Dividend Aristocrat Investing 2013

| About: SPDR Dividend (SDY)
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One of my most popular articles of 2012 was on Dividend Aristoricrat Investing. Dividend Aristocrats are stocks that have followed a policy of increasing dividends every year for at least 25 consecutive years. My article demonstrated that since Standard and Poor's first chronicled the performance of a strategy that held the stocks of these steady dividend payers at the end of 1989, the Dividend Aristocrats had outperformed the broader market while exhibiting less variable returns.

Cumulative Total Return: Dividend Aristocrats & S&P 500

Source: Bloomberg, Standard and Poor's

The article's popularity was likely driven by the large income investing audience on Seeking Alpha, the long duration of the study, and the raging debate on the relative valuation of dividend stocks. Many articles were written in that period about the overvalued nature of dividend stocks, and why future performance would trail the market. Since my first article on the topic was posted on May 10, 2012, the S&P 500 Dividend Aristocrats Index has produced a total return (including both price appreciation and dividends) exceeding that of the S&P 500 (NYSEARCA:SPY). The Dividend Aristocrats beat the S&P 500 by 3.2% over that time frame as seen below.

The Trade Historically

Recently, I have written several articles on the Low Volatility Anomaly, or the fact that lower risk stocks have outperformed the broader market and higher risk stocks over the last twenty plus years in markets around the world. The business model of Dividend Aristocrats must be inherently stable and produce continual free cash flow through the business cycle or these companies would not be able to maintain their record of paying increasing dividends for over a quarter century. The return profile of the Dividend Aristocrats is much more correlated to the S&P Low Volatility Index (SPLV, r= 0.90) than the S&P 500 (r = 0.74 ), which lends credence to the strategy's low volatility nature and stability through differing market environments.

This stability manifests itself in down markets, which has driven the outperformance of the Dividend Aristocrats over the sample period. Below are the annual returns of the S&P 500 and the Dividend Aristocrats.

The Dividend Aristocrats have outperformed the broader market by 274bp per year since 1990 (11.29% - 8.55%) while exhibiting only eighty percent of the variability of annual returns. There are three important points to be made from this historical return profile. First, this return divergence is explained entirely by the five years that the S&P 500 produced negative total returns in the sample set (1990, 2000, 2001, 2002, 2008.) Those three distinct time periods each coincided with the last three domestic recessions in the United States. The Dividend Aristocrats strongly outperformed in these years, besting the S&P 500 by 19.47% per annum. Secondly, outside of these three periods of negative returns for the markets, dividend stocks have not strongly underperformed when the market has been rising, trailing the average return of the broader market by just 190bps per annum on average. In the eighteen years in the sample period when the markets have produced positive returns, dividend stocks have outperformed the broader market in half (9) of those years, including every year post-2008. Thirdly, when the broad market has had its best relative performance versus the Dividend Aristocrats (1998, 1999, 2007), the market has corrected sharply in the subsequent year.

The Trade in 2013

Seeking Alpha readers have a wide range of expected market returns for domestic stocks, which stimulates a healthy debate in the community. I believe that you can extrapolate the historical performance of the Dividend Aristocrats in various market environments to your own expected market outcome. If you believe market performance is likely to be weak, then the Dividend Aristocrats will continue their relative strong performance versus the broader domestic equity market. If you believe that market performance is going to be very strong then Dividend Aristocrats will likely trail on an absolute basis, but likely not on a risk-adjusted basis. If Dividend Aristocrats dramatically underperform the broader market, readers should take this as a sign that perhaps it is the point in the cycle to be rotating out of stocks altogether.

Seeking Alpha readers should understand that dividend stocks are not a homogeneous asset class. As I wrote in The Dividend Sweet Spot, stocks with dividend yields above six percent have historically underperformed stocks with dividend yields of between three to six percent. If you sorted the S&P 500 constituents in descending order by estimated dividend yield (Bloomberg estimate), only four components would have an estimated dividend yield over six percent - Windstream Corp (NASDAQ:WIN), Pitney Bowes (NYSE:PBI), Frontier Communications (NYSE:FTR), and CenturyLink (NYSE:CTL). Over the last twelve months, each of these stocks has produced a negative total return despite the broad based market rally. One of my themes for 2013 is that in a low yield world, investments with above market yields will continue to generate risk-adjusted outperformance. This does not mean that investors should blindly buy yield. The two industries represented by the aforementioned four companies are wireline communications and mailing solutions - two secularly declining industries. Seeking Alpha readers seeking a continual income stream and lower volatility should buy companies that have a track record of continually increasing their dividend payouts.

Many dividend strategies are heavily overweight utilities and financials, but the Dividend Aristocrats' fifty-four members feature a nice mix of sectors as seen below. Some might contend that the lower variability of returns from the Dividend Aristocrats hides the lessened diversification inherent in the smaller population, but the number of constituents still creates a statistically significant sample. Others might claim that the equal-weighted nature and lack of rebalancing at least in part drives relative performance. A look at the Dividend Aristocrats constituents might give readers a better sense of the inherent risk:

Source: Bloomberg; Dividend Yield is most recently announced net dividend, annualized based on the dividend frequency

Since my inaugural article on the Dividend Aristocrats last year, Abbvie (NYSE:ABBV) was added to the index after its split from Abbott (NYSE:ABT), oil and gas giant Chevron (NYSE:CVX) made the list, flow control equipment manufacturer Pentair (NYSE:PNR) hit its twenty-fifth consecutive year of increased dividends, and healthcare supply distributor Cardinal Health (NYSE:CAH) was also added. The only company that fell from the list was the aforementioned Pitney Bowes, formerly the highest yielding component, which failed to meet the index's revised minimum float market cap of $2bn at the December rebalancing.

While the S&P 500 Dividend Aristocrats does not have a readily available ETF, State Street does administer an exchange traded fund, the SPDR S&P Dividend ETF (NYSEARCA:SDY), that tracks the highly overlapped S&P High Yield Dividend Aristocrats Index. The Index is designed to measure the performance of the 60 highest dividend yielding S&P Composite 1500 Index constituents (current holdings 84) that have followed a managed-dividends policy of consistently increasing dividends every year for at least 25 consecutive years. The Fund generally invests substantially all, but at least 80%, of its total assets in the securities comprising the Index. Below is the historical returns of the S&P 500, the S&P 500 Dividend Aristocrats, the S&P High Yield Dividend Aristocrats Index (began in 1999), and the ETF which replicates this index (began in 2006).

As you can see below, SDY has lagged the Dividend Aristocrats since inception. Part of this underperformance is likely attributable to SDY's focus on high dividend payers (PBI is the largest constituent), which have underperformed over this period, and the equal weight nature of the Dividend Aristocrats Index. While SDY has lagged the Dividend Aristocrats, it still has outperformed the S&P 500 while exhibiting only three-quarters of the volatility.

Dividend Aristocrat investing has produced higher risk-adjusted returns over very long time horizons, and should be considered as part of your longer-term strategic equity allocation. Understanding the historical risk/return patterns of these steady dividend payers versus the broader market should help influence more tactical asset allocation decisions.

Links to Dividend Aristocrats constituents:

3M (NYSE:MMM), Aflac (NYSE:AFL), AT&T (NYSE:T), Abbott Labs , Abbvie Inc , Air Products and Chemicals (NYSE:APD), Archer Daniels Midland (NYSE:ADM), Automatic Data Processing (NASDAQ:ADP), CR Bard (NYSE:BCR), Becton Dickinson (NYSE:BDX), Bemis (NYSE:BMS), Brown-Forman (NYSE:BF.B), Cardinal Health , Chubb (NYSE:CB), Cincinnati Financial (NASDAQ:CINF), Cintas (NASDAQ:CTAS), Clorox (NYSE:CLX), Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL),Chevron , Consolidated Edison (NYSE:ED), Dover (NYSE:DOV), Ecolab (NYSE:ECL), Emerson Electric (NYSE:EMR), Exxon Mobil (NYSE:XOM), Family Dollar Stores (NYSE:FDO), Franklin Resources (NYSE:BEN), Genuine Parts (NYSE:GPC), W.W. Grainger (NYSE:GWW), HCP (NYSE:HCP), Hormel Foods (NYSE:HRL), Illinois Tool Works (NYSE:ITW), Johnson & Johnson (NYSE:JNJ), Kimberly Clark (NYSE:KMB), Leggett & Platt (NYSE:LEG), Lowe's (NYSE:LOW), McCormick & Co (NYSE:MKC), McDonald's (NYSE:MCD), McGraw Hill (MHP), Medtronic (NYSE:MDT), Nucor (NYSE:NUE), PPG Industries (NYSE:PPG), PepsiCo (NYSE:PEP), Proctor & Gamble (NYSE:PG), Pentair , Sherwin Williams (NYSE:SHW), Sigma Aldrich (NASDAQ:SIAL), Stanley Black and Decker (NYSE:SWK), Sysco (NYSE:SYY), T. Rowe Price (NASDAQ:TROW), Target (NYSE:TGT), VF Corp (NYSE:VFC), Wal-Mart (NYSE:WMT), Walgreen (WAG).

Constituents in S&P HY Dividend Aristocrats and SDY Not Listed Above:

AO Smith Corp (NYSE:AOS), Atmos Energy (NYSE:ATO), Commerce Bancshares (OTC:CBSH), Carlisle Companies (NYSE:CSL), Clarcor (NYSE:CLC), Diebold (OTCPK:DBD), Energen (NYSE:EGN), Eaton Vance (NYSE:EV), Federal Realty Trust (NYSE:FRT), General Dynamics (NYSE:GD), Linear Technology Corp (NASDAQ:LLTC), MDU Resources Group (NYSE:MDU), Nordson Corp (NASDAQ:NDSN), National Fuel Gas (NYSE:NFG), National Retail Properties Inc (NYSE:NNN), Old Republic (NYSE:ORI), Piedmont Natural Gas (NYSE:PNY), Pitney Bowes , Praxair (NYSE:PX), Questar (NYSE:STR), RPM (NYSE:RPM), Roper Industries (NYSE:ROP), SEI Investments (NASDAQ:SEIC), Sonoco (NYSE:SON), Telephone & Data Systems (NYSE:TDS), UGI Corp (NYSE:UGI), Valspar (VAL), Vectren (NYSE:VVC), WGL Holdings (NYSE:WGL), Aqua America (NYSE:WTR).

Disclosure: I am long SPY, SPLV. 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.