Periodically, I will write about dividend stocks that we purchase or own, as an example of how the dividend growth investing (DGI) strategy works, the risks that you have to deal with in pursuing the strategy and the long-term patience that DGI requires. For a detailed review of this topic, see here. Today, we will focus on a stock that I recently purchased and how DGI tests your resolve.
We have been looking for sometime to add a good utility company to our DGI portfolio. This addition was considered because a) we wanted to increase the defensive tilt to the portfolio beyond the S&P index (lower portfolio beta), b) we liked the interesting growth prospects of some well-run, progressive utility companies so they could deliver both future growth and increasing dividends and c) we needed to deploy the dividends flowing in periodically from the DGI portfolio.
It would be nice to acquire a great company at a very cheap valuation, but that’s not likely. Especially, in the current overall market situation, really discounted prices are hard to find for good companies. Keeping Warren Buffett’s advice “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price” in mind, I zeroed in on Dominion Resources (Symbol: D) as the utility company to purchase. This would complement – both geographically and in terms of focus – other utility companies we have. If you live or have lived in the northeastern states of United States, you would know Dominion well – they supply power and gas to millions of homes. In case you don’t, here’s a brief about Dominion:
Dominion Resources, Inc. is a producer and transporter of energy. The Company is a provider of electricity, natural gas and related services to customers in the eastern region of the United States. The Company operates through three segments: Dominion Virginia Power (DVP), Dominion Generation and Dominion Energy. The Company’s portfolio of assets includes approximately 24,300 megawatt (MW) of generating capacity; 6,500 miles of electric transmission lines; 57,300 miles of electric distribution lines; 12,200 miles of natural gas transmission, gathering and storage pipeline, and 22,000 miles of gas distribution pipeline, exclusive of service lines. The Company also operates underground natural gas storage systems, with approximately 933 billion cubic feet (bcf) of storage capacity. Dominion’s operations are conducted through various subsidiaries, including Virginia Power and Dominion Gas. (Source: Google Finance)
Dominion is a Dividend Achiever (meaning they have continuously paid and increased dividends over 10 years). Recently, they announced an almost 8% increase in the quarterly dividend over prior year, to $0.755 per share from $0.7 per share. Just 3 years ago, the quarterly dividend was $0.60/share, which means their dividends have grown by 26% over 3 years, at a compounded annual growth rate of 8% a year. This announcement came around the time they delivered stellar results in the last quarter of 2016 compared to year-ago period.
|Metric||Q4 2016||Q4 2015||Year-Over-Year Change|
|Operating earnings||$618 million||$416 million||48.6%|
|Operating earnings per share||$0.99||$0.70||41.4%|
These results are not typical of a utility company but Dominion is among the best-of-breed in this sector. Dominion is a progressive utility, by that I mean, they are continuously looking to grow and add value to customers through diverse energy sources and are focused on efficient distribution to the widest possible customer base. Being primarily a distributor, they are immune to the underlying commodity prices and are able to pass on cost increases as required. Also, being part of the regulated oligopoly of consumer utilities delivering a core need for people in the United States, they aren’t likely to be disrupted by a technology change (in fact, they may benefit from it if it costs them less).
A utility company is typically considered ‘sleepy’. It is sometimes called a ‘widow and orphan’ stock due to its conservative nature and limited growth. But Dominion is anything but a sleeping utility. Dominion announced in early 2016 that it would acquire Questar Corp in an all-cash deal for $4.4 billion plus the assumption of about $1.8 billion of debt. A $4 billion+ acquisition? Not exactly a sign of a ‘sleepy’ utility, for sure. The company they acquired is also a solid one. Moody’s had this to say about Questar while reaffirming Dominion’s credit rating:
Questar Gas Co is a gas LDC with about a million customers in Utah, Wyoming and Idaho. The company enjoys a strong credit profile with decoupling, weather normalization and infrastructure trackers. On a Moody’s adjusted basis, Questar gas and Questar pipeline account for about 35% and 25%, respectively, of Questar’s consolidated cash flow. he remaining 40% comes from Wexpro, a quasi-regulated exploration and production (E&P) subsidiary. Wexpro’s operations are designed to serve Questar Gas under a cost-of-service basis, with rates having been approved by the Utah Public Service Commission (UPSC) and Wyoming Public Service Commission since 1981. Wexpro’s relationship with its utility affiliate is governed by the Wexpro Agreement and Wexpro II Agreement. The agreements reduce the business risk associated with Wexpro’s more risky E&P operations, while still allowing Wexpro to earn nearly 20% return on equity.
Dominion has continuously grown earnings and dividends over the last 10 years and the dividend growth of 8% annually is higher than what even many ‘growth’ companies in industrial and technology sectors have delivered. In addition, they project 7-9% annual earnings growth till 2021. While these are just projections, the numbers are still impressive for a ‘sleepy’ utility. I wanted to purchase D at no less than a 4% dividend yield so, I bought D at $75.25 a share, which at $0.755/share quarterly dividend starting March 2017, works to a 4.01% dividend yield. If the dividends grow at 8% a year for the next 5 years, then my yield-on-cost (YOC) for the purchase should grow to 5.9%, which is very good. Also, if the future prospects of D are just as good then, the market should not offer much more than a 4% yield, which means a price appreciation of 47% (1.08^5) over 5 years is not unreasonable. If you re-invest dividends along the way, your price appreciation should be even higher. YOC is a key metric for many dividend investors, and I know some long-term dividend investors who have 10%+ YOC’s on many of their holdings. At that level, they don’t care about selling the stock no matter what the market does because they love the dividends. Current dividends alone deliver a 10+% return on their original investment cost, even if they don’t increase in the future. In a low-return world where future index returns are projected to be 6% or less, this is a very favorable position to be in.
Even if the company is a good one, the timing of your purchase can go wrong. As an example of my bad timing, barely couple of days after we bought D, the company announced that 2017 would not be as good as projected due to lower import contract revenue at its Cove Point Terminal in Maryland and other near-term causes. This brought the stock down nearly 5% in one day, almost $3.40 down from my purchase price. More than a year’s worth of dividends disappeared, if you see it that way (which is not a good way to see it, as it can lead to depression 🙂 ). I bought the stock based entirely on long-term prospects and the acceptable valuation (and 4% yield) of a good business. I had no clue at the time of my purchase that 2017 earnings could be below expectations. This is what academics refer as idiosyncratic risk (that is, risk unique to one company). This is also why indexers say they are immune to such issues by investing in a diversified broad market. Fair point, but this is not the end of discussion.
What did I do? I doubled down! When you find a great company being unfairly punished by the market for a temporary and small earnings miss, you thank the market and buy more! I doubled up at the bottom of the selling frenzy. Just a few days later, the stock price recovered and I now have a full position of D at a good price, with an effective dividend yield nicely above my targeted 4%. You need patience and conviction to be a dividend growth investor and…a Warren Buffett-like belief that it is better to be approximately right than precisely wrong!
In Part 5 of the Investing Series, we discussed the valid risk that dividend investors face called ‘index lag’, which is the performance of a dividend portfolio can lag the underlying index. Even then, this lag is not to be measured for a year or two or even five, as short-term factors can cloud the real potential of a company. In my view, a 20 year or longer horizon is where the performance of a company should be compared against the benchmark index. All the while, the company must be delivering increasing profits and growing dividends (or else, why would you own it?).
For a good company, idiosyncratic risks can also turn into idiosyncratic rewards in the future, which nobody talks about. If Dominion is acquired, let’s say, by another major utility company in the future, the shareholders will see a significant jump in price. This is a reward for taking the idiosyncratic risk. Index investing doesn’t have a parallel here. Even if the company is not acquired, the market will give it a higher price after the near-term business issues are sorted out. While the future is yet to be known, I remain confident on Dominion’s ability to grow earnings, dividends and to remain a progressive utility company in North America.
To do this requires a long-term investor mindset, not a trader’s mindset. That’s why there is no clear arbitrage or leveraging opportunities in dividend investing because employing these ‘trading’ techniques doesn’t work for a 5-10+ year investment. Dividend investing requires patience or assiduity – ‘the ability to sit on your ass’, as Charlie Munger defines it. The good news is you are getting paid to do so with periodic dividends flowing in.
What do you think about this company and its prospects? Do you own D or similar high quality utilities in your portfolio? Share your thoughts below.