Generally speaking, it is wise to hold investments that pay out high streams of dividend income inside the confines of an IRA, so you can avoid those frictional taxes that take a tax bite out of each dividend payment and limits your compounding engine (though there is also wisdom in owning something like Starbucks in an IRA because IRAs have contribution limits and getting large capital gains inside the account can be useful, too).
Usually, the blue-chip stocks that are candidates for consideration are things like tobacco (Philip Morris International), telecom (AT&T), and oil (Royal Dutch Shell, BP, and sometimes Conoco). You don’t get an opportunity to diversify into the health-care field all that often, if you’re looking strictly for high income candidates: Johnson & Johnson has a present dividend yield of 2.77%, Abbvie yields 2.97%, Abbott Labs yields 2.08%, and Pfizer is a bit better with a 3.66% yield. But GlaxoSmithKline is a notable exception.
It’s not something you’d want to own if you required an absolutely rising payout each year (you should stick with Colgate-Palmolive, Coca-Cola, Procter & Gamble, and Exxon if that is your objective), but it is a nice holding if you approach things like a business owner because that’s what GlaxoSmithKline’s dividend policy calls for: it pays out a certain percentage of profits each year, and because health-care firms with drug arms experience fluctuations in profits, it comes as no surprise that the dividend comes in fluctuations as well.
The company, which trades at $44 per share and currently earns profits of $3.50 per share, trades at a P/E ratio of 12.85 so that current investors get an initial earnings yield of almost 8%. This cheapness is a product of current business challenges. The company has cut the price of one of its signature drugs, Advair, and this has contributed to declining revenues—GlaxoSmithKline is generating as much revenue now as it did in 2005 (and this isn’t a situation like IBM where you have buybacks and productivity gains to offset stagnating revenues—GlaxoSmithKline made $8.5 billion in annual profit in 2005 and makes $8.7 billion in annual profit now).
What is intriguing about the company is this: The HIV division is growing at a rate of 15% annually coming out of the recession, and the boneheaded supply disruptions in the United States that led to 6% declining sales over the past three years is on the mend. Furthermore, the dividend is quite high at 5.6%, putting it well above historical norms (in the 1990s, the dividend yield didn’t cross 2.1%, hovered above 3% during the 2000s, and didn’t hit the 5% mark until the financial crisis).
It’s somewhat difficult to model the annual dividend growth, because while the dividend goes up nicely over just about every five-year rolling period, there are many instances where the year-over-year comparisons are negative. For instance, the dividend payout went from $2.17 to $1.71 if you compare the 2008 to 2010 period. That could be obnoxious if you use rising dividend income as a psychologically satisfying tool to measure annual forward progress. On the other hand, if you measure the 2008 to 2014 period, the dividend income increased from $2.17 to $2.87, so the overall trajectory is upward. GlaxoSmithKline is the type of investment for investors that have the attitude, “This company will pay out a good chunk of income relative to the amount of capital I initially invest, though the amount will vary with time.”
My back-of-the-envelope math for GlaxoSmithKline is something like this: Say you start by receiving a 5.6% initial dividend yield on your income (because that’s what you’d get today), and the average dividend growth rate is 5% over the next decade (it may come in the form of 12% raises and 4% cuts, but we’re talking a blended average based on what it has done post-merger).
Here’s how it would work out: If you purchased $5,500 worth of GlaxoSmithKline in a Roth IRA (the current annual maximum), and paid $44 per share, you would get 125 shares of the $100 billion healthcare giant paying out $358 in initial annual income that is free to compound without any interference from Uncle Sam. If that $358 in annual income grows at a rate of 5%, you would collect $5,111 in annual income over the following ten years. That’s 92% of your initial investment amount returned, without any dividend reinvestment. If you plowed the dividends back into more shares of GlaxoSmithKline along the way, you could conceivably have received a dividend amount equal to your initial investment by year seven or eight.
There’s also a lottery ticket dimension to any healthcare investment, in which case R&D development leads to a break-out drug patent that greatly increases profits on short notice, and you get 7-9% dividend growth for a while. You wouldn’t make an investment that hinges on a development like this, but you also shouldn’t object to putting yourself in situations where you not only do you have a good chance of good returns, but you have an outside chance of excellent returns as well.
A lot of people don’t have much patience for this company right now because of the foreign accusations of bribery and a modestly declining revenue figure over the short-term. That’s why you get the 5.6% dividend. But despite all of this, it’s still a company pumping out $8-$9 billion in annual profits across hundreds of different profit sources. With earnings growth and dividend growth in the mid-single digits over the coming decade, you can do very well from an income generation standpoint. For a patient investor that likes lots of income but doesn’t mind some fluctuations, GlaxoSmithKline seems worthy of further investigation.