Playing Dividends: Standard & Poor's Dividend Aristocrats

by: Efficient Alpha

By Joseph Hogue, CFA

As I work through Michael Dever’s book, “Jackass Investing” and look at some of the myths in conventional wisdom for investing, a recurring theme starts to show through in regard to returns to equities. Dividends account for an overwhelming portion of an investor’s return. While this return might not be statistically overwhelming, dividend yield averages around 2.2% and nominal returns to the market without dividend reinvesting are 4.9%. The fact that investors are notorious for churning their portfolios and mis-timing the market means that dividends play an even more important role in actual realized returns. This becomes even clearer when you compare the returns to a portfolio with or without dividends reinvested. The return to a market portfolio since 1900 without dividends reinvested is 4.9%, while that portfolio with dividends reinvested is 9.5% on an annualized basis.

While it has become clear over the last decade that a simple buy-and-hold strategy should not be a large part of your portfolio, following a few select stocks that pay high and stable dividends will help augment the returns to the equity portion of your investments. For this reason, over the next several weeks, I will be exploring the popular dividend screens and the returns offered to investors. Some will be index based, while others will include more creative ways to screen for important fundamentals.

The first is one of the most popular indexes, the Standard & Poor’s Dividend Aristocrats. The index is designed to measure the performance of the 60 highest dividend yielding stocks in the S&P1500 which have followed a managed dividend policy and consistently increased dividends over the last 25 years. Index constituency is limited to no more than 4% for each stock to prevent overweighting, and all stocks must have a float-adjusted market capitalization of $500 million.

The index is slightly overweight in five sectors: consumer staples (20%), financials (15.9%), utilities (13.3%), consumer discretionary (13.2%), and materials (10.1%). Despite the skew towards these sectors, which is to be expected given growth fundamentals and dividend-policy norms, the index also holds a mix of stocks from the other major sectors. On a total-return basis, the Aristocrats Index has outperformed the S&P1500 and the S&P500 by 4.4% and 5.1% respectively over the last three years.

The SPDR S&P Dividend ETF (SDY) seeks to closely match the returns of the Aristocrats index. The fund pays a dividend yield of 3.3% and charges an expense ratio of 0.35%. The fund’s beta, a measure of volatility, is .89, meaning it is less volatile than the S&P500. While the fund is a good one-stop-shop for the dividend investor, I believe screening the fund’s holdings and selectively choosing 10-15 individuals can produce higher returns. I’ll include a selection of those within the index that could outperform overall.

I recently highlighted Walgreens (WAG) as a good large-cap contrarian play in the most recent article covering Michael Dever’s book. The company operates a chain of drug and convenience retail stores across the United States. Shares have been under pressure lately as the company tries to renew its multibillion-dollar contract with Express Scripts (ESRX). The deal should get worked-out, probably at the last hour. Walking away from the table would leave both companies to the mercy of competitors, so coming to terms is mutually-beneficial. The price has significant room until it comes up against its 52-week high, currently trading 25.3% under its high, and pays a dividend yield of 2.7%.

Archer Daniels Midland (ADM) processes, transports, and sells agricultural commodities in the United States and internationally. One of the few sectors in which the U.S. still has a competitive advantage is in agriculture, and world population dynamics promise a healthy return to investors in the space. World population is expected to hit seven billion around Halloween this week, and increased consumption of meat in the emerging markets is putting a strain on grain prices. The average analyst 12-month price target (as compiled by Bloomberg) for the company is $34.77, or an increase of 21.6% over Friday’s closing price. The company pays a dividend yield of 2.3% and sports an attractive sub-10 price-to-earnings ratio.

Exxon Mobil (XOM) is the $390 billion behemoth involved in the exploration, manufacture, and transportation of crude and natural gas products. With the price of oil down to around $85 per barrel due to fears of a recession and problems in Europe, it may be a good time to get into integrated oil before prices come back up. The stock’s price-to-earnings ratio is 10.6 times and pays a dividend yield of 2.4%. Despite weakness in oil prices, the stock has outperformed the S&P500 and the S&P Dividend Aristocrats by about 15% and 17% respectively over the last year.

Johnson & Johnson (JNJ) is the dividend standout at 3.6% annually, though it is a little more expensive than the other selections with a P/E of 15.6 times. I’ve followed JNJ for a while, and recently wrote that it is the best boring stock you’ll ever own. Sales are well diversified across the healthcare sector with about 36% coming from pharmaceuticals and 40% from medical devices. For long-term bets, i.e. the ADM selection above, I like to go with stocks that have significant tailwinds like population dynamics. Even with deficit reduction in the developed world, a significant portion of public and private spending will need to go to the healthcare sector. The company has been under pressure over the last year because of product recalls but should be able to rebound from the problems.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.