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If Adam Smith Were Alive, He’d Be a Dividend Investor

You likely associate the year 1776 with the birth of our nation.

Yet it’s also the year that Adam Smith, who is considered by many to be the father of modern economics, published An Inquiry into the Nature and Causes of the Wealth of Nations.

In it, Smith explained that the profit motive was a critical component of the free enterprise system. He believed that rational self-interest and competition lead to economic prosperity.

As Smith wrote, “It is the [capital] that is employed for the sake of profit, which puts into motion the greater part of the useful labor of every society.”

Now, things have certainly changed a lot since Smith published Wealth of Nations

But there’s no question that having a competitive advantage is still the key to profits.

And that’s why Adam Smith would love dividend growers.

Better By a Wide Margin

The reason that dividend growers outperform is simple…

Only companies with some type of edge over the competition can consistently generate greater relative profits. And companies with higher profit margins tend to have higher dividend growth.

Indeed, when you look at S&P 500 dividend payers that have a trailing 12-month (TTM) profit margin (net income divided by revenue) above 10%, they boast an average year-over-year dividend growth rate of 26%.

And S&P 500 dividend payers with a profit margin below 10% have a much lower average dividend growth rate of 11%.

It all makes perfect sense.

Why has McDonald’s (MCD) been able to raise its dividend every year since 1976? Its brand gives it a competitive advantage, and the company has some of the highest sustained profit margins around.

Now, profit margins shouldn’t be analyzed in isolation. It’s helpful to compare a company’s profitability to that of its competition. And the three companies in the chart below have the highest TTM profit margins of any S&P 500 constituent in their respective industries.

The dividend increase at Pfizer (PFE) may seem modest, but it’s actually higher than most of its drug developing peers. For example, Merck (MRK) raised its payout just 2% in November 2013, and Eli Lilly (LLY) hasn’t raised its payout since 2008.

And with relatively low dividend yields, Oracle (ORCL) and Hess (HES) are certainly not on the minds of many dividend investors.

They will be soon, however. Here’s why…

Oracle’s customers include every single Fortune 100 company. This enterprise software provider is a free cash flow juggernaut, too. And it uses this cash to make acquisitions and preserve its competitive advantage.

With the 100% dividend boost in 2013, it looks like there’s sufficient free cash flow to continue making acquisitions and significantly raise the dividend payout going forward.

Hess has become a profit margin leader after hedge fund Elliott Management shook up the company’s board of directors in early 2013.

Since then, profit margins at this oil producer have improved markedly, from only 12% at the end of 2012 to 35% now.

Hess is in the process of unlocking its value. Accordingly, the company increased its dividend payout in September 2013 by 150%.

Bottom line: These three examples serve as a reminder that there’s a strong link between competitive advantage, profit margins, cash flow and dividend growth.

If Adam Smith were alive, he’d most assuredly invest in dividend growers. (Just like us!)

Safe (and high-yield) investing,

Alan Gula, CFA