There are some solid arguments that dividends will represent the bulk of returns from stocks for a number of years into the future. Regardless of whether this is correct or not, there is a broad consensus that capital appreciation will be sufficiently low that we will see, on average, 8% annual returns per year from domestic equities. This is generally in line with estimates from a range of sources, albeit on the conservative end. These factors suggest that even investors who are not specifically focusing on income may do well to spend some time looking closely at dividend yields. That said, the dismal performance of dividend focused index funds like DVY over the last couple of years makes it clear that it is unwise to blindly invest on the basis of yield.
For the two years through March of 2007, DVY had average annual returns of -35.8% per year. The S&P 500 (IVV) had an average annual return of -25.7% per year, with about the same level of volatility. The Dividend Aristocrats, an index of stocks with a consistent increase in dividends over the trailing 25 years, out-performed the S&P 500 by a margin of more than 15% in 2008. That still makes for a bad year for the Aristocrats, of course, but this level of out-performance sure tempered the worst beat market in 70 years. Now, here’s the interesting part: the out-performance of the Dividend Aristocrats was predicted two years ago on the basis of portfolio theory.
At the end of March 2007, I published an article called Outlook for Select S&P Dividend Aristocrats that predicted an average annual out-performance for a portfolio of these stocks of 8% per year beyond the S&P 500, with no additional risk. Quantext Portfolio Planner had a long-term outlook of 8.3% in average annual return for the S&P 500, but the portfolio of 20 Dividend Aristocrats had a projected average annual return of 16.3%. This portfolio had a Beta of around 60+%, which is low for a portfolio of equities but still leaves the portfolio exposed to market risk.
When I went back to evaluate how this portfolio had performed over the last two years, I faced a problem in that two of the stocks had been de-listed because of mergers and acquisitions. Budweiser (BUD) has been acquired by InBev and Compass Bancshares merged with BBVA (BBV). I have not been able to get the data for BUD and CBSS to track their exact performance up until they were acquired, plus we have the problem of what to assume we did with the funds upon acquisition—an investor might have kept the shares in the acquiring firm or have invested in something else. To deal with this problem, I ran the portfolio of Dividend Aristocrats from the original article, minus these two stocks, so we have a portfolio equally weighted between the following stocks:
Quantext Portfolio Planner (QPP) yielded projected return and risk of this modified portfolio that was essentially identical to the original analysis. The Dividend Aristocrats were projected to massively out-perform the S&P 500, to the tune of more than 8% per year with no increase in risk (all baseline inputs and three years of trailing data to initialize the model).
In the two years since the original article was published (April 2007 through March 2009), the portfolio of Dividend Aristocrats generated average annual return of -18.4% with volatility less than the S&P 500. The S&P 500 has returned -25.7% per year. The portfolio of Aristocrats has out-performed the S&P 500 by 7.3% per year, remarkably close to the projected out-performance from QPP. The out-performance of the Dividend Aristocrats portfolio is particularly notable because a range of dividend-focused funds have performed far worse than the S&P 500 over this two-year period. DVY, which tracks the Dow Jones Select Dividend Index, has generated an average annual return of -35.8% from April 2007 through March 2009, lagging the S&P 500 by ten percent per year. This under-performance was largely due to a heavy allocation to financial stocks.
When we run QPP for this equal-weighted portfolio of stocks (using baseline settings and three years of historical data through March 2009), we obtain a projected average annual return of 12.9% with an annualized standard deviation of 16.2% vs. a projected return of 8.3% and a standard deviation of 15.1% for the S&P 500 (assuming reinvestment of dividends). QPP is projecting that this portfolio of stocks will generate 4.6% in return per year above the S&P 500, with just slightly more volatility than the S&P 500. The projected out-performance for the Dividend Aristocrats is now less impressive than it was a couple of years ago. Looking at the potential for an extended era of depressed capital growth, however, an edge of this magnitude would be enormous. We can get even higher projected returns and/or lower risk by varying the allocations to the individual stocks.
This discussion does not mean that I like or would invest in all of these stocks, but Dividend Aristocrats provide a fertile hunting ground for individual stocks—especially if dividends provide a large fraction of returns from equities in coming years. The problem with looking just at historical performance of the Aristocrats is that the sample is biased. An Aristocrat that cuts dividends is going to be a firm in trouble. Once that stock is dropped from the list, the historical performance of the remaining Aristocrats is biased upwards—just as in survivorship bias among mutual funds. This is why forward-looking projections as provided by a model like QPP are important: they provide a basis for reasonable expectations for a group of stocks. Back in April 2007, QPP projected a substantial out-performance for a selection of the Aristocrats. They have, indeed, out-performed. Going forward, QPP still projects a substantial out-performance, but considerably less than in April 2007.