For their most recent quarter, clothing giant Hanesbrands (NYSE:HBI) and discount retailer Family Dollar (UNKNOWN:FDO.DL) both raised their dividends substantially. Family Dollar increased its dividend 19.2%, while Hanes upped its payout 50%.
I recently wrote an article explaining that many dividend increases are not as good as they seem, but that's not the case with these stocks. Both stocks are examples of companies that should be raising their dividend. Here's why I'm bullish on these dividend increases.
When dividend increases are a smart move
I've often said that I wish investors would stop viewing all dividend increases as a "good idea." Since I've pointed out the opposite end of the spectrum, let's discuss which factors make dividend growth healthy.
1. A stable (even boring) business model
What we're looking for here is proof that the company in question will not be disrupted. Both companies have strong brand names -- Family Dollar through its namesake dollar stores, and Hanes through its collection of brands (e.g., Hanes, L'eggs, Playtex) that help provide a steady stream of earnings.
These industries aren't facing headwinds. The one major retail disruptor, Amazon, can't sell things cheaper than Family Dollar does, and it can only boost Hanesbrands by selling its products on its website.
This isn't the case with most dividend payers, unfortunately.
For instance, McDonald's and Wendy's pay hefty dividends that some investors could question, even though their businesses are well established. Given the disruption being created by fast-casual chains like Panera, and consumers gravitating toward healthier food choices, you could argue that their dividend cash could be better allocated elsewhere.
But are there any major disruptive competitors in the T-shirt or dollar store business? There are competitors, but no disruptions that I can think of.
The point is that this, to me, is the first thing to examine when determining a dividend's validity. Companies in a fast-paced industry, in hyper-growth mode, or those facing headwinds should consider avoiding a dividend payment.
2. A lack of better options for capital
In my opinion, a business like Apple, which needs to innovate, shouldn't be paying a dividend. But Family Dollar and Hanesbrands?
Family Dollar can open new stores (provided they continue to generate a high return on capital) and Hanes can acquire additional brands, such as its recent acquisition of the Maidenform brand. There are relatively few other places to spend the money wisely.
Hanes gets a pass, in my opinion, for raising its dividend 50% shortly after this acquisition for two reasons. First, it still boasts a sub-50% payout ratio (we'll talk more about that in a moment) and second, as the chart below illustrates, Hanes (and Family Dollar) has a track record of positive earnings with these respective strategies in good and bad times.
These companies have also reached a point of saturation to an extent, or at least a lack of hyper-growth. Family Dollar, for instance, already has 7,900 stores in 46 states. How many additional stores can Family Dollar add without cannibalizing itself?
They do not have high R&D costs or ridiculous advertising expenditures; their brands are household in nature. Hanes isn't going to reinvent the T-shirt or bra dramatically, and Family Dollar will do even less to change the dollar store concept. This gives both companies three options for their cash: bank it, make acquisitions, or pay dividends.
You can argue which is the best strategy. The point being, companies that only have those three options are the types that should be raising their dividend. Hanes and Family Dollar are right to do so.
3. Low payout ratio
The most overlooked, yet most critical, element to evaluating whether a dividend makes sense is the payout ratio -- the percentage of earnings that a company pays in dividends (or, the dividends divided by EPS).
This ratio matters simply because a company, even a boring one, needs to reinvest some capital into its business. Not to pile on Wendy's, but let's take a look at it as an example again. The company is paying more in dividends than it earned last year, and nearly as much in dividends ($0.20) as it's expected to earn this year ($0.27/share). While I love Wendy's burgers, I don't feel like that's a wise strategy for any company.
Now let's look at our two stocks. While they both increased their dividends by double digits, their payout ratios are well below 50%. This will provide them with additional funds to reinvest in their business.
More important, the low payout ratio means that both companies will have more flexibility to raise their dividend going forward, which is a catalyst that could send the stocks higher.
Dividends: Stability matters
These are two companies that might typically be overlooked by dividend investors, because they both pay yields below 2%. The stock market, however, is all about the future. When you consider the stable nature of these businesses, and their low payout ratios, their dividend future is brighter than most.
If you're venturing into the world of dividend investing, I would recommend you look for stability, over yield, in your stock purchases.
Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Amazon.com, Apple, McDonald's, and Panera Bread. 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.