The ABCs Of Dividend Investing: Divi-Do Or Divi-Don't?

by: Rising Dividend Investing

Low interest rates have propelled dividend income investing to become more popular today than at any time in the past 50 years.

Despite the dividend's newfound popularity, many investors only look at one component: dividend yield. They point to the fact that dividends have represented 40% of total return of stocks since 1960. They point to low interest rates. They point to current income. But that is where they stop. And that is where they are wrong. Dividends are more than income. Much more.

The most important element of dividend investing is the significant long-term relationship between dividend growth and price growth. Understanding this relationship is the key to unlocking the true power of the dividend.

Dividend Growth = Price Growth

The dividend is among the most convincing ways of determining the fair value of stocks. For one thing, it represents real cash, which can't be masked by clever accounting tricks.

Furthermore, companies are careful to increase dividends only when they believe the future cash payments are sustainable. U.S. stock prices are significantly damaged when their Board of Director's announce a cut to the dividend. This makes dividend growth a very accurate internal estimate of the long-term, sustainable growth rate.

If dividend growth is an indicator of long-term fundamental growth, then the relationship between price growth and dividend growth should be linked as well.

Linked, it is. This relationship between dividend growth and long-term market prices is undeniable. Since 1960, the correlation between dividend growth and price growth for the Dow Jones Industrials is over 90%. The predictive relationship between price and dividend enables investors to statistically determine where the channel of fair value resides.

Losing Sight of the Dividend

If in the long run, dividend growth is predictive of price growth, why do so many investors abandon dividend-centric investing during hot markets?

The reason, perhaps, is one of simple math. In 2013, the total return of the S&P 500 was nearly 30%. Dividends represented only 2% of that total. During times of significant market increases, the contribution of dividend yield to total return seems so small that investors wrongly deduce that dividends are no longer important.

It is during these hot markets that many investors stop watching their dividend-centric valuation metrics and opt instead for whatever the popular opinion is among the gurus on CNBC, the touts from the Wall Street Journal or, heaven forbid, whatever is being discussed in the local newspaper.

In doing so, they eventually find themselves licking their wounds on the sidelines of some future bear market.

In our judgment, the best way to understand the current valuation of the market is to understand how dividends are linked to today's prices. As we discussed in last week's blog, our Dow Jones Industrials (DJIA) proprietary model, which is primarily driven by dividend growth, indicated that at the beginning of 2013 stocks were 25% undervalued. The undervaluation was caused by a hangover from the Great Recession of 2008-09, which left prices disconnected from dividends.

The current reading is that the market is about fair valued. Since last year was such a big year, it is the right place to look to see if dividends and prices are still linked. If they are, the market is still connected to reality. If, on the other hand, stocks are moving independent of dividends, this is a market we should be very suspicious of.

Is dividend growth still leading the way?

Dividend vs. Price in 2013

Sector-by-Sector Dividend Growth vs. Price Appreciation in 2013

The chart above plots the relationship between the median dividend growth (horizontal axis) and total return (vertical axis) for each market sector in the 2013 calendar year.

It doesn't take more than a casual glance at the chart to see there is a correlation between dividend growth and total return. The market appears to be doing the kind of job we would expect it to.

Upon closer look, however, there's something astray about the chart. There are two sectors that did not appear to be rewarded for their dividend growth: technology (NYSEARCA:XLK) and energy (NYSEARCA:XLE).

As we pierce into both of them, we see that there is something unusual going on that distorts the relationship between dividend growth and rate of return.

1. Energy

The Energy sector (XLE) had dividend growth second only to Technology, but was near the low-end of total return.

Breaking down the Energy sector a bit more provides an explanation for this phenomenon.

About half of the sector is made up of smaller businesses under the sub-sectors of "Exploration and Development" and "Drillers." Dividends for these companies have exploded because of the rapid growth of the U.S. shale business.

The large increase in these companies' dividends is not reflected in overall total return for the sector because they are overshadowed by larger companies, such as Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), which have significantly slower dividend and price growth.

When you look specifically at these smaller, higher dividend growth companies, it becomes clear that they have been rewarded for growth. In 2013, the SPDR S&P Oil & Gas Equipment & Services ETF (NYSEARCA:XES), which consists primarily of these two sub-sectors, was up nearly 30%. Over the past thre years, dividend growth for XES has been 31.4% annually. Price appreciation in 2013 was right at 30%.

2. Technology

The chart also shows that Technology (XLK) did not get rewarded fully for its dividend growth.

The answer lies in the dividend history. Technology companies do not have a long history of paying and increasing their dividends. Indeed, in the late 1990s and early 2000s, many technology companies went on record that they would never pay a dividend.

That has changed in recent times, but it wasn't until the urging of their shareholders that many technology stocks began to pay dividends.

Some of the larger technology companies, such as Microsoft (NASDAQ:MSFT) (2.6% yield and 16.3% 3-year annual growth) and Intel (NASDAQ:INTC) (3.4% yield and 13% 3-year annual growth), have become significant dividend payers. Cisco (NASDAQ:CSCO), which began paying a dividend in 2011, raised its dividend 54% last year.

However, investors still remain somewhat unconvinced that the technology stocks as a whole will continue to be dedicated dividend payers. As a result, the market did not fully reward the tech sector for its dividend growth.

Having spoken to many of the large technology companies, we believe they are firmly committed to the dividend. Therefore, the tech sector may be among the best places to look for bargains.

Sector-by-Sector Dividend Growth vs. Price Appreciation in 2013
(excluding XLE & XLK)

Removing the energy and technology sectors makes the correlation between dividend growth and price growth even more obvious than in the previous chart. A linear regression of the above data reveals a significant relationship with an r-squared of near 0.80.

What Does It Mean?

Even in a year where price appreciation dwarfed dividend yields, the tight correlation between relative dividend growth and price growth held almost symmetrically. The way the market paid for dividend growth in 2013 indicates that the market was acting correctly. If it were not, we would not have seen such a high correlation between price growth and dividend growth.

Finally, because dividend ratios are 32% - well under the long-term average of 50% - and with investors clamoring for income, we continue to believe dividend payout ratios will climb over the coming years.

There are many commentators who are suggesting that dividend investing has run its course and will not be successful in the future. This is the crowd we have named the Divi-dont's. We, on the other hand, remain convinced as we have over the last 20 years that dividends are actually growing in importance. Therefore, we proudly count ourselves as members of the Divi-do's.