Markets

Does Your Latest Investment Pass This Test?

On Wednesday , I sounded the alarm about the problems looming for some consumer staples stocks. In short, many of these blue chips have been in business for decades -- if not centuries -- and have had their growth slowly grind to a crawl of late.

I pointed out one stock in particular that might soon have to cut its dividend -- which could devastate income investors who rely on those regular checks in their retirement. Kimberly-Clark Corp. (NYSE: KMB ) may still seem like a safe place to keep your money. But as I pointed out , it has some fundamental problems that should make you think twice before investing in KMB today.

Of course, not all stocks are created equal. And it certainly doesn't mean all income-seeking individuals should avoid all consumer staples forever.

The best consumer staples investments are those that can pass two basic tests.

These tests can also identify good income plays in other industries, such as utilities, telecoms and tobacco plays. Today, I've found a consumer staples stock that passes these two tests with flying colors. If you 're looking for a great new addition to your income portfolio, read on.

But you should also know how to evaluate the other stocks in your portfolio. Here are my rules for finding the best in class stocks for my income portfolio...

Dividend Safety Test #1: Low Current Payout Ratio

First, good income investments should have a low free-cash-flow payout ratio. What does that mean?

Here's a quick refresher on how to find a company's cash flow: Simply take its income from operations over a certain period and subtract its capital expenditures during that same period. For Kimberly-Clark, that came out to $1.1 billion over the last 12 months.

To find this modified payout ratio (typically, investors use earnings instead of free cash flow... but that's a topic for another day), simply divide the total dividend payments that company made over the same period by that free cash flow figure.

In KMB's case, that ended up being more than 100% ($1.3 billion spent on dividends divided by $1.1 billion free cash flow).

In other words, the company spent more money paying its shareholders than it actually made during the last 12 months. Obviously, that's unsustainable.

Dividend Safety Test #2: History of Dividend Coverage

The second of my tests is to see if the company has been able to grow its free cash flow at a rate consistent with its dividend policy. Here, we apply the same math but over time.

So for KMB, here's what its last four years of FCF and dividends look like:

KMB Free Cash Flow And Dividends (In Millions)

Income From Operations Capital Expenditures Free Cash Flow Dividends Paid FCF Payout Ratio
2011 $2,288 $968 $1,320 $1,099 83.26%
2012 $3,288 $1,093 $2,195 $1,151 52.44%
2013 $3,040 $953 $2,087 $1,223 58.60%
2014 $2,845 $1,039 $1,806 $1,256 69.55%
2015 $1,641 $798 $843 $952 115.93%

Source: Google Finance

As you can see, Kimberly-Clark's payout ratio has been sporadic these last several years... culminating in an unsustainable current rate.

This Stock Passes Both Of My Tests

So let's look at one consumer staple that does pass these two tests: Colgate-Palmolive Company (NYSE: CL ) .

Like Kimberly-Clark, Colgate-Palmolive has a very long history... dating back to 1806, when William Colgate opened his shop in New York City.

The company is known for its brands, including Speed Stick, Irish Spring and of course its Colgate-brand toothpaste and Palmolive dish soaps.

This history and these brands have built the company into a $59.2 billion behemoth .

By the way, that's an even longer history and larger market capitalization than Kimberly-Clark. But that doesn't mean it falls into the same boat as KMB.

In fact, it passes my two tests with flying colors.

Over the last 12 months, CL has raked in $2.3 billion in free cash flow. Yet, it has only paid out $1.5 billion in dividends. So it has easily covered its quarterly dividends of late.

Historically, it has done even better:

Source: Google Finance

As you can see, it has had no problem covering its dividend payments with the money it earnings from operations at any period over the last few years.

Remember, this has been a tough, flat year for all consumer staples. So for CL to come out in such great shape means it is prepared to handle good periods and bad... exactly what you want from a consumer staples stock.

This table also shows how consistently it has already proven itself as a dividend grower. From just $1.2 billion in 2011 to $1.45 billion last year, it has been one of the best in the industry.

So if you currently own CL, or are looking to add a consumer staple stock for its lucrative dividend growth, you're looking at a great play.

Risks To Consider: Nothing stays completely invulnerable to macroeconomic forces. Colgate-Palmolive Company (NYSE: CL ) is no exception. As we saw in 2008 and 2009, even companies with more than 100 years of dividends can suddenly fall on hard times and cut their payments. While there is much lower chance of that happening to CL than to KMB, it is still something you need to stay vigilant against. These two tests will help you do just that.

Action To Take : If you own shares of Colgate-Palmolive, you don't need to take any action here. Your dividend is amongst the safest in the industry. If you don't own CL shares, consider picking them up now. If we face any headwinds economically, expect some consumer staples stocks to suffer. CL won't be one of them.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.