The ABCs Of Dividend Investing: Part II - Dividend Growth Is Vital

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 |  Includes: UTX
by: Rising Dividend Investing

In our previous blog on dividend investing, we offered some of our dividend research and a general theory on how to think about the importance of both dividend yield and dividend growth. In this edition, we will share some our insights into how different combinations of dividend yield and growth act in various kinds of stock markets.

When most people think of dividend-paying stocks, often they incorrectly think that such companies are unusual. The truth is among the 500 stocks in the S&P Index, nearly 400 of them pay a dividend. What makes a company valuable, according to our research, is that it has raised its dividend persistently and consistently over a long time. We do not place hard limits on these descriptors because we do not want to eliminate companies that have persistently and consistently raised their dividends but not on a calendar basis. United Technologies (NYSE:UTX), for instance, increases its dividend every six quarters; thereby, having years where it does not increase its dividend on a calendar basis. The every-six-quarters approach is consistent and persistent, but UTX does not the lists of dividend stars because of the occasional calendar miss.

Our research in the dividend world began with the Utility sector in the late 1980s. That early research revealed some surprising results. Over any longer period, say five to ten years, the companies with the lowest dividend yields and the highest consistent dividend growth were the top performers. For example, Company A had a current dividend yield of 6% and long-term average annual dividend growth of 4%; Company B had a current dividend yield of 7% and long-term annual dividend growth of 2%; and Company C had a current dividend yield of 8% with no recent dividend growth. In almost every period we studied, Company A would outperform Companies B and C on a total return basis, even though on a dividend yield basis, it did not appear to be as attractive as the other two companies. In essence, the market was willing to pay for dividend growth -- if it was consistent and visible -- it still.

We found the same phenomenon worked in almost all the major industry sectors, including those with low dividend yields. It did not always work on a one or two year time frame, but given enough time, it was clear that investors were willing to pay up for a faster growing dividend, as long as the growth was consistent and enduring. As a result of this, in the early-1990s, we restructured our main dividend investment strategy away from a focus on high dividend yield with modest dividend growth and partitioned the portfolio into three separate sub-portfolios. Today our Cornerstone Portfolio (our main dividend strategy) is not one monolithic portfolio where all the stocks have similar features. It contains three different kinds of dividend companies, which we call sub-portfolios A, B, and C. The division into three sub-portfolios has made Cornerstone more of an all-season investment style.

Dividend Yield Dividend Growth
Sub-Portfolio A Near the average yield of S&P 500 Dividend growth higher than S&P 500
Sub-Portfolio B Yield much higher than S&P 500 Dividend growth at approximately the rate of inflation.
Sub-Portfolio C Above average dividend Yield Dividend growth approximately the same as the S&P 500
Click to enlarge

Sub-Portfolio A

Sub-Portfolio A stocks (average yield, above average dividend growth) possess a characteristic that has dramatically improved Cornerstone's annual returns over the last 15 years: They tend be driven more by their own results and less by what is going on in the overall markets. As long as Sub-Portfolio A companies are hitting their earnings and dividend growth targets, they will normally outperform the average stock both when the markets are trending sideways or are in a bull market. These stocks normally fare poorly in bear markets.

Sub-Portfolio A stocks most often come from Consumer Cyclical, Tech, and Industrial sectors.

Sub-Portfolio B

Sub-Portfolio B stocks are just the reverse of Sub-Portfolio A stocks. Portfolio B stocks have a much higher than average dividend yield combined with dividend growth at about the rate of inflation. Inclusion of these stocks in the portfolio helps us in two ways:

  1. They often have a dividend yield twice the rate of the average stock.
  2. They almost always perform well relative to the average stock in slow growth environments or in bear markets. .

Sub-Portfolio B almost always lag the overall market in strong bull markets. Portfolio B stocks are mostly filled with Utilities, Telecommunications, REITs, and Energy stocks

Sub-Portfolio C

Sub-Portfolio C stocks are our favorite stocks of the three portfolios, but they are the rarest. They combine a higher than average dividend yield with at least an average annual dividend growth rate. These stocks are usually the most undervalued of all stocks in the portfolio from the perspective of our valuation models. That is because these companies are usually facing some sort of company specific headwinds or uncertainties.

Our models are good at finding these companies, but their attractiveness is always clouded by a big question mark hanging over them. That is where our investment strategists become critical. It is their job to dig deeply into the company and determine if the headwinds are temporary or permanent. Portfolio C companies can do well in any kind of market, especially if the question mark is removed.

Weighting the Three Sub-Portfolios

The weightings of each of the sub-portfolios within the total portfolio are not left to chance. We increase or decrease the weightings of each sub-portfolio based on a combination of the readings from our valuation models and how the markets are reacting to unfolding fundamental and economic data. The table below show how much we have shifted portfolio weightings over the last twelve months.

Sub-Portfolio Weightings

July 2012 vs. July 2013

July 2012 July 2013
Sub-Portfolio A 22.0% 39.0%
Sub-Portfolio B 41.0% 23.0%
Sub-Portfolio C 37.0% 38.0%
Total 100% 100%
Click to enlarge

We made these shifts because we recognized that continued U.S. economic growth, even though it has been modest by historical standards, had finally led to significant increases in investor confidence. Investors were no longer rushing indiscriminately in and out of stocks as each round of new bad news (Europe is crashing!) or good news (Employment numbers are up!) hit the headlines. Instead, their increased confidence was causing them to differentiate their investing based more on the fundamentals of each company, which would favorable for Sub-Portfolio A companies and modestly unfavorable to Sub-Portfolio B companies for reasons described earlier.

The sizable shift that we made in cutting back on the high dividend yield, low dividend growth stocks in Sub-Portfolio B and adding to the above average dividend growth companies in Sub-Portfolio A has already proven itself to be the right move. It was not something, however, that we did overnight. We saw the trends, we read our models, and we began a gradual shift that sped up in March and April of this year.

Constructing a portfolio of three different types of rising dividend companies allows us to stay true to a high-quality, rising dividend strategy, while rebalancing the dividend growth versus dividend yield weightings in the overall portfolio in recognition of changing market conditions.

Back to that Pony

Last time we said some people have accused us of having a "one trick pony" investment strategy. We hope what we have shared here answers that accusation. In addition, dividends in one form or another have been around as long as investing itself. We are not at all worried that companies will stop paying dividends. True, over the years, the percentage of all companies paying dividends has waxed and waned. But there have always been at least several hundred quality companies around the world that paid a dividend. And many of them were regularly increasing their dividends.

With a portfolio of only 30 stocks - more than enough to optimize the safety benefits of diversification - we can't see the day when we won't have more than enough companies to choose from for our Rising Dividend strategy to continue to deliver dependable, growing income and outstanding total returns.

Simply stated, the Rising Dividend strategy is the belief that companies that pay you more each year - in cash (i.e. dividends) - are more valuable than companies that don't, and the increased cash flow has the effect of driving up stocks prices in the long run. Companies that do not pay a dividend are in effect telling you to have faith that someday someone will be willing to pay you more for your shares than you did. In the meantime, just sit tight and wait for that day.

We may be naive, but it's hard to imagine a day when increasing amounts of cold, hard cash in the hand will cease to be more attractive to most investors than a hope that some other investor will rescue them down the road by buying their shares.

As much faith as we have in our strategy however, we continue to test that faith regularly. We have developed several analytical models, one of which screens thousands of companies around the world in a matter of minutes, identifying those that might be Rising Dividend candidates. Another model then tests the correlations between each company's stock price, dividend, and market interest rates. That model tells us whether there has been and continues to be a tight correlation between a particular company's dividend and its stock price. Every week in our Investment Policy Committee meeting we challenge the basic premise our strategy is built on, company by company.

Once a company makes it past these two models, our various industry specialists on the Investment Committee study the company's financial results and prospects, clarity and honesty of its communications, quality of its management, and other fundamentals to see if it is good enough to belong in our clients' portfolios.

The final model compares the stock prices of these "finalist" companies to their value based on estimated future dividend flows and whether now is tactically a good time to buy it or whether we should wait.

We do all this testing and do it frequently, because we have found that -- even with a strategy as fundamentally sound as ours -- there is no one universally effective formula for all seasons. We change the mix of company types as conditions change.

Early in our previous blog, we mentioned that in the 1980s, there was a tight correlation between interest rates and the stock prices of utilities and energy companies. Recently, that correlation has broken down for most utilities and energy companies. Their prices now correlate most highly with their earnings and dividends growth. Only Real Estate Investment Trust (REIT) stock prices still correlate strongly with interest rates. When we saw that interest rates were rising, we reduced our holding of REITs and they subsequently sold off sharply. Our models now tell us they may have sold off too much. We will watch for a reentry point later in the year.

We Don't Have a Trick Pony, And We Don't Need It.

So, we don't believe we need a trick pony. Instead, we believe we are executing a strategy that doesn't require any tricks at all. We continue to test that strategy, because we would want to be the first to know if it no longer held true. But, the relationship of consistently rising dividends to total return has been a market truth that has endured and persisted through some of the best and the worst that the global economy could throw at it. It is indeed a flexible, "all-weather" strategy for the serious, long-term investor.

The ABCs of Dividend Investing Part III will discuss some basic investing principles we have garnered over the years.

One last thing. These blogs on the elements of our Rising Dividend Investment Strategy are time tested and real life stuff. If you are a regular reader of these blogs, please pass this series on to friends and acquaintances who might have an interest in them. We see lots of very bad information on dividend investing. We know because we have tried a lot of different approaches and the one we are describing here has worked for the last 15 years.

Disclosure: Clients, officers, and directors of DCM own UTX.