U.S. stocks are trading at elevated price/earnings ratios, and potential market headwinds abound. A strengthening US dollar, a seemingly more hawkish fed, or margin pressures from wage growth could all potentially weigh on earnings growth, derailing the 8-year bull market in stocks. Against that backdrop, dividends could contribute even more to stock returns over the next 5 years than they have historically.
Shrewd Seeking Alpha readers already know that dividends have been a major driver of stock returns over time. The chart below, from JPMorgan's 2017 Q1 Guide to the Markets, illustrates just how important dividends have been. From 1926 until 2016, dividends accounted for more than 40% of the S&P 500's total returns. (Note: I've often heard that dividends have accounted for 33% of S&P 500 returns over time, but in any event, dividends have accounted for a significant portion of total returns.). The dividend share of return is even more impressive when you consider that not all S&P 500 constituents pay dividends. (According to Factset, 419 constituents paid a dividend as of the end of Q2 2016.)
Meet the Dividend Aristocrats
Standard & Poors, the well-known index provider and credit rating agency, has two indices that track companies that have a proven track record of consistently increasing their dividends over long periods of time.
The S&P 500 Dividend Aristocrats Index is an equal weight index of stocks in the S&P 500 that have increased their dividend for at least 25 years. There are 51 stocks, including new additions Federal Realty Investment Trust (NYSE:FRT) and General Dynamics (NYSE:GD). (The indices will be rebalanced effective the close of business on Tuesday, January 31.)
The S&P High Yield Dividend Aristocrats Index includes stocks from the S&P 1500 (which includes mid- and small-cap stocks and covers 90% of the US market cap) and lowers the bar to only 20 years of consistent dividend increases. The index includes the 50 stocks with the highest yields that meet the dividend criteria.
Dividends are never guaranteed, and some blue-chip companies such as GE and Citigroup had to decrease dividend payments significantly in the financial crisis of 2008-2009. However, by following a "managed dividends" strategy, these companies have clearly signaled that they are more likely than not to continue increasing their dividend payments in the years ahead.
Dividends Will Drive Future Stock Returns
John Bogle, the index fund pioneer responsible for Vanguard and the index fund revolution, has a simple formula for predicting the future performance of stocks.
Future Market Returns = Dividend Yield + Earnings Growth +/- Change in P/E Ratio
I recently wrote an article on Seeking Alpha that suggested that a 10%+ correction was brewing in US stocks. The premise of the article was that after the post-election rally, the P/E ratio of the market was considerably above the long-term average. Furthermore, earnings expectations seem a bit rosy, considering that we recently had 5 quarters without YoY earnings growth (the period Q1 2015 - Q2 2016).
If we break down Bogle's formula by component, we can see where stock returns might come from in the future.
Earnings growth is an unknown. EPS growth is likely based on Trump's campaign promises of lower corporate and personal tax rates, repatriation of foreign cash, fiscal spending, and decreased regulation. However, it is easy to imagine subdued earnings for any number of reasons. If the US dollar continues to strengthen (as many are forecasting), overseas sales will lose value when translated back to USD. If wage pressures continue, margins could compress. Finally, the Fed could spook the market by raising interest rates more aggressively than expected (or signaling their intent to do so).
Increases in the P/E Ratio of the market are unlikely. The forward P/E is more than 17 vs. a long-term average of 15.9. The very low level of interest rates has justified a higher than average P/E, but interest rates seem to be headed higher, and if Trump is successful in spurring economic growth then they'll have to move higher.
Dividend increases from companies that have been increasing their payouts for at least the past 20 years, on the other hand, are far more likely than not to continue.
What's the Trade?
Below I have listed a few ways you might consider implementing an investment in the Dividend Aristocrats.
1) Buy Dividend Aristocrat ETFs
The Proshares S&P 500 Dividend Aristocrats ETF (BATS:NOBL) has a yield north of 2% and an expense ratio of 0.35%.
The SPDR S&P Dividend ETF (NYSEARCA:SDY) tracks the S&P High Yield Dividend Aristocrats Index. It offers a yield of 2.4% and also a modest expense ratio of 0.35%.
2) Opportunistically Buy Dividend Aristocrats ETFs Using Limit Order or Cash-Covered Puts
While I know the arguments against market timing, I'm on record suggesting that a selloff in stocks is likely in the near term. My preference, then, is not to buy today but instead to set myself up to buy if the correction occurs.
One obvious way is to set a "good-till-cancelled" order to buy shares of NOBL at $50 (closed Friday at $54.46). The benefit of using a limit order is that if the shares hit your price, you'll get to buy the shares.
Another option is to sell a "cash covered put." With a put, you sell somebody the right to be able to sell their shares of a stock to you at a pre-set price, for a set period of time. In exchange for selling that right, you get paid a premium up front.
Selling a put on NOBL, with a July 21st expiry and a $51 strike price, would generate $1.45/share of premiums. One risk here is that if NOBL trades down below $51, but before July 21st it recovers, you may never get to buy your shares. You trade the premium income for that uncertainty. If you do end up buying the shares because of the option, your breakeven is $49.55.
3) Buy Dividend Aristocrat Stocks Directly
Finally, a third way to play the dividend aristocrats is to pick individual names. Here is a link to a website that updates the list of aristocrats regularly. By picking individual names, you can screen out stocks that you think are growing too slow, are too richly valued, have an unsustainable payout ratio, or are in a sector that you don't like (if you would like to see some write-ups with screens leave me a note in the comments). Once you've got some names in mind, you can incorporate the trading strategies outlined above.
In summary, dividends have been a consistent source of returns for stock investors for a long time. You can bet on this trend to continue. The dividend aristocrats indices can provide an easy to implement way to invest in companies that have a strong record of consistent dividend growth. Formulate a strategy today to add dividend aristocrats to your portfolio on a 10% correction.
Disclosure: I am/we are long SDY.
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.