railways also tend to be very efficient compared to other forms of transportation, particularly when transporting large amounts of commodities.

Canadian National Railway’s dividend yield is currently only 1.60%, but the dividend growth is high. The last increase was 7%, and the five-year dividend growth rate is 17%.

Wal-Mart (WMT)

Wal-Mart is the biggest, baddest retailer around. The company pulls in over $400 billion per year in revenue. When they purchase products to sell, they purchase so many at a time, that they can demand pretty much any price they want. Simply by being so huge, they can buy products cheaper than any of their competitors, and therefore they can sell at a lower price while simultaneously having an excellent profit margin compared to other retailers. Since they sell at a lower price, everyone flocks to Wal-Mart to buy things, and they get even bigger and continue to dominate their competitors. It’s a cycle.

How would a retailer go about trying to compete with Wal-Mart? A given competing retailer isn’t big enough in terms of purchasing power to match Wal-Mart’s prices, so people shop at Wal-Mart instead. Since people shop at Wal-Mart instead, this competing retailer does not grow very quickly, and so they can never outpace Wal-Mart in terms of purchasing power. It’s a catch-22. It’s like not being able to get a job because you don’t have enough experience, and not having enough experience because you can’t get a job.

Most economic moats are viable because they form an endless cycle; a catch-22 against competitors. Wal-Mart offers a dividend yield of 2.20% with a five-year dividend growth rate of 15%. Costco and Amazon have been innovative enough to chip away at the moat, but Wal-Mart’s current valuation and continued growth offer considerable upside and a fairly low downside.

Johnson and Johnson (JNJ)

Johnson and Johnson has a moat made up of two things: a) Scientific know-how and patents, and b) A collection of strong brand names.

When healthcare companies develop a new medicine or a new product, they patent it, and this stops companies from producing similar products. This allows the company to charge high prices. With the vast size of the company, JNJ has the vast technical know-how to continue to research and develop new products, and to patent them against competitors. At any given time, Johnson and Johnson has a huge patent shield in diverse categories, and they have a healthy pipeline of new products coming out to be patented.

In addition, Johnson and Johnson’s collection of brands are well-known. Their consumer products can sell for 2x as much as an exact non-brand name copy of the formula because people tend to buy it anyway. This patent-shield-wielding juggernaut offers a 3.40% yield and more than 10% annualized dividend growth over the past five years.

Brookfield Infrastructure (BIP)

Just about any utility company or pipeline has a large economic moat due to the local monopoly they have on their communities. A utility or pipeline invests in a large amount of assets that return a stable cash flow over time, and nearly untouched by competitors.

I picked BIP in particular because their operations are global, and I wanted to point out that a company with a huge moat does not have to be a huge company. BIP has ownership or partial ownership of the following:

Utilities:
Transelec- Electric transmission lines in Chile
NGPL- Natural gas storage and pipeline in the US
Powerco- Electricity and gas distribution in New Zealand
IEG- Electricity and natural gas connections in UK
Ontario Transmission- Electric transmission lines in Canada
TGN- The only natural gas distributor in Tasmania

Transportation:
DBCT- Coal terminal that supplies port export services from Australia
WestNet Rail- Australian rail infrastructure
PD Ports- Collection of shipping ports in UK
Euroports- Ports in Europe and China

Timber:
Island Timberlands- timberland in British Columbia
Longview Timber- timberland in Northwestern US

Social Infrastructure:
Peterborough Hospital- UK hospital
Long Bay Forensic and Prison Hospitals- Australian hospital
Royal Melbourne Showgrounds- Exhibition Center in Australia

BIP offers a yield of 5.50% and their last distribution raise was nearly 4%. Looking forward, BIP management hopes to boost the distribution by 3-7% per year. Still, their leveraged position and exposure to cyclical infrastructure should be carefully considered.

United Parcel Service (UPS)

UPS is a logistics company that is strong mainly because of its massive scale. It has an international distribution system that allows it to ship packages all over the world. The company uses hundreds of planes and thousands of vehicles to ship millions of packages each day.

Unlike a retailer, however, one can barely even start a business in this field. The barrier to entry is massive. One can’t start a delivery service without an enormous capital investment, and there’s no reason to even try because UPS is large enough to do it better and cheaper than you no matter where you start it. This keeps the number of players in this industry fairly low.

UPS offers a dividend yield of 2.80% and 7% dividend growth.

Microsoft (MSFT)

Usually, large companies with strong moats tend to have an equally famous brand name, but this is certainly not the case for Microsoft. In fact, their brand name is infamous for crashing PCs, buggy software, inferior updates, and annoying paperclips. Although it’s true that everyone knows Microsoft, almost everyone has something negative to say about Microsoft, and yet we still use their products. Why? Because their moat is just absolutely huge.

The strength of their moat comes in the form of high switching costs. It’s difficult to switch to one of their competitors even if you want to. Everyone is familiar with Windows, but not everyone is familiar with Apple products or Linux. Windows has a huge percentage of the PC software market share. Even more powerful in terms of switching cost is Microsoft Office. Nobody can switch, because unless a large portion of the market switches at the same time, nobody will be able to read the documents of the people that switched first. There are even entire training and licensing programs about learning and becoming certified in Microsoft Office usage.

Microsoft currently offers a dividend yield of 2.60% and has grown its dividend by an annualized 10% over the past five years. The danger, however, is that Microsoft’s epic moat may be matched by the speed in which it is crumbling away. Innovative companies like Google and Apple are stealing its market share, and online document software threatens the future of the Microsoft Office model.

Compass Minerals (CMP)

Compass Minerals owns some of the largest salt mines in the world including the largest underground rock salt mine. In addition, their mines tend to be located near excellent rail networks, and they effectively use the Great Lakes, Mississippi River, Ohio River for transportation of their salt. There are a finite number of huge salt mines in the world, and because the transportation costs are so high for such a heavy-volume mineral, location plays a huge role.

CMP offers a 2% yield and 7% dividend growth. The company has quite a bit of leverage but has been effectively reducing it.

Summary

A moat isn’t everything, and some of these companies have pretty substantial threats to their economic advantages. Google and Apple are attacking Microsoft, Amazon and Costco are attacking Walmart, UPS has Fed Ex and a union to deal with, Johnson and Johnson is letting its collection of brands receive bad press with poor quality, and BIP, CNI, and all of them are affected by what the global economy is like at any given time.

But these aren’t just any old moats; they’re some of the biggest around, and the companies skillful enough to put up these moats might be good enough to keep them. Companies with huge moats don’t go away overnight, and if their valuations are reasonable, they may make solid investments. A thorough analysis should be performed on any stock before investing.

Full Disclosure: At the time of this writing, I own shares of JNJ and BIP, but none of the others mentioned.
You can see my full list of individual holdings here.