Why Consumer Stocks Make Good Dividend Payers

Consumers will continue to purchase staples, even when they can’t afford discretionary spending on a vacation, a new car, or the latest iPhone

Michael Hodel, CFA 24 August, 2018 | 8:54AM
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Smokers are going to smoke, drinkers are going to drink, and everyone needs to eat and attend to personal hygiene. The companies that make the products to meet those needs, often dubbed consumer staples, are considered to be somewhat impervious to economic cycles.

The logic is that consumers will continue to purchase these products, in some form or another, even when they can’t afford discretionary spending on a vacation, a new car, or the latest iPhone. Morningstar groups these companies in its consumer defensive sector.

Natural-Born Dividend Payers

Many of these companies have established economic moats – or sustainable competitive advantages, often due to consumer loyalty to specific products and brands, established relationships with distributors and retailers, and economies of scale.

In turn, many consumer staples companies are themselves staples of dividend portfolios, as their relatively steady cash flows allow them to pay meaningful dividends to shareholders.

The Question of Streaking

Companies with 10-plus years of consecutive annual increases are sometimes dubbed Dividend Achievers, while companies with streaks of 25 years or more are called Dividend Aristocrats, and those that can point to 50-year streaks earn the Dividend Kings designation. Given that many consumer staples companies have been publicly traded for close to 100 years or longer, such dividend streaks are fairly common in the sector.

If nothing else, long streaks seem to indicate that management has made annual dividend increases a priority. But it’s a backward-looking measure, and by itself, the number of consecutive annual dividend increases isn’t a meaningful gauge of dividend growth or yield relative to other companies. Sometimes companies will make nominal annual increases to keep a streak going, but those increases don’t necessarily add up to a meaningful yield.

In our view, a company’s prospects for future dividend growth—based on expected earnings growth, the current payout ratio, and other factors — are more important than a past streak. Still, in cases where management goes out of its way to tout a dividend increase streak, perhaps it is more likely to continue the streak, even with nominal raises.

A management team focused on the dividend is less likely to make decisions that jeopardise future cash flows, such as putting excess debt on the balance sheet or investing in projects with scant strategic merit. Still, a streak is no guarantee, and sometimes a dividend focus can promote short-term thinking or complacency.

This is the risk consumer staples investors are wrestling with today: Have these companies underinvested in their brands and products in recent years to prop up margins? Will they need to take bold, dividend-jeopardizing actions to rectify the situation?

Strong Competition, Developing Opportunities

While consumers are unlikely to ever stop purchasing the staple goods that they need and use on a daily basis, competition among staples providers is intensifying. Some customers are loyal to their preferred brands, but most products have no switching costs, as consumers can simply pluck a different product from a store shelf or add a different item to an online shopping cart.

Indeed, the emergence of online shopping via Amazon (AMZN) and other retailers allows for product launches that don’t depend on retailers, which traditionally served as gatekeepers by controlling space on store shelves, as well as a means for marketing new products. In addition to expanding distribution, attracting attention is now easier than ever. Upstarts can use social media to launch new brands via digital word of mouth, and online advertising allows for highly targeted, small-scale campaigns.

The flip side of expanding distribution and marketing opportunities is that it is increasingly difficult to rise above the fray. The large consumer goods companies still have the resources to shout the loudest in support of their products.

Smoking Stocks

Sometimes declining sales are just a fact of life. Tobacco consumption is in decline in much of the world, but an addictive product makes for steady customers, and emerging markets can still provide growth opportunities for tobacco companies.

Morningstar Equity Research’s tobacco analyst recently reduced his fair value estimates for Philip Morris International (PM), British American Tobacco (BATS), and Imperial Brands (IMB) due to his view of medium-term margins, but he believes the stocks still have upside potential.

Most of these companies own brands that can’t be duplicated due to marketing restrictions, providing some pricing power. In addition, as volume declines, costs decline as well, leading to expanding margins. The big tobacco companies face disruption as many smokers transition to heated products, because volume is likely to spread across multiple product platforms instead of remaining with the bigger firms.

The party won’t go on forever for these pay-outs, but we expect the next several years should at least be stable, likely followed by a long, slow decline thereafter.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Amazon.com Inc182.81 USD-0.68Rating
British American Tobacco PLC2,425.00 GBX0.00Rating
Imperial Brands PLC2,007.00 GBX0.00Rating
Philip Morris International Inc101.24 USD-0.79Rating

About Author

Michael Hodel, CFA  Michael Hodel, CFA, is an associate director of research with Morningstar.

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