This expectation does not change even when the economy turns down and earnings decline; dividend growth investors still require annual dividend growth. The companies that are able to accomplish this are those with a operating model that generates strong free cash flows with room to pay out a higher percentage as dividends. Below are several companies with a low free cash flow payout (below 40%):

An interesting twist to the above is a 2006 study conducted by Credit Suisse that found high dividend yield stocks generally
outperformed those with lower yields. However, the best returns did not come from those with the highest yields, but those with higher yields coupled with low payout ratios. The study found that high yield, low payout stocks that produced the better returns were priced at low ratios of price-to-earnings, and as a corollary, at high ratios of earnings-to-price; i.e., earnings yield. Put another way, the stocks prices were depressed, thus creating the higher yield and a value play. Below are several dividend growth stocks with a higher yields (around 4%+) and low free cash flow payouts (50% and below):

At some point we will all want to retire, but that is not to say we want our portfolio to stop working for us. A good dividend growth stock portfolio will not only provide us income in our retirement, but provide us more income each year than the one before.

Full Disclosure: Long GD, MDT, ADP, PG, INTC, ABT, GPC, TEG, CINF, LLY, HGIC. See a list of all my income holdings here.

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(Photo Credit)

What’s the difference between a Ponzi scheme and a utility company? Before I answer that question, let’s look at what a Ponzi scheme is.  Wikipedia defines it as:

A  fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

In effect, a Ponzi scheme pays yesterday’s investors with money from today’s investors. It works great until there aren’t enough new investors to pay the old investors. In a similar manner, most utility companies rely on new capital either in the form of debt or equity to fund investment and to pay dividends. Consider the following:

Atmos Energy Corp. (ATO) – Yield: 4.88%
Shares Outstanding: 2000 31m; 2009 92m
Long-Term Debt: 2000 363.2m; 2009 2,159.5m
Years of Negative Free Cash Flow: 5 of 10

Black Hills Corp. (BKH) – Yield: 5.10%
Shares Outstanding: 2000 22m; 2009 38m
Long-Term Debt: 1999 160.7m; 2008 719.2m
Years of Negative Free Cash Flow: 7 of 10

Connecticut Water Service Inc. (CTWS) – Yield: 4.01%
Shares Outstanding: 2000 7m; 2009 8m
Long-Term Debt: 1999 65.4m; 2008 92.2m
Years of Negative Free Cash Flow: 5 of 10

California Water Service Group (CWT) – Yield: 3.29%
Shares Outstanding: 2000 15m; 2009 20m
Long-Term Debt: 1999 156.6m; 2008 373.5m
Years of Negative Free Cash Flow: 10 of 10

Consolidated Edison, Inc. (ED) – Yield: 5.52%
Shares Outstanding: 2000 212m; 2009 276m
Long-Term Debt: 2000 5,415.4m; 2009 9,854.0m
Years of Negative Free Cash Flow: 6 of 10

MGE Energy Inc. (MGEE) – Yield: 4.40%
Shares Outstanding: 2000 16m; 2008 22m
Long-Term Debt: 1999 148.6m; 2008 272.5m
Years of Negative Free Cash Flow: 7 of 10

Middlesex Water Co. (MSEX) – Yield: 4.31%
Shares Outstanding: 2000 10m; 2008 13m
Long-Term Debt: 1999 82.5m; 2008 118.2m
Years of Negative Free Cash Flow: 10 of 10

Progress Energy, Inc. (PGN) – Yield: 6.48%
Shares Outstanding: 2000 157m; 2008 260m
Long-Term Debt: 1999 3028.6m; 2008 10,659.0m
Years of Negative Free Cash Flow: 5 of 10

Integrys Energy Group, Inc. (TEG) – Yield: 6.17%
Shares Outstanding: 2000 26m; 2008 76m
Long-Term Debt: 1999 634.5m; 2008 2,396.7m
Years of Negative Free Cash Flow: 10 of 10

Each of the above companies are growing their debt and shares outstanding while generating insufficient cash to fund their operating expenses, including normal capital replacements, in at least 5 of the last 10 years. For a company to consistently raise its dividends, it must generate strong cash flows sufficient to meet operating obligations and to service outstanding debt. When the day comes that these companies can not raise enough capital to fund the operating requirements, the first source of additional cash will likely come in the form of a lower or eliminated dividend.

So, back to the original question, what is the difference between a Ponzi scheme and a utility? The answer is simply disclosure. All the above information on these companies was made available via S.E.C. filings. Unlike Bernard Madoff, these companies are telling you exactly what they are doing, thus there is no intent to defraud. I own some of the companies above, but I won’t be rushing to add to increase my positions.

Caveat emptor!

Full Disclosure: Long ED, PGN, TEG. See a list of all my income holdings here.

(Photo Credit)

I have been using my new evaluation model now for about a month now. So far, I have been quite pleased with the results. It is helping me to efficiently review a lot of dividend stocks and identify those with strong financials, that are likely to continue increasing their dividends and that are fairly priced.  As I was developing and testing the new model I noticed it had a distinct dislike of Real Estate Investment Trusts (REITs) and utilities.

This got me to looking at these classes of stocks and asking the fundamental question, ‘Are they really quality dividend investments?’ Sure both are known to have above average yields, but as any knowledgeable dividend investor will tell you, current yield is just one small part of what makes up a great dividend stock.

I currently own three utilities and three REITs.  In addition to those, I follow three other utilities and three other REITs. Let’s take a look at some of them and determine if they are good dividend investments:

REITs
Health Care Property Investors Inc. (HCP) – 0 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: 131%

Realty Income Corp (O) – 0 Stars
Debt to Total Capital: 47%
Free Cash Flow Payout: -65%

Federal Realty Investment Trust (FRT) – 2 Stars
Debt to Total Capital: 51%
Free Cash Flow Payout: 101%

Kimco Realty Corporation (KIM) – 2 Stars
Debt to Total Capital: 55%
Free Cash Flow Payout: -1753%

National Retail Properties, Inc. (NNN) – 4 Stars
Debt to Total Capital: 39%
Free Cash Flow Payout: -144%

Utilities
SJW Corp. (SJW) – 0 Stars
Debt to Total Capital: 49%
Free Cash Flow Payout: -94%

Progress Energy, Inc. (PGN) – 1 Stars
Debt to Total Capital: 56%
Free Cash Flow Payout: -36%

Atmos Energy Corporation (ATO) – 1 Stars
Debt to Total Capital: 54%
Free Cash Flow Payout: 1045%

Black Hills Corp. (BKH) – 2 Stars
Debt to Total Capital: 48%
Free Cash Flow Payout: -105%

Integrys Energy Group, Inc. (TEG) – 3 Stars
Debt to Total Capital: 18%
Free Cash Flow Payout: -47%

Consolidated Edison, Inc. (ED) – 3 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: -40%

For a company to consistently raise its dividends, it must generate strong free cash flows sufficient enough to meet other obligations, such as debt, before paying a dividend. I look for a maximum of 45% Debt to Total Capital and a maximum of 60% Free Cash Flow Payout with the last 10 years positive.

With the exception of NNN and TEG, each of the above companies failed the Debt to Total Capital and Free Cash Flow Payout tests.  NNN and TEG passed the Debt to Total Capital test while failing the Free Cash Flow Payout test. All the above companies had multiple years of negative FCF over the last 10 years thus their dividends are supported via non-operating cash such as debt issuances and property sales. Ironically, NNN was the only 4 Star stock and it just recently froze its dividend.

Most REITs and utilities may provide your income portfolio with an additional boost in yield, but may end up costing you more in the long run. I will continue to look at REITs and utilities, but they must measure up like any other stock.

Full Disclosure: Long HCP, O, NNN, PGN, TEG, ED. See a list of all my income holdings here.