Doe the Chowder rule enhance or detract from dividend growth stock returns? This article will serve up some food for thought.
Chowder Rule Defined
What is the Chowder rule? Chowder is the handle of a Seeking Alpha contributor. Chowder writes sensible articles on the practice of dividend growth investing. After refining the list of dividend growth stocks down to a short-list of high-quality names, Chowder examines the trailing dividend growth rate and dividend yield to determine if the mix of value and growth warrants a timely buy.
Chowder's readership has turned this principle the famous Chowder Rule:
- If dividend yield is 3 percent or higher - the sum of the dividend yield and the trailing 5 year dividend growth rate must be at least 12
- If the dividend yield is less than 3 percent - the sum of the dividend yield and the trailing 5 year dividend growth rate must be at least 15
- There is a separate set of rules for utility stocks
My first impression is that the logic is sound. This reminds me of Peter Lynch and his use of the price-to-earnings ratio with the projected growth rate (PEG ratio). We should demand more growth if a stock has less value and demand more value if a stock has lower growth. The two should complement each other for the total package.
But does a sensible system translate into a tangible benefit? Will this result in higher total return? Let's find out.
Dividend Growth Chowder Test
The test will only consider dividend growth stocks with a trailing 10-year annual dividend increase.
This is not a buy and hold strategy. Why not? Because then the test would be meaningless from a statistical point of view. We want to know if stocks which meet the Chowder Rule provides additional return while fulfilling the rules requirements. If you wanted to know the average annual return of value stocks, your portfolio must hold value stocks. The same is true of growth stocks or dividend stocks or any other factor you can think of. We need to see the correlation between return and the Chowder Rule. If a stock fails to meet the Chowder Rule, it is put in the non-Chowder-approved portfolio.
The test starts in January 2000 and ends in January 2017.
Chowder Rule and Dividend Yield 3% Minimum
Dividend yield is a minimum of 3% and the combination of the trailing 5 year dividend growth ratio plus the dividend yield is at least 12%. This is a 'Chowder Approved' portfolio.
Dividend yield is a minimum of 3% and the combination of the trailing 5 year dividend growth ratio plus the dividend yield is less than 12%. This is the Non Chowder Approved portfolio.
Overall, we can say that the Chowder Rule in this instance does lead to higher risk-adjusted returns. We see an annual outperformance of 2.39%. Sharpe and Sortino ratios compare return to volatility and if we use these metrics we can say that the extra upside that comes from the Chowder Rule is worth the additional volatility.
Yet the one feature that disturbs me a little is the Chowder Crash in 2015. What happened there?
A closer examination shows that the oil sector (GICS 10) is largely to blame. This major portfolio drawdown could be avoided by removing the oil sector or MLPs in general. But many would cry foul saying you cannot remove entire sectors in retrospect to make the backtest look better. Maybe you would have avoided oil and maybe you would have bought it.
An Added Industry Performance Rule
A better rule which makes sense if you want to cut down on risk is to remove any industry, which over the trailing 6 months, has under-performed the market by 10% or more. If we apply this rule and re-run the test, the results are more stable.
Minimum Yield 3% - Chowder Approved Portfolio
And this is the effect of that same rule in dividend stocks with a minimum 3% dividend yield where the Chowder number is less than 12. Some tickers in this portfolio is Exxon (NYSE:XOM), Chevron (NYSE:CVX), International Business Machine (NYSE:IBM), Altria (NYSE:MO), Qualcomm (NASDAQ:QCOM) and Occidental Petroleum (NYSE:OXY).
Minimum Yield 3% - Non Chowder Approved Portfolio
What this shows me is that the Chowder rule can definitely enhance returns, but as Chowder himself has pointed out this is one of the final considerations before buying. You first want to ensure that you are buying into a high-quality company. I am sure that Chowders filtering of a high-quality company would improve these results even further.
Chowder Rule and Dividend Yield Under 3%
The next set of tests looks at the Chowder formula for stocks which have a dividend yield of less than 3%. The Chowder Number needs to be at least 15 if we are to buy. We will run with and without the industry performance rule that will remove lagging industries.
Yield Less 3% - Chowder Approved Portfolio
Yield Less 3% - Chowder Approved Portfolio Remove Lagging Industries
Yield Less 3% - Chowder Non Approved Portfolio
Yield Less 3% - Chowder Non Approved Portfolio Remove Lagging Industries
I am having difficulty finding any additional benefit from the Chowder Rule when analyzing lower yielding companies. To my eye, it seems to make little difference whether the 5 year dividend growth rate is high or low in these companies with a small dividend yield.
Yield On Cost
A final consideration is to look at the yield on cost of the 4 portfolios. These portfolios will all have the 'remove lagging industries' rule applied.
Minimum Yield 3% - Chowder Approved
Current Yield: 5.6% Yield on Cost: 97%
Minimum Yield 3% - Non Chowder Approved
Current Yield: 4.0% Yield on Cost: 31%
Minimum Yield Less Than 3% - Chowder Approved
Current Yield: 1.9% Yield on Cost: 9.4%
Minimum Yield Less Than 3% - Chowder Non Approved
Current Yield: 2% Yield on Cost: 9.4%
What I Learned From This
What am I taking home from this? The Chowder Rule seems to work very well on stocks of a higher yield. Good job Chowder!
What areas might there be room for improvement? One might be to tweak the formula similar to the PEG ratio. For instance, we could compare the price-to-dividend ratio (inverse div yield) to the trailing 5 year growth. This would allow for a single number rank that makes sense even when dividend yields are very high or very low.
Another area would be to consider other ratios besides the trailing 5 year dividend growth number. My tests show that this number has little forecasting ability for the stock or future dividends. Perhaps using the trailing 5 year sales growth or trailing 5 year earnings growth or the forward 5 year earnings growth estimate might make more sense.
What are your thoughts? Does Chowder in fact rule?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.