A Very Lucrative Investment Over The Next Fifteen Years

The past decade has been a godsend for income investors that have owned McDonald’s stock because the profits have grown by 14.5% annually and the dividend has grown by 25.5% annually. Those $0.55 annual dividends in 2004 became $3.40 dividends in 2014. You were to able capture two things that were happening simultaneously over the past ten years while you held McDonald’s stock: (1) profits continued to grow, and (2) the payout ratio continued to grow as McDonald’s went from paying 28% of its profits as dividends to paying out 58% of its profits as dividends.

Such opportunities are hard to find ahead of time, but they can be lucrative additions to your portfolio when you find them because it’s great being along for the ride of a company that is raising its dividend by 10%, 15%, or 20% in a year. Do I have a candidate for consideration of a company that may be similar to McDonald’s in the next fifteen years, in terms of raisings its earnings and payout ratio simultaneously? Yes, I do, and it is Ross Stores.

Ross Stores is an off-price retailer that operates in 33 states—it still has quite a bit of room for American expansion before its growth story is over. They aim to sell designer apparel, footwear, and accessories at discount rates of 20-60% below what you would find at a specialty store.

The economics of the business are beautiful to study: Over the past ten years, Ross Stores has grown sales by 14.5% annually, cash flow by 18.0% annually, earnings by 18.5% annually, dividends by 26.0% annually, and book value by 14.5% annually. The P/E ratio is at 19x earnings, which is slightly distorted because Ross Stores has 58 new stores in existence that are pumping out profits (the company has about 1,100 stores in total) that did not exist at the start of this examination period, and the company is rolling at 28 new stores before the end of the year. It’s only a $17 billion company, and it still has 17 states in which to establish a presence.

When I examine the company’s business results, I like seeing that the company has held its margins steady—in fact, they have grown from 7% to 8% over the past five years, and I find that fact encouraging. Sometimes, when a business rolls out into new areas or establishes new locations in a state, the concern is that there is a reason why certain markets were slow to get established or might potentially saturate a market if you’re adding to existing locations, and this has not proven to be the case when you look at Ross’s numbers.

Other than Visa and BP, Ross Stores has been the stock that has been quietly though quickly winning my affections because the formula for future growth seems very clear. The company has an immaculate balance sheet—it’s a $17 billion company with only $150 million in debt. Sales are growing in the 8-11% annual range as the company continues to roll out new stores, and so far, sales have been growing 2-3% annually at existing locations.

The company is buying back massive amounts of stock—it had 377 million shares outstanding in 1998, and now only has 209 million shares outstanding. It has eliminated 44% of its outstanding shares over the past sixteen years. That is very impressive for a mid-cap company that is still in its growth stages. A lot of times, companies that are growing quickly issue capital raises so they can fund new rollouts, and the growth of the business is tempered by share dilution. Ross Stores has been able to fund its growth internally—not only does it have minimal debt, but it’s balancing its store rollouts by earmarking consistent funds for share repurchases. And they actually retired 30 million shares during the course of the financial crisis, so they earn points in my book for actually buying back stock at an opportune time when many other companies refused to do so. Heck, Ross Stores grew its profits per share from $1.17 to $1.77 during the 2008-2009 stretch and raised its annual payout from $0.20 to $0.25. It held up well during our recent bout of troubled times.

Here is what I find especially interesting though from an income standpoint—even though dividends have been growing at 26% annually over the past 10 years in comparison to 18.5% annual earnings growth, the dividend payout ratio is still only 24% (it was at 14% around 2004). I anticipate that, over the long-term, Ross Stores will pay out between 50% and 60% of its profits as dividends, in line with other retailers.

I understand why people don’t pay attention to it. It’s not as big as Wal-Mart and established as Wal-Mart, although it does do $10 billion in annual sales and has initiated a policy of raising its dividend annually (starting in 1999) and actually managed to grow profits significantly during the financial crisis. The balance sheet is extremely conservatively financed with only $150 million in debt compared to $885 million in annual profit (in other words, it could wipe out all of its outstanding debt with the amount of profit it generates over the course of two months). The store count is growing, and there is much growth left in the United States alone, to fuel 8-11% core organic growth. The company is also buying back 3% or so of its stock annually, bolstering earnings per share even more. The dividend payout ratio is only about a quarter of overall profits. The starting dividend yield is 1%, and that is automatically a turnoff for a lot of investors. I get that. I especially understand why retirees wouldn’t consider this company. But if you are looking for substantial capital gains, and a high growth rate of the dividend, I put Ross Stores on that same pedestal next to Disney, Becton Dickinson, and Visa as those very fast-growing dividend stocks.