Retirees Please Don't Index, You Deserve Better Than Average

by: Chuck Carnevale


Outperforming the S&P 500 Index with blue-chip Dividend Aristocrats.

Two primary reasons to not choose indexing.

85% of the Dividend Aristocrats outperformed the S&P 500 since 1996.

Introduction: The Plight Of The Retiree Conflicting Investment Advice

The most prudent retirees have spent their lifetimes accumulating a retirement portfolio that can support them and their families once they've quit working. At that point, it's imperative that the retiree's portfolio and the money it represents works as hard or harder for them as they did for it. In the best-case scenario, the prudent and successful retiree will have amassed enough assets in their portfolios to provide a comfortable lifestyle for their remaining years. This is especially true when the portfolio assets are large enough to generate enough income to meet their needs without having to harvest their principal.

Personally, I am a strong advocate of creating a retirement portfolio that's capable of producing an adequate and growing income stream to meet future needs. I understand that many people entering retirement have not amassed enough assets to accomplish that goal. I do consider this a tragedy, and recognize that those unfortunate retirees might be forced to liquidate assets just to live on. However, this article is oriented to those prudent retirees that have systematically contributed enough to their retirement plans over their working lives in order to adequately fund a comfortable life in retirement from the income their portfolio holdings generate.

If an adequate portfolio has been amassed, the retiree is now faced with the critical decision of how to properly invest those assets for income. This can be confusing on many fronts because there is a lot of conflicting advice on the best course of action, even from and among professional registered investment advisors. However, even worse is the plethora of scaremongering pundits attempting to scare the retiree into accepting their own often self-centered agendas.

One common tactic is the effort to convince the retiree that they are incapable of managing their own affairs. I disagree, and further direct this article to those retirees with the confidence and desire to trust their affairs to their own capable hands. Like most aspects of living and enjoying a fulfilling life, I believe that decisions based on applying their natural common sense will serve most people quite well. Investing retirement assets is not rocket science, therefore, contrary to the opinion of many; I believe most people are quite capable of doing it effectively.

And, thanks to the Internet, today's retiree has numerous tools and resources available to assist them. Admittedly, it does take some effort, and a basic understanding of how investments work. Additionally, since retirees are no longer working, in theory at least, they have the time available to successfully accomplish their goals. Furthermore, managing their own retirement portfolios might be just the ticket to avoid boredom and keep their minds active and healthy throughout their remaining years.

Consequently, I also vehemently disagree with those that advocate people putting all their equity allocations into broad market index funds usually on the notion that even most professional investors can't outperform the broad index. Frankly, there are many extenuating circumstances that are often ignored when conducting the studies that portend to support that notion. In truth, most professional money managers, to include those that manage mutual funds, ETFs, etc., are often burdened with stringent requirements that preclude them from providing their best judgments. In this vein, a large majority of professionally managed portfolios are in fact forced into behaving as closet index funds. As a result, it's difficult to outperform an index when you are forced to behave like one.

The S&P 500 Index: Reasons Not To Invest

There are many people, and some of them renowned, that advocate that most investors should simply put their money into index funds. However, I am not one of those people for several reasons that I will share in a moment. Even legendary investor Warren Buffett has been credited with supporting indexing. Conversely, I feel it's important to understand that Warren Buffett is only making those recommendations to people that are not willing to invest the necessary time or work into managing their own portfolios. Moreover, he would be delighted to have those same investors own shares of Berkshire instead - and perhaps rightfully so.

There are two primary reasons why I do not advocate indexing. First and foremost, I do not consider investing in an index fund the appropriate choice for every individual. Some investors may require a higher dividend yield than the index offers, and as I previously alluded to, I am not a fan of harvesting principal unless it's absolutely necessary. Each individual investor possesses their own unique goals, objectives and risk tolerances and an index fund cannot simply cover them all.

Second, I do believe that individual investors can do better-than-average by simply applying a few basic common sense investing rules and through the willingness to do a little work. Moreover, there are many choices and strategies available to the individual investor to build and design a portfolio that will meet their needs better than an index can. Additionally, as I will soon present more fully, the timing of when to invest in an index fund is just as relevant as the timing of when to invest into an individual stock. Stated more plainly, the index can at any point in time be dangerously overvalued and thus simultaneously a bad investment choice.

As usual, I will utilize the earnings and price correlated F.A.S.T. Graphs™ research tool with annotations on the S&P 500 to illustrate several reasons why I don't consider indexing the appropriate choice for everyone. The orange line on the graph plots a P/E ratio of 15 (which I consider fair value) on the S&P 500 since 1996; I chose this time first because this is as far back as my data goes. However, I also chose this time frame in order to put the long-term track record of the S&P 500 on a fair and appropriate basis. In other words, I chose a starting time when the S&P 500 was fairly valued at or at least near a 15 P/E ratio.

The black line on the graph plots monthly closing stock prices. To oversimplify, when the black price line touches the orange earnings justified valuation line fair value for the index is manifest. When the price is above the orange line, overvaluation is indicated, and when price is below the orange line undervaluation is indicated. I placed a red arrow pointing to the irrational exuberant time frame, which ended in calendar year 2000. This was clearly a period of time when investing in the S&P 500 index was a mistake. At its pinnacle, the P/E ratio of the S&P 500 was north of 30. More importantly, significant overvaluation was manifest for approximately 6 years indicating that the S&P 500 was a bad investment choice for all those years.

More to the point, I placed five light green circles indicating how few opportunities there were to invest in the S&P 500 at fair value since 1996. I believe this simple analysis provides compelling evidence that making a sound investment in the S&P 500 index is not only not always a wise choice, but also a rare opportunity at least over the past couple of decades. Simply put, ascertaining fair value is just as important when considering investing into an index as it is when considering investing into a single company. Indexing is simply not a "set it and forget it" option.

Additionally, the S&P 500 doesn't seem like an appropriate choice for the retired investor seeking current income. I did a quick analysis of all of the S&P 500 constituents and discovered that 76 of them did not even pay a dividend. Consequently, if my objective is income, why would I want to own an index that contained so many names that don't even pay a dividend? I believe that my investments should be appropriately selected based on what my goals and objectives are.

Further analysis of the earnings and price correlated graph also reveals two periods of time when the price of the S&P 500 fell precipitously and did so over several years. Furthermore, although long-term earnings growth of 6.3% might be considered acceptable and even reasonably consistent, there were two periods of time during our last two recessions where the earnings of the S&P 500 fell (Note: * on graphs longer than 15 years all the data is plotted but only every other year's information is typed on the graph). To put this all in context, let's review the S&P 500 index performance over this time frame next.

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From the perspective of the S&P 500's historical performance during this time frame, additional reasons why index investing may not be appropriate for every investor are revealed. First of all, we discover that long-term capital appreciation of 6.3% per annum might be considered acceptable and in line with long-term historical norms. However, by looking at the "Dividend Cash Flow" table we discover that the S&P 500 cut its dividend during both of our recent recessions. The cuts during the recession of 2000-2001 could be considered minor. However, the 21% dividend reduction during the Great Recession would be considered severe for those retirees living off of their dividend income.

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One Logical Approach To Beating The S&P 500 Index

As I previously stated, many proponents of indexing investing present the argument that most professional money managers can't beat the index so how can the everyday investor expect to. However, I disagree with that argument and offer the following logical approach as but one of many ways of beating the S&P 500 index. My one example most aptly applies to the prudent dividend growth investor. This strategy is simple and requires a few logical tactics and considerations. The most logical and first approach is to build your dividend income portfolio comprised solely of the blue-chip dividend paying stocks on the S&P Dividend Aristocrats list. Currently there are 55 companies on this prestigious list of dividend payers that have increased their dividend every year for at least 25 consecutive years.

Second, be prudent and disciplined enough to only invest in any of these names when the companies are trading at or below fair value. In the vast majority of cases, this would imply a current P/E ratio of 15 or lower. As it was with the S&P 500, the beginning period 1996 was a time when the majority of companies on the Dividends Aristocrats list were also at or near fair value, but not all of them, as we will see later. However, in certain cases it might be considered prudent to pay a quality premium for the bluest of blue chips, but I would argue only modestly so and within reason. Finally, I suggest being selective by sticking to only those names that have produced consistent above-average historical earnings results and growth rates.

In order to validate this strategy I offer the following portfolio review of the S&P Dividend Aristocrats since 1996. I have listed them in order of historical annualized performance highest to lowest. Since the argument that it's hard or impossible to beat the index is so prevalent, I found the results quite revealing. Over 85% or more specifically 47 out of the 55 Dividend Aristocrats outperformed the S&P 500 since 1996. Additionally, all of the top 30 names generated higher average earnings per share growth and the vast majority of all the Dividend Aristocrats that beat the index generated superior historical earnings growth. Simply put, this is clearly a universe comprised of above-average blue-chip dividend paying companies. Therefore, it only stands to reason that they would produce above-average results.

The following portfolio review presents historical earnings per share growth ((NYSEARCA:EPS)), current dividend yield, the subsector, market cap and finally each company's annualized performance since 1996. The same results for the S&P 500 are included and illustrate that the index landed in 48th place on the list (red highlight). Since those arguing in favor of indexing are fond of touting total return as the basis for supporting their argument, I found these results quite revealing. Moreover, the fact that more than 85% outperformed the index offers compelling evidence that it can be done, and that it can be done through investing in extremely high-quality dividend-paying blue chips. But most importantly, it doesn't require a professional investor to do it. All you have to do is stick with the highest quality blue-chip dividend-paying stocks and be careful to only invest in them when they are at fair value.

However, there are additional aspects of return that the majority of the Dividend Aristocrats also offer prudent dividend income-oriented investors. Since a reliable and growing income stream is the primary objective of these investors, it was gratifying to learn that 46 out of the 55 Dividend Aristocrats, or a strong 84%, produced higher total cumulative dividends paid than the S&P 500 index. Perhaps more importantly, the reader might note that this was accomplished without ever suffering a dividend cut like we saw with the S&P 500 index. In fact, by definition the dividend income of the Dividend Aristocrat group increased each year.

Note: There is a minor flaw in the above presentation that should be acknowledged. There are a few names on the list, AbbVie Inc. (NYSE:ABBV) to cite one that resulted from a splitting of the original company Abbott labs (NYSE:ABT). Consequently, since this company has such a short history as an independent company, I am not sure why it was included in this list. But most importantly, its short performance history should be excluded. Other spinoffs and/or reorganizations were also problematic. However, these examples were few and therefore insignificant and not material to the overall analysis.

Comparison of S&P Dividend Aristocrats to the S&P 500 Index

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For additional perspective, I applied this similar analysis on the Dividend Champions list provided and monitored by fellow Seeking Alpha Author David Fish. This list is also comprised of companies that have increased their dividends every year for at least 25 consecutive years. However, this is a larger list comprised of 105 dividend paying companies. Applying the same portfolio review analysis as I did on the Dividend Aristocrats, I am pleased to report that 78%, or 82 of the 105 Dividend Champions, also outperformed the S&P 500 index. For brevity's sake, I will not include the same detail on this larger list, but I felt compelled to share this additional corroborating evidence supporting a straightforward method of beating the S&P 500 index.

The Worst Performing Aristocrats

As I previously noted, most Dividend Aristocrats and the S&P 500 index were at or near fair value at the beginning of 1996. However, there were exceptions and the blue-chip Coca-Cola was one of them. Consequently, I believe that it is clear that due to Coca-Cola shares trading at a clearly overvalued P/E ratio in excess of 31 at the beginning of 1996 put it at a great disadvantage to the S&P 500 index whose P/E ratio was approximately 16.9. This resulted in Coca-Cola being one of the seven Dividend Aristocrats that underperformed the S&P 500 since 1996.

The Coca-Cola Company (NYSE:KO)

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Coca-Cola's inflated stock price resulted in the company underperforming the S&P 500 on all counts. Both capital appreciation and total accumulated dividends since 1996 were less than what could have been earned on the S&P 500 index. To me this speaks to the importance of fair valuation and validates my often presented thesis that you can overpay for even the best of companies.

Note: In each of the specific examples from here forward, I have calculated performance based on a $1,000,000 initial investment. Of course, I am not advocating that a retiree should put all of their money into a single stock. My objective is to simulate a fully-funded $1,000,000 portfolio in order to provide the reader a perspective on what actually would happen to their dividend income growth through investing in a Dividend Champion or Aristocrat. More plainly stated, I am attempting to give the reader a clear understanding of the magnitude of income growth that their dividend income portfolio can produce. With this first example I utilize a Dividend Aristocrat that underperformed the S&P 500, later I will provide the same exercise on companies that outperformed the S&P 500.

The following focal point on the performance table below based on a $1,000,000 initial investment is on the annual dividend increase. Note how total income grew from $13,575.76 in year one to $60,336.68 in 2013. Clearly, a quality blue-chip Dividend Aristocrat, even when purchased at an overvalued level, generates a powerful inflation-fighting growing income stream.

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Best Performing Dividend Aristocrats

One of the best performing of all the Dividend Aristocrats is the T. Rowe Price Group Inc. (NASDAQ:TROW). From an earnings point of view, this company's history was similar to the S&P 500 in that they experienced earnings drops during both of our most recent past recessions. However, one huge difference was that this company grew earnings at more than twice the rate of the S&P 500 (the average company). Another important difference was that even with some earnings stress during both recessions it did not cause this Dividend Aristocrat to cut their dividends (the pink line on the graph).

T. Rowe Price Group Inc.

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From a performance perspective, T. Rowe Price Group Inc. soundly throttled the S&P 500 index on all counts. Capital appreciation was more than double the index, and total cumulative dividend income approximately triple what the index delivered. Clearly, purchasing an above-average business at sound valuation is a practical way to outperform the S&P 500 index.

Just as I did with Coca-Cola, I produced the following performance report based on a $1,000,000 investment in order to illustrate the power and protection achieved by investing in a Dividend Aristocrat or Champion. In this case, the dividend income stream in year one was $18,030.32 that exploded to $246,901.56 by 2013. In this example, growth yield is more than impressive, it is extraordinary.

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Average Performing Dividend Aristocrat

In the spirit of fairness, I have included a third and final example Bemis Company Inc. (NYSE:BMS) because it produced results that were quite similar to the S&P 500 index on a total return basis. In other words, this example represents an average or close to it selection.

Bemis Company Inc.

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Interestingly, even though earnings growth rate and total return performance were very similar to the S&P 500, total cumulative dividend income was superior. Consequently, I argue that this particular example represents a better choice for the retired investor focused on income.

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You Are the CEO of Your Retirement Portfolio

In addition to eschewing indexing as the most appropriate strategy for all individual investors, I also reject the notion that it's okay to harvest principal to meet your retirement income needs. Therefore, I am not an advocate of the so-called 4% rule. Introduced in 1994, this commonly suggested strategy is recommended by those focused exclusively on total return. However, I do not believe that meets the needs and goals of every investor. If it is a necessity, I agree that it must be done. However, I believe the superior approach is to build and manage a portfolio capable of meeting your needs from the income it produces. I offer the following analogy to support my views.

I suggest that the self-reliant retiree desirous of self-directing their own retirement portfolios might think of themselves as the CEO of their own private company. In this regard, like all good CEOs, the retiree might consider each share of stock they hold as a productive and profitable member of their corporate family. This analogy is especially relevant if the retiree has been careful and selective about purchasing excellent and profitable businesses. Consequently, like all good CEOs, the retiree should strive to keep and even covet each and every productive and profit contributing member of their corporate family (portfolio).

Therefore, to my way of thinking at least, selling off any shares (harvesting principal) is akin to a CEO firing worthy employees that are capable of making meaningful contributions to their portfolios' future success. Once that share of stock is gone (the loss of a profitable contributor) all the future profit it could generate is forever lost. Of course the key is for the CEO to do everything in their power to make sure they have selected the best employee (shares in wonderful businesses) in the first place. But when that is accomplished successfully, I consider it a mistake to lose them. I believe this is especially important when the odds favor that these profitable contributors are more likely than not capable of generating a larger contribution over time.

Summary and Conclusions

I believe that every investor has important choices to make. But most importantly, I believe those choices should be made based on what's best for their own specific situations. To state that everyone should be an index investor simply does not resonate with me. Those of us who believe in being self-reliant and taking control of our own affairs are often quite capable of managing our own retirement portfolios. Perhaps there is some validity to the notion of indexing for some people, but certainly not all people. I placed myself in the camp with those who aspire to do better-than-average.

But even more importantly, I place myself in the camp that believes it can be rationally accomplished by anyone of normal intelligence and the willingness to do a little work. As I previously stated, investing is not rocket science. Moreover, I believe there are straightforward and practical strategies that can be successfully implemented when investing assets. With this article I presented only one of many. My primary objective was to simply illustrate that it can be done. Anyway, personally I find it exhilarating to dare to be better-than-average.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: Long ABBV, TGT, WAG, FAL, BCR, CL, WMT, CLX, CVX, SYY, JNJ, DOV, MCD, ADP, PG, MDT, SWK, EMR, GPC, PEP, KMB, ED, ABT, KO, T. I am long ABBV, TGT, WAG, AFL, BCR, CL, WMT, CLX, CVX, SYY, JNJ, DOV, MCD, ADP, PG, MDT, SWK, EMR, GPC, PEP, KMB, ED, ABT, KO, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.