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Dividend-Growth Investing has become popular among investors wanting stability in a volatile market. The markets go up and the markets go down, but your dividend check keeps on growing every year on through retirement. You can find such stocks by copying the S&P High Yield Dividend Aristocrats index, the Dividend Achievers Select index or the Challengers, Contenders and Champions list compiled by David Fish.

While these lists create quick shortcuts to finding dividend growth stocks, these same lists do not convey accurate historical performance figures of the dividend growth strategy…and neither do these lists claim to. What you will not find on these lists are stocks that froze or cut dividends and others that went belly up. What you have is a list of stock market survivors which does not tell you about the attrition and devastation to a portfolio that followed this strategy over the past 10 years.

Comparing Biased vs. Unbiased Returns

All the following screens, simulations and backtests will be using the Portfolio123 engine, which uses the Compustat 'point-in-time' database for results that are free of survivor-ship bias and look-ahead bias. Having the right data is key to understanding real-world performance of dividend growth investing.

Performing a 10-year back-test on a survivorship-biased list generates returns that look like this:

Name

CAGR

Max Drawdown

Sharpe Ratio

Sortino Ratio

Dividend Champions

14%

41.5%

0.46

0.60

Dividend Contenders

17.5%

36%

0.69

0.88

Dividend Challengers

19%

39.5%

0.74

0.92

S&P High Yield Dividend

13.5%

40%

0.45

0.56

Dividend Achievers Select

17%

42%

0.55

0.71

Compare this to the trailing 10-year stats when we remove survivorship bias. The following chart shows the real-world stats (dividends included) where the purchases are restricted to companies which increased dividends annually for the past 10 years (using point-in-time data).

Universe

CAGR

Max Drawdown

Sharpe Ratio

Sortino Ratio

All Stocks

10%

53%

0.26

0.33

S&P 500

10%

57%

0.25

0.31

The annual return is about 5 percentage points lower in the unbiased list while the drawdown is 15 percentage points higher. While it may seem that this strategy is still worth doing, consider that an equal weighting strategy in the S&P 500 (including dividend re-investment) would have returned :

Universe

CAGR

Max Drawdown

Sharpe Ratio

Sortino Ratio

S&P 500

12%

59%

0.31

0.39

So where does that leave dividend-growth investors? Out in the cold with inferior returns? Not at all. The mechanism of paying increasing dividends is an easy to understand method for forecasting and withdrawing income into retirement…provided you account for survivorship-bias and have a fundamental strategy. The key is to remember that increasing dividends is a management decision and says nothing of company fundamentals or equity valuation.

You might compare it to a company that commits to a program of share buybacks with larger sums of money every year. You may agree that this is a good policy if the company has the fundamentals to back it up and shares are reasonably priced. So let's take the management policy of dividend growth and see which factors make a preferred holding that will stand up to the economy with its face to the wind and protect against downside loss.

Absolute Rules vs. Relative Ranking

Fundamental analysis combined with valuation is one of the quickest and most reliable methods (in my opinion) to determine whether you should hold a stock or not. Using trailing price performance (technical analysis and momentum) to determine which dividend growth stocks to buy has proved unreliable for me. This is because a stock can drop due to a market-wide crash, a stock/industry/sector with eroding revenue and profit, or a change in sector sentiment. These three price-dropping catalysts should have investors doing three very different actions - and share price performance comes up short even if you can compare a stock price to the sector price to the market.

Grading a stock according to fundamentals and value can be achieved in various ways.

  • One method is to use absolute rules (yield>2%, earnings growth year over year > 10%, etc.).

I find this method of absolute rules arbitrary and highly dependent on the general economy. Having a minimum yield of 8% made sense in the 1980s when interest rates were sky-high but is overly restrictive in today's market.

  • The other method is to use relative ranking rules that can be used all by themselves or with select absolute rules.

Portfolio123 has built an impressive library (over 30) of these relative ranking systems built around a theme such as Warren Buffett, Graham, Lynch, Value, Quality, Sentiment or Market-timing. Or you can build your own. How does applying the various ranking systems where we pick the 'best 15' stocks influence our returns? Which theme makes the most sense?

Comparing Ranking Systems

Our lineup of ranking systems will include Buffett, Graham, Greenblatt, Value, Comprehensive: Quality Value Growth and P123 Multi-market Rank. This is a blurb about how each ranking system differs:

  1. Buffett: This ranking system prefers stocks with increasing book value growth with low valuations and earnings stability over the past 16 quarters.
  2. Graham: This ranking system prefers low valuation, historical earnings growth and earnings stability over the past 16 quarters. While the concept is similar to Buffett's ranking system, it does not look for growing book value.
  3. Greenblatt: This ranking system has two simple rules where it prefers higher return on capital and higher earnings yield.
  4. Lynch: This ranking system looks for value using the PE, PEG and PE relative ratios (where the trailing PE is in relation to the 5-year historical range). It looks for industries that are less covered, lower liabilities when compared to assets and good stocks in underperforming industries.
  5. Basic: Value: This looks for value based on earnings, sales, free cash flow and assets.
  6. Comprehensive: Quality Value Growth: This ranking system looks at 26 different ratios that prefer higher quality fundamentals, earnings and sales growth in addition to lower valuations.
  7. P123 Multi-market Rank: This ranking system prefers value, earnings growth and upward earnings revisions in bull markets while favoring price and earnings stability in bear markets.

How well do these relative ranking rules stack up with 3-month rebalancing periods compared to the broad dividend growth universe?

Name

CAGR

Max Drawdown

Sharpe Ratio

Sortino Ratio

Dividend Growth Benchmark

10%

53%

0.26

0.33

Buffett

6.7%

66%

0.10

0.14

Graham

8%

63.7%

0.16

0.22

Greenblatt

15.3%

55.4%

0.45

0.57

Lynch

11.5%

46.9%

0.31

0.42

Basic: Value

13.7%

67.4%

0.34

0.46

Comprehensive: QVG

15.2%

51.6%

0.44

0.57

P123 Multi-market Rank

12.7%

38.3%

0.38

0.51

If you are looking for the lowest maximum drawdown, the 'soft market-timing' method works best (it still stays 100% invested at all times). For highest risk-adjusted return, it is pretty much a tie between Greenblatt and the QVG model. My preference is for the QVG due to the breadth and depth of ranking in addition to a slightly reduced drawdown, but some people feel that simpler is better. Your choice.

A Couple Quick Modifications

When it comes to dividend growth investing, I have a couple of favorite rules. The first is to eliminate the lower-yielding products (compared to the rest of the dividend growth stocks) and the second is to eliminate stocks with lower yields compared to their own trailing 5-year history. When applying this strategy to the QVG ranking system we get the following results on all stocks and just the S&P 500 universe:

Name

CAGR

Max Drawdown

Sharpe Ratio

Sortino Ratio

Dividend Growth Benchmark

10%

53%

0.26

0.33

Comprehensive: QVG (all stocks)

18.3%

43%

0.59

0.79

Comprehensive: QVG (S&P 500)

14.72%

49%

0.46

0.58

S&P 500 Dividend Growth strategy compliments of Portfolio123:

(click to enlarge)

The 15 stocks making the list right now in the S&P 500 are as follows:

Ticker

Name

QVG Rank

MktCap

Industry

PEInclXorTTM

Yield

(NYSE:CVX)

Chevron Corp

97.14

224997.5

Oil, Gas & Consumable Fuels

8.63

3.13

(NYSE:XOM)

Exxon Mobil Corp

92.86

397796.7

Oil, Gas & Consumable Fuels

9.11

2.58

(NASDAQ:CHRW)

C.H. Robinson Worldwide Inc.

87.14

9314.83

Air Freight & Logistics

15.79

2.42

(NYSE:JNJ)

Johnson & Johnson

85.71

210396.4

Pharmaceuticals

19.68

3.2

(NYSE:ADM)

Archer-Daniels-Midland Co

81.43

21463.63

Food Products

15.66

2.33

(NYSE:BDX)

Becton, Dickinson and Co

71.43

17163.61

Health Care Equipment & Supplies

11.74

2.24

(MHP)

McGraw-Hill Companies Inc. (The)

68.57

12482.62

Diversified Financial Services

29.38

2.49

(NYSE:WMT)

Wal-Mart Stores Inc

65.71

232709.4

Food & Staples Retailing

14.29

2.29

(NYSE:ACE)

ACE Ltd

64.29

29437.85

Insurance

10.98

2.27

(NYSE:RTN)

Raytheon Co.

62.86

17710.84

Aerospace & Defense

9.55

3.71

(NYSE:TGT)

Target Corp

58.57

40389.2

Multiline Retail

13.68

2.33

(NYSE:COP)

ConocoPhillips

51.43

69216.3

Oil, Gas & Consumable Fuels

8.52

4.63

(NASDAQ:PBCT)

People's United Financial Inc

50

4289.95

Thrifts & Mortgage Finance

17.99

4.94

(NYSE:WAG)

Walgreen Co

45.71

38891.07

Food & Staples Retailing

18.54

2.67

(NYSE:MDT)

Medtronic Inc

41.43

47591.2

Health Care Equipment & Supplies

14.37

2.21

Some Quick Observations

  • This is a fairly diversified portfolio with 6 sectors being represented
  • The average yield is 2.9%.
  • The average beta is 0.75
  • The average volume is over 6 million shares
  • The average market-cap is 91 billion

Summary

Before I wrap this up I want to be very clear on one issue - I support the dividend growth investing concept with open arms. With that being said, just because a company commits to a program of annual dividend increases does not automatically make this a suitable strategy. This is a management decision only and you need to understand fundamentals and valuation in order to determine if the stock can support such a policy long term. Most dividend growth investors already have certain criteria to determine a suitable holding and many do this by intuition.

All I have done in this article is try to clearly define to me and to the reader what many dividend-growth investors already know in their gut.

Source: The Hard Truth Of Dividend-Growth Investing