If you are familiar with some of my writings, you have probably encountered my use of the phrase “high-quality dividend stock” to describe the kind of company worth buying and tucking away in your portfolio for decades to come.

Even though I like the phrase a lot, it is one of those descriptive terms that has fallen victim to overkill and probably cause eyes to glaze over when the word is used on a repetitive basis. That’s why I wanted to scribble down a quick post to state the obvious—what exactly I mean when I talk about high-quality assets, and why I think they make great investments for you on your life’s financial journey.

How can I tell if an asset is high-quality?

I generally look for one of three character traits to tip me off:

(1)    The company has brand equity—customers flock to a certain product even if it is priced a little bit higher. I could sell Tim’s Soda Water at the local grocery store for eighty cents, but you’d still be much more likely to pay a buck for a can of Coke, Pepsi, or Dr. Pepper. That twenty cent spread (or whatever the difference actually turns out to be in real life) is the kind of thing that has allowed Coca-Cola to raise its dividends every year for the past half century. You know which brands are good without me having to go into the obligatory paragraph explaining it—when someone wants chips, they’re going to pay a bit more for PepsiCo’s Ruffles or Lays than for the generic store brand. Heck, Kimberly Clark’s Kleenex product has such strong brand equity that people are just as likely to ask for a Kleenex as they are for a piece of tissue.

(2)    Economies of Scale or Expertise In a Niche Market—Take something like Compass Minerals, the company that sells the salts you see on the side of the road when it snows. There is no particular brand equity there—you simply go to a place like Ace Hardware, find the salt, and load up, but the company has a huge share of the market and is expert at the craft of selling salt. It’s a noncompetitive market—the world isn’t filled with kids dreaming of disrupting the salt and sulfate markets, and that partially explains what makes it easy for Compass Minerals to sit on its perch indefinitely. The same thing applies to Wal-Mart. 70% of Wal-Mart’s inventory gets sold before Wal-Mart even has to pay its vendors. It keeps its profit margins slow and steady at 3%. People don’t go to Wal-Mart because they want Wal-Mart goods, but rather, they go there because they know the goods there are cheap. The only ways Wal-Mart shareholders can “lose” is if an online vendor like Amazon manages to get people to buy fruit, meat, clothes, televisions, and other consumer products from an online source. The other main threat to Wal-Mart’s business model would occur if Wal-Mart management tried to increase profits by raising profits, creating room for a competing firm to steal market share. If Wal-Mart can sidestep those two threats, shareholders should be treated quite well over the next two decades.

(3)    The company has monopolistic-like power or sells a product we cannot do without. Take something like Aqua America, a water utility company that operates in a dozen or so states. They sell the most indispensable product in existence. You will literally die if you go a couple days without using their product. Water is here to stay. It doesn’t really matter if Aqua America’s management is brilliant—they don’t need brand equity or particular competence to turn a profit for shareholder (note: I happen to have a very high opinion of Aqua America’s current management, but I am mentioning my belief that the company could have bumbling men at the top and still do all right). The same logic extends to electric utility companies like The Southern Company.

Why are these the kind of companies that I want to stuff in my portfolio?

First, I know what I want to avoid. I don’t want to own a stock for twenty years, reinvest the dividends, and then see the company go bankrupt and see all that effort and delayed gratification go to waste. Companies with durable profits take me a long way towards avoiding that investing hell.

Second of all, when you deal with companies that grow earnings per share on a reliable basis, you can get away with stupid stuff like overpaying for a stock a little bit easier. In 1999, Johnson & Johnson traded at 31x earnings. That’s nuts. That means you were looking at a 3.5% earnings yield plus the earnings per share growth rate to determine your total returns. That’s a terrible place to start (given that you’re dealing with a megacap company) in most situations. Yet, if you had purchased Johnson & Johnson stock in the summer of 1999, you would have achieved 7.50% annual returns since then. That is because the company managed to go from generating $1.49 in profits for each share in 1999 to generating $4.49 per share today. Those 7.50% should make you want to shout for joy—the underlying strength of Johnson & Johnson’s brands was able to overcome your own mistake of paying too much for the stock. That’s why you deal with companies that grow their profits just about every year. The passage of time can heal the sin of overpaying for a stock when you’re dealing with excellent businesses.

For me, that’s what quality is all about. It lets me recover when I enter “justification mode” and pay too much, and it also prevents me from seeing decades of hard work evaporate like Wachovia, Eastman Kodak, and General Motors shareholders experienced with their shares. I look for strong brands. I look for companies with economies of scale. I look for companies that sell products that people can’t live without. There’s about a hundred or so companies you can reasonably guess will be making profits thirty or so years from now. My job is to identify them, generate the surplus capital from a combination of my labor and living below my means so I can establish ownership stakes in those stocks, and then build a diversified collection of them so I can get richer even as I make mistakes. When you combine diversification across the sectors with high-quality stocks, you are creating little moats with crocodiles around your castle. You’re on the path to building one hell of a good financial fortress.

Originally posted 2013-08-20 23:53:13.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!