PBY shares are now up 35% since we selected them as one of our top picks for 2012. If you don’t own the shares now, it is too late as they are currently trading near the purchase price of $15/share and will most likely discontinue their DRiP plan upon completion of the company’s sale. There are still nine DRiPs remaining from our top-10 list, however. So, if you’re not a First Share PRO member and are interested in learning more about our top picks for 2012 click here to upgrade or register as a new member.

We will most likely sell the PBY shares that we hold in our model portfolio. We’ll let our members know what we did with the cash in the February edition of The DRiP Report.

Investing with dividend reinvestment plans can help minimize the “buy high, sell low” mentality of investors. Dividend reinvestment plans provide a way for investors to dollar-cost average into a stock. Dollar-cost averaging helps the investor buy more of a stock when the price is low and buy less of a stock when prices are high.

Consider direct investing with DRIPs today. FirstShare.com is here to help!

What Do You Mean the Poor Aren’t Paying Their “Fair Share”?

So, you may be asking yourself what kind of person would say that it’s not the rich who aren’t paying their “fair share”, but the poor. My answer would be a person who looks to the data.

As of 2008, which is the most recent data provided on the IRS’ website, IRS.gov, the top ten percent of all wage earners paid 70% of the taxes collected by the government in that year. That is up from 49.3% in 1980 and 65% in 2001.

At the same time, the bottom 50% of wage earners paid only 2.7% of the taxes collected by the government in 2008. That’s down from 7.1% in 1980 and 4.0% in 2001.

Welfare Spending Increasing

As the top 10% of wage earners bear an increasing burden, welfare spending as a percentage of total government spending has soared in recent years.

I point this out because which group do you think is more likely to partake of the welfare pot? Certainly not those making more than $330,000 per year (top 10%). I argue that it’s more likely that those in the bottom 50% are more likely to receive some sort of government aid. So, while that group is taking an increasing amount from the government’s coffers, it is putting in a smaller amount than ever before (2.7%). Is that group really paying its “fair share”?

Tax/Candy Analogy

Consider for a moment that you have two siblings. Each week the three of you do your assigned chores. Since you are older than your other siblings, you have a longer list of chores, but you also get a higher allowance. Your youngest sibling has the fewest chores to do and, therefore, receives a smaller allowance.

Now, assume that at the end of the week you and your siblings go to the candy store to buy some candy. You decide to purchase one large bag of candy with you paying a larger amount of the purchase price (you have more money) and your youngest sibling paying the least. Would you expect to get a larger portion of the candy? Yes, you paid a higher portion of the purchase price.

However, what if one of your parents saw that you had more candy than your other two siblings and made you give some of your candy to each of them so the split would be fair? Now, you’re all left with the same amount of candy, yet you paid more than either of them. Is that fair?

Final Thoughts

I certainly realize that income inequality in the U.S. is at all-time highs. The fundamental question is how do we close that wealth gap? Do we punish those who make more than $250,000/year (which isn’t much, by the way, for those living in cities such as New York), or do we make it easier for those in that bottom 50% to get to the top 10%?

For Lockheed Martin investors, war is good for dividends — and lots of them. In fact, since the United States military invaded Iraq in 2003, Lockheed Martin has increased its dividend from $0.44/share to more than $3 (estimated $3.15) in 2011. The company has increased its dividend for nine straight years at an average compounded rate of 20% per year. My problem with this company is its dependence upon the U.S. Government for its revenues. Approximately 85% of the company’s revenues currently come from the federal government and it is my opinion that our federal government is broke.

Current Dividend Yield

Of the five dividend-paying stocks included on our Dividend-a-Month Club list for September, Lockheed Martin is currently in a tug-a-war with Intel for the highest dividend yield. Currently, Lockheed Martin is on top with a yield of 4%, slightly higher than Intel’s 3.8% yield. While the current dividend yield is an important factor to consider, it is not the only factor. Equally, if not more, important is the company’s history of growing its dividend, as well as its ability to maintain that growth, going forward.

Dividend Growth History

To be included in the First Share Dividend-a-Month Club, a company must have raised its dividend each year of the previous five years and Lockheed Martin fills that requirement. As previously mentioned, Lockheed Martin has raised its dividend for 9 consecutive years and during that period has increased its dividend by an average of 20% per year (compounded).

Dividend Sustainability

This is the category that worries me the most as it relates to Lockheed Martin. While I don’t feel that the company’s dividend is in jeopardy in the short-to-medium term, I am extremely pessimistic on the fiscal health of the U.S. government, going forward. With 85% of its revenues coming from federal spending, Lockheed Martin’s dividend could come under pressure over the longer-term. With total debt in excess of $14 trillion, the U.S. government will eventually be forced to drastically cut spending. In 2010, defense spending totaled over $700 billion, or 14.5% of total government spending. Only spending on social programs such as Social Security and Medicare exceeded defense spending.

I am convinced that significant reforms in Social Security and Medicare will not come until it is too late. That leaves defense spending as the only other category where enough spending can be cut to actually make a difference. The good news for Lockheed Martin investors is that global warfare is likely to only increase in the near-term.

I don’t believe that the fighting is nearing an end, however. History shows that recessions are followed by war.

So, the “good news”, for lack of a better phrase, for Lockheed Martin investors is that the wars and the fighting are not likely to end anytime soon.

Regardless, Lockheed Martin is on track to pay out only approximately 50% of its free cash flow as a dividend during 2011. While that is above its 11-year average of 29%, it’s still not too high. Keep in mind, also, that the company is in the process of developing one of its newest fighter planes – the F-35. This is a capital intensive process which will likely inflate the company’s payout ratio in the short-term.

Yield-to-Cost Explained: If you were to buy shares in Lockheed Martin at its current price of $76.04 and received $3.15 per share in dividends, your yield-to-cost would be 4.1%. Yield-to-cost is determined by simply dividing a company’s dividend by the investor’s average cost basis in a stock. Assume, for example, that Lockheed Martin were to continue to increase its dividend by its long-term average rate of 20% per year. By 2016 it would be paying an annual dividend of $7.83 per share. If you paid $75.06 per Lockheed Martin share today and held the stock through 2016, you would essentially be receiving a dividend yield (on your investment) of 10.4% in 2016.

Conclusion

Lockheed Martin has a solid history of paying a dividend and has increased its dividend every year for that past nine years. Its payout ratio, while not low, is reasonable at approximately 50%. I do think its dividend could be threatened in five-to-ten years or so as defense spending must decline, but I don’t think it is in danger in the near-term. Therefore, investor’s who purchase the stock at current prices could see their yield-to-cost rise significantly over the course of the next several years.

Lockheed Martin shares are offered as part of the First Share Program for DRIP Investors!

Nevertheless, I cannot let Tuesday’s report, by the Census Bureau, on the U.S. poverty rate go without a response. I’m sure you’ve seen it all over the news by now; poverty at a 50-year high, 15.1% living in poverty etc…. There are two important points that you may not be hearing reported by the news media.

1) In 2010, the Obama administration announced a change in the way it calculates the nation’s poverty rate. For the previous 45 years, the nation’s poverty rate considered a person’s income level and the cost of food. Beginning with the 2009 report, the poverty rate began considering several other expenses including the cost of healthcare. I have no problem with this calculation change, as the typical American family has a much different budget now, in terms of what they purchase, than in 1965. However, this change should be made clear to the public because it has the effect of significantly increasing the number of people considered to be living in poverty. Also, the actual poverty rate, or percentage of working age population, is not at a 50-year high. As can be seen in the graph below, things were much worse in the early-1960s. The number being reported as a 50-year high, is the actual number of people living in poverty. Remember, however, that our population has grown significantly over the years, so it’s not surprising that the actual number of people living in poverty has increased as well.

2) The average person living in poverty, as calculated by the government, has a car, air conditioning, two color televisions, cable or satellite TV, DVD and VCR, video game system, refrigerator, oven and stove, washer and dryer, ceiling fan, cordless phone and a coffeemaker. In addition, 70% of those living in poverty report being able to meet all essential needs, including: mortgage, rent, utility bills and important medical care.

The problem with statistics is that you can get them to tell whatever story you want. The problem with government statistics is that the story will usually lead to more spending, higher debt and more class warfare. Remember, one of my goals for this blog is to get the average, small investor to dig beneath the headlines and see what is really going and not simply accepting what the government and the news media tell you. Given the two points I outlined above, it appears that a large part of the problem is that many Americans are still living above their means.

Real poverty can be seen by studying current conditions in Somolia, where parents are forced to leave their dying children along the roadside so that they can make it to a refugee camp for food and water to ensure their own survival. We are fortunate to live in a country where being poor means choosing between a big-screen TV and food, not between our children and food.

Current Dividend Yield

Interestingly, of the five stocks included on our September list, Intel currently offers the highest dividend yield at 4.15% — slightly higher than Lockheed Martin. So you may be wondering why, if Intel currently has the highest dividend yield of the companies on our list, why it is ranked #3 and not #1. As I’ve mentioned in my blog postings on both IBM and Walgreens, the current dividend yield is an important factor to consider in dividend investing, but it is not the only factor. Equally, if not more, important is the company’s history of growing its dividend, as well as its ability to maintain that growth, going forward.

Dividend Growth History

To be included in the First Share Dividend-a-Month Club, a company must have raised its dividend each year of the previous five years and Intel fills that requirement. Intel has increased its dividend every year for the past eight years and during that period has increased its dividend by an average of 33% per year (compounded). Since 2005, the company’s dividend growth rate has averaged 16% per year.

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Dividend Sustainability

To summarize my previous thoughts on dividend sustainability, I believe that this is the most important factor to consider when accessing a company’s dividend. Any company can essentially mortgage its future to pay its shareholders a fat dividend for one year, but only the most financially-stable companies can continue to pay an attractive dividend over the long-term.

To gauge a company’s dividend sustainability, I look at the company’s payout ratio, or its dividend per share divided by its free-cash-flow per share. This ratio tells you what percentage of a company’s annual free cash flow it is paying out as a dividend to its shareholders. Generally, the lower the better because it provides the company with more of a financial cushion should it go through a down period.

For 2011, Intel is on track to pay out approximately 53% of its free cash flow as a dividend, so its payout ratio is just that, 53%. While that is below the company’s five year average payout ratio of 76%, it is still somewhat higher than I’d like to see. Generally, I would prefer a company’s payout ratio to be below 50% and even lower than that for a company with choppy cash flows such as Intel. However, Wall Street’s forecast for Intel’s 2012 payout ratio is approximately 40%. I feel that may be an optimistic forecast on Wall Street’s part given the cyclicality – or economic sensitivity – of Intel’s free cash flows and the fact that I believe we will be in a recession at some point during 2012. Nevertheless, I don’t think Intel’s dividend is in any short-term danger.

Yield-to-Cost Explained: If you were to buy shares in Intel at its current price of $20.28 and received $0.78 per share in dividends, your yield-to-cost would be 3.8%. Yield-to-cost is determined by simply dividing a company’s dividend by the investor’s average cost basis in a stock. Assume, for example, that Intel were to continue to increase its dividend by its long-term average rate of 17% per year. By 2016 it would be paying an annual dividend of $1.64 per share. If you paid $20.28 per Intel share today and held the stock through 2016, you would essentially be receiving a dividend yield (on your investment) of 8.1% in 2016.

Conclusion

Intel has a respectable history of maintaining, and growing, its dividend given the industry in which it operates. The company’s payout ratio is slightly higher than I would like to see, but is not so high that its dividend is in imminent danger. Investor’s who purchase the stock at current prices could see their yield-to-cost rise significantly over the course of the next several years.

Intel shares are offered as part of the First Share program for DRIP investors.

Current Dividend Yield

Of the five dividend-paying stocks included on our Dividend-a-Month Club list for September, Walgreens has the second lowest current dividend yield (2.52%) – slightly higher than IBM. Interestingly, IBM and Walgreens ranked number one and two, respectively once all of the September stocks were run through our dividend selection model. You may be wondering how this can be. Why aren’t the stocks that have higher dividend yields ranked higher on a list of best dividend stocks? While the current dividend yield is an important factor to consider, it is not the only factor. Equally, if not more, important is the company’s history of growing its dividend, as well as its ability to maintain that growth, going forward.

Dividend Growth History

To be included in the First Share Dividend-a-Month Club, a company must have raised its dividend each year of the previous five years and Walgreens fills that requirement. As previously mentioned, Walgreens has raised its dividend for 36 consecutive years and during that period has increased its dividend by an average of 13.6% per year (compounded). Since 2005, the company’s dividend growth rate has accelerated to 22.7% per year, compounded annually.

Dividend Sustainability

To get more on my thoughts of the importance of dividend sustainability, please check out my dividend analysis of IBM. To summarize, I believe that this is the most important factor to consider when accessing a company’s dividend. Any company can essentially mortgage its future to pay its shareholders a fat dividend for one year, but only the most financially-stable companies can continue to pay an attractive dividend over the long-term.

To gauge a company’s dividend sustainability, I look at the company’s payout ratio, or its dividend per share divided by its free-cash-flow per share. This ratio tells you what percentage of a company’s annual free cash flow it is paying out as a dividend to its shareholders. Generally, the lower the better because it provides the company with more of a financial cushion should it go through a down period.

For 2011, Walgreens is on track to pay out approximately 31% of its free cash flow as a dividend, so its payout ratio is just that, 31%. That is below its five year average payout ratio of 36%. In my opinion, this is a very solid number and gives the company plenty of room to increase its dividend, going forward. In fact, the company just recently increased its quarterly dividend by 29% to $0.23 per quarter ($0.92 per year). Theoretically, the company could also increase its payout ratio and, therefore, pay an even larger dividend, but, with the exception of 2007 and 2008, Walgreens has been fairly consistent in paying out 20% – 30% of its annual free cash flow in dividends. The high payout ratios during 2007 and 2008 are anomalies as the company was investing heavily in building new stores during that period, so its free cash flow was artificially low.

Yield-to-Cost Explained: If you were to buy shares in Walgreens at its current price of $35.88 and received $0.92 per share in dividends, your yield-to-cost would be 2.6%. Yield-to-cost is determined by simply dividing a company’s dividend by the investor’s average cost basis in a stock. Assume, for example, that Walgreens were to continue to increase its dividend by its long-term average rate of 13.6% per year. By 2016 it would be paying an annual dividend of $1.51 per share. If you paid $35.88 per Walgreens share today and held the stock through 2016, you would essentially be receiving a dividend yield (on your investment) of 4.2% in 2016.

Conclusion

Walgreens has a solid history of maintaining, and growing, its dividend. Given its low payout ratio, it appears as though the company will be able to sustain that growth, going forward. While its current dividend yield is the second lowest of our September picks (2.52%), investor’s who purchase the stock at current prices could see their yield-to-cost rise significantly over the course of the next several years.

Walgreen shares are offered as part of the First Share program for DRIP investors.

History of Corporate Earnings During Recessions

As someone who loves to analyze data, I looked at the average annual earnings for the S&P 500 from 1965 through 2010. During that period, the U.S. economy experienced seven official recessions, during which corporate earnings (peak-to-trough) fell by almost 19%. During each of the past two recessions (2001 and 2007-2009), corporate earnings fell by almost 31%. So, it appears as though corporate earnings can be expected to fall by between 19% and 30% during the average recession.

Current Estimates Too High

Currently, analysts are expecting corporate earnings to increase by 9% during 2012. Given my expectations that we are about to enter a recession, I feel that those estimates are too optimistic. In fact, if you assume that corporate earnings decline as they have in past recessions (19% – 31%), current estimates would need to come down by over 30%. For my part, I assigned a 50% chance that profits fall 19% and a 50% chance that profits fall 30% and came up with an estimate of $72.41 for S&P 500 earnings. The current average estimate is for earnings of $104.59.

Markets Pricing in 75% Chance of Recession

With the S&P 500 currently at 1,198.62 and the average 2012 earnings estimate of $104.59, the implied P/E ratio for the market is only 11.5x. Over the past nine years, the average P/E ratio has been approximately 17x and during the last recession, the P/E ratio for the S&P 500 reached a low of 13.8x (average of 15.4x). By assuming that my estimate of $72.41 is appropriate for a recession and the current average estimate is appropriate for an expanding economy, it appears that the market is currently pricing in a 75% chance of a recession in 2012.

Why I Think Stock Prices Will Fall 10% by Year-End 2012

I’ve already made it clear that I expect the U.S. to enter a recession in short order. As such, my estimate for S&P 500 earnings during 2012 is only $72.41. Taking the average of the two P/E ratios mentioned above, I apply a P/E of 15.4x to my 2012 earnings estimate to arrive at a fair value estimate of 1,115. Given that the S&P 500 closed at 1,198 on Wednesday, stock prices would have to fall 7.4% to be fairly valued. However, as we’ve seen many times in the past, the market tends to overreact in both directions. So, a 10% decline is not out of the question.

The one thing that could prove me wrong would be aggressive action taken by the Federal Reserve. While I don’t think it would solve the country’s economic problems, it would effectively take the lid off of the cookie jar for Wall Street and stock prices would likely become inflated.

Good News for DRIP Investors

While this sounds unnerving, DRIP investors should be welcoming such a scenario. Given their propensity to invest on a regular basis, any decline in stock prices would help the average DRIP investor acquire even more shares with the same investment. For an analysis of how market volatility can be good for DRIP investors, check out my blog posting from August 18.

Current Dividend Yield

Interestingly, at 1.82%, IBM has the lowest current dividend yield of the five stocks that were included on the list. The average dividend yield of the other four stocks is currently 3.6%. However, this presents me with the perfect opportunity to show exactly what I want to accomplish with this monthly list. While the current dividend yield is an important factor to consider, it is not the only factor. Equally, if not more, important is the company’s history of growing its dividend, as well as its ability to maintain that growth, going forward.

Dividend Growth History

To be included in the First Share “Dividend-a-Month Club”, a company must have raised its dividend each year of the previous five years and IBM fills that requirement. IBM has raised its dividend for 11 consecutive years and during that period has increased its dividend by an average of 17% per year (compounded).

Dividend Sustainability

To me, the most important factor to consider is the sustainability of a company’s dividend. Any company can essentially mortgage its future to pay its shareholders a fat dividend for one year, but only the most financially-stable companies can continue to pay an attractive dividend over the long-term.

To gauge a company’s dividend sustainability, I look at its payout ratio, or its dividend per share divided by its free-cash-flow per share. This ratio tells you what percentage of a company’s annual free cash flow it is paying out as a dividend to its shareholders. Generally, the lower the better because it provides the company with more of a financial cushion should it go through a down period.

For 2011, IBM is on track to pay out approximately 21.4% of its free cash flow as a dividend, so its payout ratio is just that, 21.4%. That is slightly below its five year average payout ratio of 22%. In my opinion, this is a very solid number and gives the company plenty of room to increase its dividend, going forward. In fact, I believe that IBM may raise its quarterly dividend to $0.85 per share ($3.40 annual dividend) in June 2012. For those interested, I arrive at this estimate by simply assuming the company maintains its payout ratio of 22% and multiply that by the average analyst estimate for 2012 free-cash-flow per share ($15.68). Theoretically, the company could also increase its payout ratio and, therefore, pay an even larger dividend, but it has been fairly consistent in paying out 22% – 23% of its annual free cash flow in dividends.

Yield-to-Cost Explained: Assume for a moment that I am correct and that IBM increased its quarterly dividend to $0.85 per share ($3.40 per share per year). If I were to buy shares in IBM at its current price of $165.10 and received $3.40 per share in dividends, my yield-to-cost would be 2.1%. Yield-to-cost is determined by simply dividing a company’s dividend by the investor’s average cost basis in a stock. This is also another opportunity to stress the importance of dividend growth. If IBM were to continue to increase its dividend by 16% per year, then by 2016 it would be paying an annual dividend of $6.09 per share. If you paid $165.10 per IBM share, you would essentially be receiving a dividend yield (on your investment) of 3.7% in 2016.

Conclusion

IBM has a solid history of maintaining, and growing, its dividend. Given its low payout ratio, it appears as though the company will be able to sustain that growth, going forward. While its current dividend yield is the lowest of our September picks (1.82%), investor’s who purchase the stock at current prices could see their yield-to-cost rise significantly over the course of the next several years.

IBM shares are offered as part of the First Share program for DRIP investors. To get started now, click here!