The Magic Dividend Cocktail

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This is a guest post by Mr Tako, who writes about investing and financial independence over at . The author is a financially independent dividend investor, who focuses his time on his family, investing and blogging. Mr Tako is in retirement, which is the ultimate goal for most of us.

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The dream of dividend growth investing is a dream about passive income — An ever growing stream of passive income that lasts for decades and requires very little work to maintain.
That was my dream anyway, and for the most part .

Unfortunately, the dream of passive income is easier to dream about than it is to achieve. It takes work. Dividends don't just keep growing out of "thin air" — Companies have to actively make the right moves to keep those beautiful dividends growing.

This means investors must also find the right companies to stay invested in — the ones with dividends that grow faster than inflation for long periods of time.

How does an investor find companies like these? One great place to start is by identifying the four methods by which companies grow dividends…

While most people are aware that high payout ratios are unsustainable, investing in companies with rising payout ratios can still work-out for savvy investors. Why? Payout ratios often rise when a rapid growth company mature into a cash-cow.

This doesn't mean cash-cows stop growing of course, there can still be decades of growth ahead for a newly-minted cash cow.

Microsoft sets a good example for this point — Microsoft first started paying a dividend back in 2003. The initial dividend was $0.08 per share on $0.69 per share of earnings (roughly 12% of earnings). Over the years, the dividend payout ratio has slowly risen to roughly 50% of earnings. Microsoft's annual dividend is $1.53 per share.

This works-out to be a 10.3% annual dividend growth rate over the past 14 years… all from a supposedly "mature" company. Not too shabby!

Of course, the best way to capture a growing dividend stream is . When the business grows, earnings grow… and ultimately the dividends should rise with earnings.
But earnings growth doesn't just happen "for free". A company must invest additional capital to grow the business. New stores must be built, inventories have to grow, new product lines created, people have to be hired, and so on.

This is why high-payout ratio stocks are best avoided — If a company is paying out too much of earnings (say 90% of earnings), they'll have little available to reinvest in the business for growth.
Debt can sometimes be used as a substitute for free cash flow, but only the strongest and stablest of companies are able to pull-off debt fueled growth.

While are often seen as a way to simply "boost" stock prices, this investment of free cash flow can have a direct impact on long-term dividend growth.

Fewer shares outstanding mean even stagnant corporate earnings will show growth on a per-share basis. If we extend this line of thinking over a long enough period of time, dividends could eventually be raised.

Confused? Imagine a company that buys-back shares year after year. It does so at a rate greater than or equal to the dividend growth rate — 5% fewer shares outstanding every year and a 5% annual dividend growth rate. This means the total cash payout required to pay the dividend remains the same year after year, but the dividend per share continues to grow because of fewer shares outstanding.

This is phenomenon (if maintained) can be very positive for investors.

Pricing power is probably the rarest of the four dividend growth methods, but by far the most powerful.

Why? The company can raise the prices of the product faster than customers will leave. This leads to growing earnings for investors, without the requirement of additional capital. Only a price change is required!

Companies with the power to raise prices faster than inflation are rare birds indeed, but they do exist!
Offhand, I can think of several businesses that exhibit this wonderful quality:

• Altria (MO) — Despite decades of decline smoking rates, Altria is earning more money than ever (and paying larger dividends). It's because they've raised prices on cigarettes faster than smoking rates have declined.
• Disney Theme Parks (DIS) — Have you ever noticed that tickets to the Disney theme parks rise every year? They do! I've been watching them for years, and they've definitely been rising faster than inflation!

• Cable TV — Yes, you're not imagining it. Your cable TV bill grows all the time. that cable TV prices have grown (on average) 6% annually since 1995, while inflation has only grown 2.3%.
• See's Candies — When Warren Buffett bought See's back in 1972, the company sold 16 million pounds of candy and produced $4.2 million in profit. Thirty five years later, See's now sells over 32 million pounds of candy (twice the candy), but profits are now over $82 million dollars annually.

Finding a company that grow dividends faster than inflation for decades is no easy task. I spend a lot of time writing about finding these companies on my blog . I firmly believe that companies with the best chance of doing so exhibit a mix of these 4 key "ingredients".

If you look closely at the () you'll see this same story played out in many companies over decades — a mix of earnings growth, significant and meaningful share buybacks, pricing power, and a slow growth of the payout ratio.

Those lists are a great resource for finding companies with just the right mix of "dividend growth" ingredients, but are by no means the end-all be-all of dividend growth investing.

Like a fine cocktail, the right ingredients in the right proportions can produce stunning results.

I like to think of those four ingredients as the Magic Dividend Cocktail — key ingredients that together create a healthy environment for continually growing dividends. The actual "ingredient" amounts are going to vary depending upon the company and industry … certain "ingredients" may be entirely missing from some investments.

Take Phillips 66 (PSX) for example – The company invests a third of free capital back into the business for growth, a third into share buybacks, and a final third into paying dividends. This "cocktail" has resulted in 10%+ dividend growth for years, despite being in a commodity business with absolutely no pricing power.

Another company I follow, Expeditors International of Washington (EXPD), has far lower capital requirements for growth. The company only reinvests 10-15% of free capital into growth. The

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