There are few investments hotter than dividend growth stocks. Following the 2008 financial crisis, many investors saw the risks inherent in stocks built solely for capital appreciation. Why not look for capital appreciation and cash dividends at the same time?
The logic follows that a portfolio that spins off cash dividends can provide current income, regardless of where stock prices go. And thanks to dividends, investors won't have to sell shares at less-than-opportune times (say, 2009) to raise cash for immediate needs.
The dividend growth stocks of the future
A list of dividend aristocrats (dividend stocks that have increased dividends for 25 years or more) gives you a look at history's best dividend stocks. You'll find conventional widow-and-orphan stocks in this list -- Coca-Cola, Procter & Gamble, and Johnson & Johnson.
Here are three reasons.
1. They're cash cows
Payment processing is a truly remarkable business. It's effectively a duopoly market, with Visa and MasterCard playing part in nearly 90% of all transactions. Discover and American Express merely pick up the scraps. Thus, Visa and MasterCard have ample pricing power, which can be found in their impressive margins.
Net margins at Visa have hovered around 40%; MasterCard's have been in the mid to high 30% range. In both cases, free cash flow has closely mirrored net income over time, so this isn't a case of earnings on accrual. Instead, Visa and MasterCard's earnings are coming in the form of cash -- cash that can be paid out as a dividend.
Neither Visa nor MasterCard are cheap, trading at more than 20 times 2015 earnings estimates, and nearly 30 times earnings in 2013. Both, however, are consistently repurchasing shares. Visa is the most aggressive buyer of its own stock, spending some $5.3 billion on share repurchases in its 2013 fiscal year. MasterCard's repurchases are much smaller, coming in at $2.3 billion in the last 12 months.
Since a majority of Visa and MasterCard shares are held by institutional investors -- many of which are buy-and-hold investors -- their ability to repurchase shares may be limited in the future. With much of the float controlled by institutional investors, and both being fairly valued, a dividend may make more sense than growing, ongoing repurchases.
3. Future growth
There are only two limits to a growing dividend: the payout ratio (percentage of income paid out as a dividend) and growth in net income. Future growth is much more important given their low payout ratios and growth-stock valuations.
Of course, it is growth that makes the payment processors attractive. MasterCard suspects that 85% of global payment volume is done in cash. Over time, the mix should shift to digital forms of payment, preferably cards with a Visa or MasterCard label. This will only fuel growth as more and more transactions are done over payment networks, with the payment processors collecting fees on every swipe.
In the last five years, Visa has averaged annual revenue growth of roughly 13.5%, compared to 12.7% growth for MasterCard. During this same period, global economic growth topped at 5.3% in 2010, and bottomed at -0.5% in 2009. Clearly, Visa and MasterCard are very capable of growing faster than the global economy thanks to a shift from cash to card.
The Foolish bottom line
We're in the first innings of the payment processing boom, and Visa and MasterCard are natural beneficiaries. Luckily for investors, Visa nor MasterCard require significant new investments to grow, generate billions in annual cash, and pay out only a fraction of their income as a dividend.
MasterCard's recent announcement of a bigger dividend marks three years of consistent dividend increases. Visa is now on track for six straight years of dividend increases. This is behavior consistent with companies wanting the coveted dividend growth stock crown, and the reason I believe Visa and MasterCard should be on any dividend stock investor's radar.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. It recommends and owns shares of Coca-Cola, Johnson & Johnson, MasterCard, and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.