Why Dividend Investors Should Rely On The Past

Includes: BAC, JNJ, JPM, KO, USB, WFC
by: Tim McAleenan Jr.

One of the most repeated lines inscribed in the fine print of potential mutual fund investments is the warning "past performance is no guarantee of future performance." Heck, even Warren Buffett said that if history is the only element necessary to evaluate a good investment, then the richest people in the world would be the librarians. It might seem counterintuitive for me to suggest that investors could do well by looking to the past to make the investment decisions of today. But I believe that the most reliable way to predict the profits of the future is by looking at the industries that have reliably created profits both in the past and present.

Benjamin Graham had this to say about investors using the past as a proxy for current investment decisions:

"But what are the processes by which the security analyst determines both the average future earnings and the suitable capitalization rate? In both cases he is turning himself into a prophet, without the benefit of divine inspiration. As a poor substitute he turns for guidance to a threefold source-the past record of the company, the known or generally accepted factors bearing on the future, and something referred to by the courts as 'the informed judgment of the expert'.

The fact of the matter is that he almost always rests heavily on the past record. In so doing he has a fair degree of logical justification. If average recorded earnings can be relied upon fairly well to measure the safety of a bond issue, they must in the typical case supply a useful clue to the normal earning expectancy of a common stock. Even the rather crude assumption that past average earnings will be repeated in the future may be found a more reliable basis of valuation than some other figure plucked out of the air by either optimism or pessimism."

There are a lot of things that I can learn by framing the debate in terms of looking at what led to success and failure in the past and then comparing those circumstances to the present. For instance, when I look at David Fish's CCC List of companies that have been raising dividends for decades, I notice something: the list isn't exactly swamped with banks that have raised their dividends continually for decades on end. Why is that? Because every generation or so, as if on cue, bank stocks tend to blow up in a financial crisis that leads to dividend cuts and takes years to repair earnings quality. Aware of this historical fact, I can place sharp limits on the types of banks that I invest in, only considering high-quality banks like US Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC), and JP Morgan (NYSE:JPM), and maybe a very well-capitalized small bank or two. From there, I can use my awareness that banks tend to experience a financial crisis every generation or so to take an additional step: not reinvest my dividends into bank stocks to adjust for the chance that banks get hit by another significant financial crisis.

If you invested in what became Bank of America (NYSE:BAC) in the early 1980s, you would have received 2.5x your initial investment in total dividends by the time the financial crisis hit and Bank of America had to slash its quarterly dividend from $0.64 to a penny. Aware of the historical warts that come with bank stock investing, I can go out of my way to limit myself to the bluest of blue chips in the industry and invest bank dividends elsewhere to guard against the threat of earnings/dividend deterioration in the event of a future financial crisis. Knowledge of the past would lead me to this decision.

Also, dividend histories can tell me what types of sectors to avoid entirely-airline companies and automotive companies tend to not show up on lists of companies with strong dividend growth histories, and there is a reason why: fixed cost hurdles and sensitivity to commodities make sustained earnings growth for decades on end very difficult, so I can build a portfolio that completely ignores these sectors. Sure, I might miss out on a good investment opportunity or two, but thankfully there are no called strikes in investing, and I can use the abysmal dividend growth pasts of these sectors to wipe them off my radar screen for potential investments.

What kind of companies do tend to show up on lists of companies that have been raising dividends for decades? Health care stocks, consumer staple stocks, and utility stocks. Because they sell products that are generally recession resistant, I'm fairly confident this past trend with continue into the future. So how would the past affect my present portfolio construction? You can bet I'll spend most of my investable income throughout my life loading up on health care companies like Johnson & Johnson (NYSE:JNJ), consumer staples like Coke (NYSE:KO), and utilities like Southern (NYSE:SO). I'm a big fan of the analogy that regards each investor as the CEO of his own corporation that treats each stock holding as an employee. Well, when you hire an employee, what must they have before you hire them? A resume (Hat tip: I got this analogy from an excellent recent comment by RichJoy403). And I can't think of a better resume that a company can have than a long record of reliably growing earnings and dividends in all kinds of environments.

Of course, investors cannot focus exclusively on the past. I think we ought to be like one of those Janus coins-one head looking to the past, one looking to the future. I have a choice in how I orient myself as an investor: I can bet on the next big thing, I can bet a big turnaround, or I can bet on continued success. I like the third option because it provides a safer framework for trying to find guaranteed profits. Instead of spending my time looking for speculative companies that might eventually get it right, I can spend my time scooping up shares of businesses that have historically gotten it right, and then hold until that is no longer the case.

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