Why Capital Appreciation Must Not Be Overlooked

As dividend investors, we may find ourselves at times focusing too much energy on the dividend, not paying enough mind to capital appreciation and market value. 

We are lucky in the sense that the companies we invest in tend to be stable, growing earnings, reducing shares, and producing cash.  These are just the natural precursors to strong dividend growth.  And with these positive attributes comes capital appreciation.  Over time, as dividends and eps grow to stay in line with average yields and p/e ratios, the stock prices move accordingly. 

But we must not be complacent with sub par capital appreciation just because our dividends are still growing.  Even worse, we cannot accept major capital losses, as no amount of dividends will recoup our investment. 

The easiest way to assure good capital appreciation is to buy when a stock is undervalued.  There are many metrics we can use to evaluate this, such as p/e and p/book ratios, net asset value, and the king of them all, net present value.  By buying companies selling for less than their worth, we are creating a “margin a safety.”  This idea, developed by the godfather of value investing, Ben Graham, is as solid today as it was 50 years ago. 

The larger the gap between intrinsic worth and selling price, the better our chances of not losing money.  A stock may never again hit its boom time highs, but by purchasing good businesses at major discounts, we can be reasonably sure their value will grow.

Take for example a dividend favorite, Johnson and Johnson.  You can see my analysis of this company in the archives of this blog.  But for today’s purpose, let’s quickly look at an easy valuation metric, the p/e. 

In the year 2000, at the height of the 20 year bull market, JNJ sold for a whopping $105.94 on earnings of $1.55 a share, for a p/e of 68.35.   Then, as now, JNJ was a great business.  Earnings and dividends were growing, debt was low, and multiple revenue streams were reliable and consistent. 

In 2001 JNJ hit $49.13.  If you had bought in at the peak with $10,000, your investment decreased to about $4,367.00.  Your dividends for that year were only $65.80. 

This is why we must not overlook capital appreciation potential when we enter a stock.  Remember, Warren Buffett has said he made most of his money off of 12 investments.  So be patient, do your research, and look for discounts.  A few good decisions now will pay off handsomely later. 

WGL Holdings Dividend Stock Analysis

Company Overview

WGL Holdings Inc. is a public utility holding company serving the Washington, D.C. metropolitan region.  The company is a holding company for 4 main businesses, and three more unregulated smaller ones.  The main subsidy, Washington Gas, has provided natural gas service to customers in the D.C. area for over 160 years and, today, serves more than one million people in the District of Columbia, Maryland and Virginia, including residential, commercial, and government customers.  

The company has both regulated and unregulated utility companies, of which the regulated ones account for 91% of assets.  I searched around online, and this is the best definition I found about the difference between regulated and unregulated utilities. 

            “About 50% of the country's markets, electricity markets, are regulated, meaning that you have elected officials or appointed government officials that work with utilities to set formulaic rates that they are able to charge.

            Use of the word “unregulated” is deceiving, because they have to deal with environmental regulations, the power markets still operate under the overview of state governments and the federal government.

Basically, there is an actual market where the marginal cost of providing electricity is what you'll receive if you're going to the market that day and selling your power. So there's no intermediary saying, "This is what the rate payer wants to pay and this is what we think they should pay."

So basically the regulated utilities are saying, "We want to charge our customers this much." The unregulated utilities are kind of selling power into this power market.”

This artice can be found here http://www.morningstar.com/cover/videocenter.aspx?id=335580

WGL serves customers in Delaware through their retail energy marketing subsidiary, Washington Gas Energy Services. In West Virginia, they maintain a natural gas storage facility to serve customers throughout the Washington Gas service territory. Washington Gas also provides wholesale delivery service to portions of West Virginia.

WGL talks of dabbling in “green” energy, but I have not found much about specific projects. 

Financial Analysis

Dividends

WGL has paid a dividend every year for 158 years.  They have increased their dividend every year for the past 33.

Dividend Growth	CAGR
10 year	1.89%
5 year	2.53%
1 year	3.52%

Payout Ratios	2009	10 yr Avg.
EPS	62%	74%
Cash	43.83%	24.96%

At the current price of 36.41, the stock yields 4.04%

Income Statement

Revenue Growth	CAGR	EPS Growth	CAGR
10 year	8.88%	10 year	3.23%
5 year	5.76%	5 year	3.16%
1 year	2.99%	1 year	2.58%

Margins	10 yr Avg.
Operating	8.09%
Net	4.45%

The company is not buying back shares but rather increasing them at a ten year CAGR of 1.92%

Balance Sheet

Balance Sheet Ratios	2009	10 yr Avg.
Current Ratio	1.08	1.04
Lg T Debt / Equity	0.51	0.69
Tot Debt / Equity	0.75	0.90
Debt / Total Capital	0.43	0.47
Cash Return / Tot Capital	8.73%	1.71%

Cash Flow

WGL has had 4 years of negative free cash flow in the past decade.  This is not a good sign.

Stock Price

Current Price	36.41
P/E	15.2
Est Forward P/E	15.6
Div Yield	4.04%
Int. Value	57.42
2011 Int. Value	58.98

	High P/E	Low P/E	High Yield	Low Yield
10 year	18.2	13.8	5.34%	4.07%
5 year	16.4	12.8	5.14%	3.94%

Qualitative Analysis and Conclusion

WGL is in the utility business, which is not known for being a high growth industry.  Most companies have a monopoly in their regions, and it would be almost impossible for a competitor to create the infrastructure necessary to compete.  As long as the population is growing, so is demand, and as long as people need power (which they always will) there is business.  However, the business is uber capital intensive, and regulated markets make it difficult to be a very profitable business.   

With that said, I do like WGL, for what it is.  As far as utilities go, the company is in a great area – Washington DC will always have a strong population, as it’s the nations capital.  And as DC and the surrounding areas become more desirable to non-government workers (it was voted one of the best places to start a business this year by Forbes), this will mean strong demand for energy, of which WGL is the provider. 

Revenues and EPS have shown decent growth, and the balance sheet is clean for this type of business, with low debt.  The dividend growth is pretty sluggish, but the payout ratio, both in earnings and cash, is acceptable for a utility company.  I do not like the annual increase in shares, or the 4 years of negative cash flow. 

Overall, I am not intersted in this stock.  The p/e and yield are good for a consumer goods company, but for a utility, which are known to be safe for “widows and orphans” I am not that excited.  Though I think WGL is a decent business, and can continue it’s dividend increases, I am not yet ready to trade strong dividend growth and capital appreciation for safety.  If the yield ever reaches 6% or more, I may reconsider. 

 

Positive Press for Dividend Growth Investing

Although many of us dividend investors are very confident in our approach, it is still nice to receive a little positive feedback.  Here, an article on Forbes.com praises the dividend investing approach.  

Why Dividends Really Do Matter 

Why Entry Criteria is a Must Have

I was pretty lucky when I purchased my first stock.  I hadn’t really done any research; in truth, I wouldn’t have known what to look for or where to look for it anyway.  I knew that prices were low, because we had just entered a recession and everyone was talking about the big market crash.  I had extra money lying around, so I opened up a brokerage account and bought some shares. 

Luckily for me, I had already decided I was going to be a dividend investor.  The approach fit my personality, and the dividends provided the passive income I sought.  Up till that point I had been following a few dividend investing blogs, and was so excited to get involved in the market I blindly took their advice and bought shares in Coca Cola.  As luck would have it, their praise of Coca Cola was well deserved, and I had bought a solid dividend growth stock.

Now that I have a little bit more experience and patience, I perform the analysis necessary before buying into any company.  As I decreased the time it takes me to analyze a companies finances, I am now working at a rate of about 1-2 companies a week. 

I find new companies to analyze from many different sources, but the majority of them are from the commonly used dividend indices: Aristocrats, Achievers, and Champions.  The businesses that comprise these lists generally have the qualities you would expect of a dividend growth stock; strong revenue, low debt, positive cash flow, and increasing dividends. So how do you narrow down the ones you want to buy?

This is where your strict entry criteria comes into play.  By following a (semi) rigid formula, we can focus on the companies that provide the most value. 

After I find a company that is worthy of investment, I then decide if it is selling at a price I want to pay for it.  I look for a 3% yield, a p/e of 15 or below, and an intrinsic value that is higher than a 10 year treasury.  If a stock meets these criteria, I put it into my “watch” category. If the price is still within my buy range when funds become available, I will buy in. 

Johnson and Johnson Dividend Stock Analysis

Company Overview

Johnson and Johnson (NYSE JNJ) is the world’s premire consumer healthcare company.  JNJ is actually a holding company, and is made up of over 250 operating companies who do business in 60 countries. 

JNJ was incorporated in the State of New Jersey, USA, in 1887.  In 1944, their shares were listed on the NYSE.  The company is a world leader, and 70% of it’s sales come from products that hold the #1 or #2 positions in their categories.  The company has 47 years of dividend increases.  It has also generated a return of 5.6% in the last decade, vs. the SP -1.4%.

* On the JNJ website they claim 76 years of sales increases and 25 years of earnings increases.  However, in their 2009 annual report sales were down, as were eps.  Maybe they haven’t got around to changing that yet*

The company employs 114,000 people worldwide, organized in a decentralized management structure.  The operating companies are organized into three business segments: Consumer, Pharmaceutical and Medical Devices and Diagnostics.  Some of the most common and recognizable household names are owned by JNJ, including Nuetrogena, Aveeno, Clean and Clear, Band-aid, Splenda Sweetener, Tylenol, etc., along with many prescription drugs like Concerta.  

Financial Analysis

Dividends

Dividend Growth	CAGR
10 year	13.30%	Payout Ratios	10 yr Avg.
5 year	10.81%	EPS	40%
1 year	7.22%	Cash	37.63%

Dividend growth is slowing, but as dividends get higher, it is much harder to continue large increases.  For example, a 10% increase in a 0.10 dividend is only 0.01, while a 10% increase in a 1.50 dividend is 0.15.  However, the dividend is well covered, and a 13% 10 year annual growth rate is very respectable.  

At the current price of 61.29 JNJ yields 3.15%

Income Statement

Revenue Growth	CAGR	EPS Growth	CAGR
10 year	8.63%	10 year	12.16%
5 year	5.21%	5 year	7.05%
1 year	-2.90%	1 year	-3.72%

Margins	10 yr Avg.
Gross	70.90%
Net	18.21%

Share buybacks have averaged 2.41% over 10 years. 

As I noted above, though they claim 76 years of sales increases and 25 years of earnings increases, I found this was not the case, and attribute this to not updating this part of the website.  

Balance Sheet

Balance Sheet Ratios	10 yr Avg.
Current Ratio	1.85
Lg T Debt / Equity	0.11
Tot Debt / Equity	0.18
Debt / Total Capital	0.15
Cash Return / Tot Capital	23.96%

As expected from a company of this caliber, very low debt.  And a good cash return on total capital employed. 

Cash Flow

Free Cash Flow	CAGR	FCF Per Share	CAGR
10 year	11.66%	10 year	12.86%
5 year	11.57%	5 year	13.65%
1year	19.32%	1 year	21.31%

Cash growth is strong, stronger than earnings and sales growth.  Just by doing a quick once over of the numbers, they have done a great job of increasing cash from operating activities and keeping capital expenditures down. 

Stock Price

Current Price	61.29
P/E	13.93
Est Forward P/E	13.01
Div Yield	3.15%
Int. Value	69.68
2011 Int. Value	75.81
Max Buy Price	64.33

	10 yr Avg.	5 yr Avg.
High P/E	29.86	17.85
Low P/E	20.12	14.28
High Yield	2.35%	3.01%
Low Yield	1.75%	2.34%

Qualitative Analysis and Conclusion

JNJ has a reputation as one of the most successful companies of all time, and for good reason.  I don’t think I need to explain why this company is a major world player, and will be for probably some time.  One of my favorite things about JNJ is that they have managed to get so large without any of the anti-corporate backlash other companies such as Wal-mart have had to deal with. 

Their brands are iconic, and it is doubtful they will be going anywhere anytime soon.  Yes, JNJ faces risk factors that all businesses face.  But the company has so many revenue streams, from so many areas, I find it hard to believe it’s going to go belly-up any time soon.  Hell, even the great Warren Buffett has not just a huge stake in JNJ, he recently increased his holdings. 

There has recently been some issues with quality control at a few of it’s Pennslyvania plants, and they made huge recalls of Children’s Motrin and Tylenol.  But JNJ has shown over the past century it can whether the storm, and it has the financials to back that up.

I feel JNJ is a great buy right now.  The stock has never returned to it’s 2000 high of 105, but most companies have been caught in a rut for the past decade.  The company has all the attributes you look for in a stand-out company, and I feel once the economy picks up again there will be some capital appreciation.

 In addition, they pay a great dividend, with a yield above my buy point of 3% and above the 5 year average high yield of 3.01%.  It is well covered by cash flow, with plenty of room to grow.  P/E is below 15, and it’s trading below my max buy price.  I look forward to adding to my position. 

$ Full Disclosure: Long on JNJ