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I have written several SA articles wherein I talk about a Figure of Merit [FOM] involving a relationship between Yield [Y] and Dividend Growth [DG]. Comments were made that I was being too complicated with my formulas and should use the Chowder Rule [CR] instead. This article is meant to look at both in a rational manner and let the reader investor decide which, if either, they choose to use. I think we can all agree that a good metric to use in choosing DG stocks is 'some combination' of Y and DG.

For the uninitiated, CR is the sum of Y and DG. Minimum values are 12 for regular stocks and 8 for Utilities, REITs and MLPs. I believe these minimums are for new buys. I am unsure if they still apply later. For the DG value, 5 year CAGR numbers are used. CAGR stands for Compounded Annual Growth Rate. I point out that Utilities, REITs and MLPs do not compound in the generally accepted sense. They do not follow the Rule of 72.

FOM is the product of Y and DG for regular (exponential DG) stocks and Y*(DG+10) for linear DG stocks (which include Utilities, REITs, MLPs, Telecoms). Although the formulas are different, the have one thing in common. In both cases (exponential and linear DG), for any 2 stocks with the same FOM, they also have a relationship with Yield on Cost [YOC]. YOC is a concept that measures dividends at a future time divided by initial cost (rather than current cost). This relationship is approximate for the exponential DG case and exact for the linear DG case.

This relationship between FOM and YOC can be demonstrated as follows: Assume $100 initial investment. D1 is the dividend for the first year, Y*100. For the exponential DG case, dividend value at the tenth year is D1*(1+DG)^10, DG expressed as a decimal. For the linear DG case, tenth year dividend is D1+(D1*DG)*10, (DG as a decimal).

Exp DG

FOM=20

FOM=20

FOM=30

FOM=30

FOM=40

FOM=40

D1

DG

Div@10y

DG

Div@10y

DG

Div@10y

2.0

10

5.19

15

8.09

20

12.38

3.0

6.7

5.72

10

7.78

13.3

10.49

4.0

5

6.52

7.5

8.24

10

10.37

Average

-

5.81

-

8.04

-

11.08

The table above shows these calculations for the exponential DG case. Since the cost is the same in all cases, then the dividend at the tenth year is YOC (as a percent). Note that the calculated dividend is not exactly the same for all yields, but close enough. It could be made more precise at the expense of a more complicated formula for FOM. Note that the dividend increases with yield in the third column, decreases then increases in the fifth and decreases in the seventh. I don't understand this, but take it as a good omen. A FOM in the 30s area is where many stocks are. The relationship between YOC and FOM is shown in the graph below.

(click to enlarge)

The curve is not a straight line, but has a slight upward tilt.

Linear DG

FOM=65

FOM=65

FOM=70

FOM=70

FOM=90

FOM=90

D1

DG

Div@10y

DG

Div@10y

DG

Div@10y

5.0

3.0

6.5

4.0

7.0

8.0

9.0

6.0

0.83

6.5

1.67

7.0

5.0

9.0

7.0

-0.71

6.5

0.0

7.0

2.86

9.0

Average

-

6.5

-

7.0

-

9.0

The table above presents the same analyses for the linear DG case. By rights, I should distinguish between the 2 FOMs, they have different formulas. Do not be alarmed at the negative DG. If you are above the target, you have to aim down. Here we see there is a precise relationship between YOC and FOM, it is: YOC = FOM/10. As I pointed out in a previous article, the formula for a 20 (rather than 10) year target is: FOM = Y*(DG+5).

As a further clarification of these issues, it is helpful to insert Y and DG data from stocks and compare those data with each of the techniques under discussion.

(click to enlarge)

In the above graph, the red curve is the CR equation Y+DG=12. The green curve is the FOM equation Y*DG=16. The blue dots are the Y,DG data from stocks in my Dividend Growth segment using 2012 DG (1 year) and EOY 2012 Y data. I recognize that CR calls for 5 year CAGR dividend growth, and this may well move the blue dots slightly to the right, but that doesn't change the picture. There are 11 stocks that fail the CR=12 test. If the rule was 12 for new buys and (say) 8 for current holdings, then all would pass. And/or the rule could be that you use the stricter test to identify close calls that require a further look. This is what I do. In any event, both approaches (CR and FOM) define a no-buy zone to cull poor performers in the DG world.

The 11 stocks in question are: Clorox (NYSE:CLX), Flowers Foods (NYSE:FLO), Illinois Tool Works (NYSE:ITW), Procter & Gamble (NYSE:PG), BlackRock (NYSE:BLK), Johnson & Johnson (NYSE:JNJ), PepsiCo (NYSE:PEP), Kimberly-Clark (NYSE:KMB), United Technologies (NYSE:UTX), AstraZeneca (NYSE:AZN), Colgate-Palmolive (NYSE:CL). All are good solid companies. Note that all have DG values greater than 5%, well above current inflation. Another interesting thing, in at least 4 out of the past 5 years, all have had significant stock buybacks. The money is there to increase dividends; the question is, why not? Some may still be recovering from the Great Recession. Stock buybacks reduce future EPS (earnings per share), which may determine management bonuses, who knows?

The one stock that failed the FOM test was ITW. I analyzed its situation in some detail in a recent article and could find no reason why the dividend could not be increased more in line with their average DGR.

To me, the battleground is not where the 2 approaches intersect near the origin, but out where DG is high, Y is low. FOM spreads the numbers more than CR, making decisions easier. Some investors have a lower limit of 3% for Yield, but there may be a 2.99% out there with a high enough DG to make it a swinger.

(click to enlarge)

The graph above show the same information for the linear DG case. Here, red is the CR equation Y+DG=8. Green is FOM=Y*(DG+10) and blue are the Y,DG data from stocks in my High Income & Fixed Income segments using the same time frame as before.

The 5 stocks that failed the FOM test are: Centerpoint Energy (NYSE:CNP), Shaw Communications (NYSE:SJR), Verizon (NYSE:VZ), Realty Income (NYSE:O), EV Energy Partners (NASDAQ:EVEP). Of these, VZ and O also fail the FOM test using 8-year Composite DG data. Needless to say, my eyeball is on them. SJR is the stock that failed FOM and passed CR. The limit set here for FOM was 65, for new buys. For portfolio holdings that is lowered to 55. Using that as a limit, of the 5 stocks only CNP and VZ would fail, both at 53. Don't forget, this is only one of many factors that go into buy/hold/sell decisions. I can't sell VZ; the dividends pay my VZ wireless monthly bill.

In the linear DG case, there is a better match between the CR and FOM formulas. In all truth, either approach will work just fine. Probably the best method would be to pick either approach: 1) set limits for new buys, 2) set limits for portfolio holdings such that a few fail. These are marginal and require more attention and this is a good way to ferret them out. What could go wrong?

Source: Chowder Rule Vs. Figure Of Merit

Additional disclosure: I am long all stocks listed in the article.