Taking Advantage Of Volatility - A Diversification Opportunity For Dividend Growth Investors

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 |  Includes: AFL, EMR, ETN, HON, ITW, UTX
by: Winning Formula

Dividend Growth Investing is a very conservative method of investing your portfolio into a group of stocks that have steady growth with increasing dividends over the long run. By investing in these steady stocks with increasing dividends, your annual income increases every year. It is a very successful strategy for many investors who are building a revenue stream to live on during their retirement. My portfolio is full of these steadily growing DG stocks and I highly recommend investors of any age to purchase dividend paying stocks.

Typically, DG investors have rules that must be met to invest in a stock. Some of my rules include yield, payout ratio and dividend growth rate. I prefer a yield above 3% and use the payout ratio and dividend growth rate to determine whether to invest in a stock. Based on the characteristics of my portfolio, I require a payout ratio below 35% to invest in stocks with 3.0% yields, a payout ratio below 55% to invest in stocks with 4% yields and a payout ratio below 70% for higher yielding stocks. Most of the lower yielding stocks in my portfolio have growth rates over 10% and the higher yielding stocks have dividend growth rates of about 7%. Sometimes these rules limit the number of stocks that can be purchased in your portfolio.

The recent volatility in the stock market that occurred in August and September brought many new names within my yield requirements. Suddenly stocks like AFL, EMR, ETN, HON, ITW and UTX started looking relatively attractive. These stocks showed up in my screens because they are very volatile, meaning they fall and rise much faster than the market. The volatility, or falling stock prices, raised the yields on these stocks to very attractive levels when compared with their low payout ratios and high dividend growth rates. These stocks fell enough that they looked relatively cheap when compared with the dividend yields, payout ratios and dividend growth rates of the steady DG stocks in my portfolio. The following table shows how attractive the dividend yields on these volatile stocks were at their recent lows compared with their normal yields of below 2%:

Ticker

Quarterly

52 Week

Yield on

Payout

5 Yr Ave.

5 Yr. Ave.

Dividend

Low

52W Low

Ratio

Yield

Div Growth

Aflac (NYSE:AFL)

$ 0.30

$ 31.25

3.84%

30%

1.90%

18.0%

Emerson Electric (NYSE:EMR)

$ 0.35

$ 39.50

3.54%

42%

2.17%

9.2%

Eaton Corp. (NYSE:ETN)

$ 0.34

$ 33.09

4.11%

35%

1.20%

10.4%

Honeywell (NYSE:HON)

$ 0.33

$ 41.22

3.20%

34%

2.12%

5.9%

Illinois Tool (NYSE:ITW)

$ 0.36

$ 39.12

3.68%

34%

2.43%

15.1%

United Technologies (NYSE:UTX)

$ 0.48

$ 66.87

2.87%

34%

2.09%

12.5%

Average

3.54%

35%

1.99%

11.9%

Click to enlarge

With this new group of stocks now being within my investing criteria, I had to decide if it was prudent to take advantage of the opportunities. I remain 100% invested in my DG portfolio, so I had to sell portions of my steady DG stocks to purchase these new opportunities. I looked at the yields, payout ratios, and growth rates of some of my current holdings and decided to sell some of them to purchase these new names. The following table shows the relative dividend yields, payout ratios and growth rates of some of my more stable companies:

Ticker

Quarterly

52 Week

Yield on

Payout

5 Yr Ave.

5 Yr. Ave.

Dividend

Low

52W Low

Ratio

Yield

Div Growth

AT&T (NYSE:T)

$ 0.43

$27.20

6.32%

87%

4.9%

5.4%

Bristol-Myers (NYSE:BMY)

$ 0.33

$24.97

5.29%

68%

4.7%

0.2%

Kimberly-Clark (NYSE:KMB)

$ 0.70

$61.00

4.59%

66%

3.7%

7.5%

Abbott Labs (NYSE:ABT)

$ 0.48

$45.07

4.26%

64%

2.8%

9.4%

Johnson & Johnson (NYSE:JNJ)

$ 0.57

$57.50

3.95%

54%

2.9%

8.9%

Procter & Gamble (NYSE:PG)

$ 0.53

$57.56

3.68%

50%

3.0%

11.6%

Average

4.68%

65%

3.7%

7.7%

Click to enlarge

To determine if this strategy may be something to consider, the first thing to understand is volatility. Volatility is movement up and down in stock prices that is typically measured in Beta. Beta is a relative measure of how a stock moves compared with the market. A stock with a beta above 1.0 will move up and down faster than the market. A beta of 2.0 means a stock’s price will move twice as much as the market gaining or falling 20% when the market moves 10%. The risk of buying these new names is that when a recession occurs, the earnings of these higher volatility companies will likely fall hard and the stocks will drop further than the market. Some DG investor may not appreciate the increased volatility of their portfolios with these high beta stocks. The following table shows the volatility of each of the stocks listed above:

Low Volatility Ticker

60 Month Beta

High Volatility Ticker

60 Month Beta

T

0.65

AFL

1.77

BMY

0.57

EMR

1.21

KMB

0.39

ETN

1.45

ABT

0.30

HON

1.36

JNJ

0.58

ITW

1.13

PG

0.48

UTX

1.04

Average

0.50

Average

1.33

Click to enlarge

The reward for purchasing these higher volatility stocks in pullbacks is that when the economy recovers, the earnings on these stocks will grow faster than the steady stocks. Combine the faster earnings growth with the lower payout ratios and you get the opportunity for faster dividend growth rates than with the slower growing steady stocks. These volatile stocks need to keep their payout ratios lower than the steady stocks to maintain their dividends during recessions. If their payout ratios get too high, there is a higher likelihood that the dividend could be cut during a recession. To avoid potential dividend cuts, I decided to only invest in the volatile stocks that may have frozen their dividends during previous recessions and avoided the ones that cut their dividends in previous recessions. Stocks that freeze dividends may not be acceptable to all DG investors. I also required a much lower payout ratio for a given yield for these stocks to avoid potential dividend cuts.

The end result of this rotation into the higher volatility stocks is that I now have a more diversified portfolio with a similar dividend yield, lower payout ratio and higher growth rate. I believe this is a benefit for my portfolio, which will not be used for living needs for at least 10 more years. But the drawback of this approach is that now my portfolio has a higher beta meaning it will be more volatile. A portfolio that fluctuates more in value may be harder to live with for some DG investors.

You may want to consider adding diversification to your portfolio when the market dips in the future and the higher beta stocks become relatively attractive again compared with the lower volatility stocks that are in most DG portfolios.

Disclosure: I am long AFL, EMR, ETN, HON, ITW, UTX, T, BMY, KMB, ABT, JNJ, PG.