Dividend investing can be a dynamic and diverse exercise, which may come as a surprise to those new to dividend investing. From momentum strategies to low payout strategies such as the one detailed, there are a number of approaches one can take based on his or her objectives. However, my impression is that four factors are most important to the majority of dividend investors:
- Yield. Everyone loves to get paid, and dividend investors are no exception. The higher a company's yield, the more they pay investors to hold their stock.
- Sustainability & Growth. A check in the mailbox today is great, but if you can't expect your employer to send you another one in two weeks, it can be bittersweet. The same goes for dividend investors – we want to invest in companies that will continue to pay us over time and increase our “wages” with time.
- Capital preservation. A dividend is great, but how good does a 3% yield feel if the company's share price drops 30% , even if the drop may be the result of larger economic and market forces? See 2008 and 2000-2002 for examples of the impact large drawdowns in equity markets can have on invested capital.
- Volatility. This factor is closely related to capital preservation. A stock that drops 50% and is followed by 50% return is down 25% at the end of the day. Volatility can eat away at returns, not to mention it can be unnerving for investors. When it comes to dividend investors, many of whom may be in the later stages of a personal investing cycle, high volatility generally does not serve the goals of income and capital preservation.
Portfolio and stock volatility can not only quicken an investor's pulse, but may also have a negative impact on portfolio returns and sustainability of dividends. As Geoff Considine noted in a recent article:
Volatility is considerably persistent through time, and the implied volatility from options prices is a key signal for determining the probability of corporate distress.The higher the implied volatility, the higher the probability of distress. Along the same lines, the lower the volatility of a stock, the more sustainable should be its dividend
How can we put the four factors above into action? Using Stockscreen123, I searched for stocks that met the following criteria:
Yield > 2%
Payout Ratio < 50%
Dividend 5 Year Growth Rate > 5%
Dividend 1 Year Growth Rate > 5%
Underlying Index (S&P 500) above 200 day moving average
Stocks Ranked on Standard Deviation of Weekly Returns over the past 52 weeks
Why have I required the S&P 500 be trading above the 200 day moving average? The 200 day moving average is but one way to gauge market trend but is by no means the only method – longer term moving averages such as the 10 month moving average (see Mebane Faber's The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets for in-depth analysis of long-term trend investing) are also appropriate measures of long-term trend. The goal is simple – limit large drawdowns of stock holdings when the overall market is in a downtrend. For those most concerned about volatility and capital preservation, this strategy could serve them well even if it may limit capital appreciation in the early stages of market recoveries, before the index crosses above its long-term moving average. An alternative approach to simply selling all holdings when the market begins a downtrend would be to continue to hold a dividend portfolio but short the market via a 1x short ETF like SH when the market crosses below a long-term moving average.
How has the strategy of exiting the market in turbulent times performed recently? Significant variables will affect performance, such as how frequently and when the strategy is rebalanced as well as the number of holdings in the portfolio and commissions/taxes. Below is a graphical representation if one were to hold 10 stocks and rebalance every 4 weeks and exit all positions if the benchmark is below the 200 day moving average on the day the portfolio is rebalanced. This chart excludes dividends, however, a significant source of returns for the strategy but it still offers a good representation of the importance and power of capital preservation during periods of significant drawdowns in the overall equity market:
(Click to enlarge)
I used the Russell 3000 as the searchable index, which will also include smaller capitalized stocks than simply searching the S&P 500. This criteria could uncover some stocks that may not have as wide exposure as dividend paying stocks in the S&P 500. I ranked the top 25 results based on volatility, the lower the recent volatility the higher the stock ranked. Again, one could modify this requirement if yield was of greater importance at the cost of some additional volatility. Below are the results:
|Ticker||Name||MktCap||Yield||Pay RatioTTM||Div5Y Cgr%||Div% ChgA|
|(PG)||The Procter & Gamble Company||179708.2||3||48.52||11.81||9.76|
|(CPB)||Campbell Soup Company||11490.58||3.37||47.02||9.59||7.5|
|(WMT)||Wal-Mart Stores, Inc.||201965.09||2.13||28.97||15.95||14.74|
|(JNJ)||Johnson & Johnson||164802.7||3.6||41.71||12||7.52|
|(WEC)||Wisconsin Energy Corporation||7017.32||3.46||40.63||10.22||25|
|(MKC)||McCormick & Company, Incorpor||5358.97||2.52||38.18||10.2||8.33|
|(HRL)||Hormel Foods Corporation||6613.63||2.05||28.27||10.07||10.53|
|(GIS)||General Mills, Inc.||22215.26||3.21||42.76||9.14||11.63|
|(TRV)||The Travelers Companies, Inc.||25619.24||2.58||20.57||9.15||14.63|
|(CB)||The Chubb Corporation||17676.94||2.55||20.73||12.41||6.06|
|(AXS)||Axis Capital Holdings Limited||4400.66||2.58||14.81||10.13||7.28|
|(NJR)||New Jersey Resources Corporat||1737.79||3.42||47.85||8.45||9.68|
|(NEE)||NextEra Energy, Inc.||22467.94||3.7||42.62||7.09||5.82|
|(UNS)||UniSource Energy Corp.||1286.61||4.37||47.91||12.63||20.83|
|(XOM)||Exxon Mobil Corporation||398311.5||2.23||30.37||9.39||7.1|
|(SJM)||The J.M. Smucker Company||7362.41||2.85||36.7||7.29||10.69|
|(SXL)||Sunoco Logistics Partners L.P||2844.32||5.49||48.81||11.64||5.39|
|(TAP)||Molson Coors Brewing Company||8654.72||2.41||21.54||17.54||21.05|
|(LMT)||Lockheed Martin Corporation||28162.04||3.84||35.86||20.25||12.82|
I believe this low volatility dividend screen could be a great starting point for investors looking to meet the four criteria listed at the start of the article. With equity markets dropping significantly on Friday, Egypt in unrest and potentially spreading to other parts of the world, and many market technicians forecasting a top (at least in the short to intermediate term), now is an excellent time for investors to reevaluate their volatility exposure.
For the most risk-adverse dividend investors I believe the system detailed above is an improvement over a system I recently detailed because a) the time period used to gauge volatility is longer, b) it combines a benchmark study to help further limit drawdowns for the most risk-adverse investors, and c) ranks stocks based strictly on volatility as opposed to volatility and recent returns.