Dividend Growth Investors: Quality Might Be Only Half The Battle

by: Adam Aloisi


Dividend growth investors are typically attracted to equities with "quality" attributes.

A cherry-picked illustration of how timing can dramatically impact longer-term investment results.

Some discussion of fair value, and why some dividend investors might eschew the concept altogether.

Ruminations on the current economic environment and some equity ideas with good tailwind.

"Quality" is a highly subjective term in the equity realm, with potentially variable assertions from investor to investor. One prevalent definition of a "quality" dividend growth stock is one with a long history of upward climbing payouts, with durable business attributes, and positive current quantitative factors.

Thus, it is no mistake that large-cap stocks with multi-decade dividend histories seem to dominate such portfolios. Some commentators or investors might refer to some of these specific names as "forever" holdings. In other words, they should be bought and then never sold. Whether you should maintain that kind of mentality or not is an interesting subject, but beyond the scope of this article.

To maximize dividend growth over the long run, investors need to find equities possessing attractive combinations of current yield, dividend growth sustainability, and appropriate risk over a certain time frame. Of course, for some, dividend growth maximization may be subordinate to current yield or some other time-sensitive cash flow objective.

Still, whatever one's personal income investment goals might be, efficient allocation of capital is always an issue. Said somewhat differently, "quality" stocks don't always make for quality investments.

Say It Ain't So, Joe

To illustrate how near-term differences can affect longer-term outcomes when it comes to quality stocks, let's consider recent examples. Using a bit of recent market history as lesson, let's examine two stocks, Microsoft (NASDAQ:MSFT) and Realty Income (NYSE:O), that have become highly prized retail-investor dividend growth names.

Let's say two individuals each with $35,000 of investable capital considered shares of MSFT in 2007 shortly before the onset of the financial crisis. Late in the year, Investor "A" decided to buy 1,000 shares at $35 with an accompanying 1.25% yield and $440 of annual income (11 cent quarterly payout).

Investor B for whatever reason - they saw the pending financial crisis coming, considered shares overpriced, or whatever - deferred the opportunity to buy shares. They waited until the beginning of 2009 to buy their $35,000 block. While Investor B did not cherry pick the $15 basement, they did get a price of $20 and were able to buy 1,750 shares of MSFT, with 2.6% yield and $910 of annualized income (13 cent quarterly dividend rate).

Fast forward to today. Investor A has $65,000 in their capital account with an annualized dividend of $1,560. Investor B has $113,750 in theirs, boasting $2,730 of income. Investor B's opportunity cost for waiting about 15 months to invest is five dividend payments valued at a total of $570.

Our same two investors have another $40,000 to invest in 2013. This time the target equity is Realty Income. Again, Investor A is somewhat impatient and decides to invest as the stock's price rises during the spring. They plunk all $40K down for 800 shares at $50 (4.34% yield - $1,738 annual income). Investor B waits as the "taper tantrum" ensues and invests at the end of the year - 1,000 shares at $40 (5.46% yield - $2,184 annual income).

Today, Investor A has $48K in their O capital account along with $2,025.60 in income. B has $60K in the capital account and $2,532 of annual income. The opportunity cost was about $1,165 of dividends during the time of wait in 2013.

Situation Summarized: $75,000 Total Investment - Today

Investor A: $113K capital account and $3,586 of annualized income

Investor B: $174K capital account and $4,914 of annualized income

Investor B Opportunity Cost: $1,735 for waiting

On a percentage basis, B has 54% more capital today and 37% more annual income being generated.

Clearly, this was a cherry-picked scenario, but it does illustrate the dramatic difference that small time frame deferrals can have on your growth and income experience over time. There are certainly examples where the investor who chooses to wait on a large-scale purchase ends up on the short end of the stick, err, stock!

The reality is that dividend investors are going to reinvest dividends, accumulate, and potentially pare positions over time. Still, while I'm mostly an advocate of the "time in the market" as opposed to the "timing the market" aphorism, investors shouldn't give short shrift to how consistently poorly timed capital infusions might affect longer-term performance.

I'd see that as especially true today, with the valuations income investors are looking at with favored income vehicles.

Not-So-Fair, Fair Value?

If you peruse sell-side third-party research frequently, you'll know that many of those outfits place fair value bull's-eyes on equities. Of course the subjectivity of that endeavor comes to the surface when vast disagreement occurs from outfit to outfit in terms of what they think fair value actually is.

Price objectives or targets may also get play, with analysts terming equity over- or under-valued depending on their forward projections.

The reality of the matter is that whatever one's opinion on price, fair value is what you are able to purchase any security for on the open market at any given time with a market order. You may have your own views or models as to what fair value is, but until other investors see it your way, yours or others' opinions of fair value are, well, just opinions.

Getting the best value for your income dollar in the market is never an exact science. Dividend growth investors themselves are likely to come to alternate conclusions depending on the look of their portfolios and what incremental decisions make the most sense.

Some may shun the idea of fair value altogether, preferring some form of yield capture, dividend floor, or credit screen (or combination) as a favored buy methodology. A conservative investor might see Realty Income's investment grade cash flow as a buy anytime the yield sits above 4.25 percent. With today's payout that would mean comfort anytime the stock's price is beneath $59.50.

Others may criticize that decision, noting O's high AFFO multiple and menial yield/growth. They may prefer another NNN REIT like STORE Capital (NYSE:STOR), with higher yield, a lower multiple, and higher growth expectations. Veritable beauty in the eye of the beholder stuff.

The difference might be equated to the investor who prefers long-term investment grade bonds to someone who looks for yield sweet spot or high yield. Many, perhaps most income investors may own combinations of investment-grade and higher-yielding, deemed riskier non-investment-grade situations.

The real question you should be asking yourself is whether buying a higher valuation investment grade position presents more end-goal risk than seeking out more moderately valued, yet higher-yielding positions. The more practical question may be whether your forward need for total return realization outweighs a need for durable income.

There's no textbook answer to these questions; each investor must come to the answer on his or her own. And there is risk both ways: either underestimating the need for capital growth or playing things overly aggressive when a more conservative approach might be more appropriate.

Strategy Session

The market continues to fixate on whatever economic gains may be made during the Trump presidency. It also seems to be closely following the parade of Fed Governor rate predictions for the rest of the year. The recent cavalcade of voices would indicate that another 1-3 might be expected, with 2 the seeming median.

Though the Fed has perennially overshot its ability to raise rates since the financial crisis, the tide is clearly turning. As I've noted previously, this is a development income investors would be foolish to ignore. Still, the bond market seems to be pricing much of this in, with yields turning over a bit since the Fed's last tightening decision. I'd opine bond investors right now to be casting a dovish vote in terms of rest-of-the-year rate movement.

On the equity side, having substantial cash on the sideline has clearly been the wrong decision for many years now. Still, an interesting dichotomy is setting up should the Fed be able to string a few sequential moves together.

On one hand, rising rates would probably be evidence of continued economic advance and possibly mild upside cost inflation, which would be generally positive for equity income as a whole. On the other hand, you'd start to see risk-free yields move to levels where lower yields won't seem quite so attractive - a decided negative for equity.

How this might play out over the intermediate-term is uncertain, although logic might dictate slight valuation erosion as the net result.

If fully invested, there would seem little reason to do wholesale selling. For those with loads of cash, the search for "quality" opportunities continues to be difficult.

I'd probably avoid putting cash into floundering mega-cap consumer product stocks - your Procter & Gambles (NYSE:PG), Colgates (NYSE:CL), and Cokes (NYSE:KO) of the world. Long-term dividend growth will lag here in my opinion.

Instead, I'd look at names tied to housing. Home Depot (NYSE:HD) has become a top 5 position for me, and I'm frankly considering buying more on any weakness. Another large-cap with momentum is Masco (NYSE:MAS) with diverse household brands such as Delta, Peerless, Merillat, Behr, and Kilz. A more aggressive idea is Apogee (NASDAQ:APOG), a mostly commercial provider of architectural glass solutions.

I also love the aerospace theme for the long term, with its high barriers to entry and secular tailwinds. While I'd probably wait for weakness to buy Boeing (NYSE:BA), its Brazilian counterpart Embraer (NYSE:ERJ) still appears like a bargain to me. Unfortunately, it does not pay a dividend right now. Another buy right now is Air Lease (NYSE:AL), which owns and places planes with commercial carriers around the globe. Higher-yielding Aircastle (NYSE:AYR) is another way to play that business.

I'll also mention leisure experience companies again. Cedar Fair (NYSE:FUN) and Royal Caribbean Cruises (NYSE:RCL) are well positioned and constantly improving guest experience. Bookings in the cruise business are up across the board at substantially elevated fares, which is also good news for Carnival (NYSE:CCL) and Norwegian (NASDAQ:NCLH) - no dividend.

For those wishing to play things a bit more conservatively with above 3% yields and some both on and off the beaten path names, I'd probably suggest Cisco (NASDAQ:CSCO) and Qualcomm (NASDAQ:QCOM) in tech, and Physicians Realty (NYSE:DOC), CubeSmart (NYSE:CUBE), and DuPont Fabros (NYSE:DFT) in REITs. In high-yield, consider Landmark (NASDAQ:LMRK) and Pattern Energy (NASDAQ:PEGI).


What defines "quality" for each dividend investor is going to truly be in the eye of the beholder. Regardless of the semantics involved, strategies undertaken, or specific equities chosen, constantly picking up shares at disadvantageous price points - or more generally poor buy and sell decisions - can dramatically impact longer-term comparative investment outcomes.

While no investor will time transactions to perfection, the income investor adept at buying valleys and trimming peaks will do much better than someone prone to doing the exact opposite!

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Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Disclosure: I am/we are long AL, APOG, AYR, BA, CL, CSCO, CUBE, DFT, DOC, ERJ, FUN, HD, LMRK, MAS, MSFT, PEGI, QCOM, RCL, STOR.

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.