Get This: Past Performance Does Not Predict Future Returns (Except When It Does)

Includes: HRL, MCD, NKE, SHW, SPY
by: Investing Doc

A recent article by a fellow contributor examined Dividend Aristocrats and touted a few based upon strong 10-year risk-adjusted performances.

I wondered how strong periods of long-term outperformance affected stock performance over the past 2 decades.

I examined the relationship between risk-adjusted performance and subsequent total returns in Dividend Aristocrats and Dividend Achievers. Here's what I found.

A recent article by fellow contributor, Sure Dividend, examined the Dividend Aristocrats by historical risk-adjusted returns. Basically, Nick McCullum took as his population sample the 50 or so Dividend Aristocrats, and broke these down by Sharpe ratios over progressively longer time periods. Nick’s conclusions — that short-term outperformances in Sharpe Ratio often result from short-term runups in price, and longer-term outperformance is more reflective of economic durability — are quite reasonable and are worth considering by any retail investor.

That said, the standard boilerplate caveat attached to any investment instrument tends to be that “Past performance does not necessarily indicate future results.” So if the defensive stalwarts that Nick cites — McDonald’s (MCD), Hormel (HRL), and Sherwin-Williams (SHW) — have exhibited strong 10-year performances on a risk-adjusted basis, what does that say about how they’ll do down the road? What does that say for the average dividend-paying stock? I decided I would study this issue a little further.

To start with, I took one such Dividend Achiever (indeed, Aristocrat) that has been on a tear of late — McDonald's. Over the past couple years, having replaced the CEO and making some significant operating changes, McDonald’s has rewarded shareholders with total returns that far outpace the wider market, coming in at about 25% annualized. And certainly, with the company recently pointing to continued improved same-store sales over the next year with its menu changes and food philosophy more fully implemented, investors looking for a (probably) safe dividend might be tempted to jump in at this point (increasing debt ratios be damned). What does history suggest about how total returns might look in the future?

The answer is: probably not as great as they’ve looked recently. A review of the stock’s performance over the past 20 years shows that periods of outperformance — even over the intermediate or long term — are followed by middling performance thereafter. By way of example, the stock’s highest trailing 5-year Sortino ratio peaked around 2008, with the annualized total return from 2003 clocking in around a whopping 33% per year (from about $13 to $54 during this time frame, with splits and dividends taken into account).

Over the next 5 years, McDonald’s continued to reward investors, with a final total return in 2013 of about $99. Nothing to sneeze at, to be sure — but with an annualized rate of about 13% yearly, this hardly kept up with the blistering pace it had previously achieved, or even the S&P 500 (SPY).

Compare this, conversely, how a McDonald’s investor might have fared when purchasing the company when its trailing 5-year Sortino was at its absolute lowest — around 2003.

In this instance, plucky investors willing to ignore McDonald’s lousy total returns over the prior 5 years would have been rewarded tremendously (with the 33% total return discussed previously). The astute reader will no doubt point out that a) it would have been impossible to know in 2003 that total returns weren’t going to get much worse and, conversely that b) future returns were going to look a lot better. And this isn’t to suggest that it would ever be possible to predict the future of McDonald’s — or any other company — with reliability. In fact, by itself, it doesn’t prove anything.

What is more suggestive, though, is when we look at other instances of MCD’s performance, coupled with subsequent total returns:

Here, the data are a bit more compelling. Over the past 20 years, investors who chose to buy MCD when it had performed poorly — say, any time its 5-year Sortino ratio fell below the 50th percentile — would have enjoyed, on average, a 16% annualized return. This would compare favorably against buying the company when it had performed better, which would only generally produce (on average) a 6% annualized return. Based upon its recent performance, investors buying MCD stock now might reasonably expect an annualized return of about 9-10% - solid, but unspectacular returns that interestingly match up with consensus expectations for the next 5 years.

Basically: buying a company based upon recently strong performance and expecting that strong performance to continue unabated is a fool’s errand. Buying quality companies when they look weak, it seems, is better than buying them when they look strong.

But wait, I hear you saying — surely these results apply only to McDonald’s, and ignore the greater context in which the company delivered this performance. Over the past 20 years, McDonald’s has been counted as both an overwhelming juggernaut and a creaky dinosaur whose main products no longer held mass appeal. What about other Dividend Aristocrats and Achievers, whose histories may differ? Surely, their results would look different! And they do: here is the same histogram relating Sortino ratios and subsequent returns for Nike (NKE):

For Nike, buying during periods of relative lower performance would have yielded only a 300 basis point advantage — significant, but hardly substantial. Oh, and buying when Nike was absolutely thrashing the market? That yielded the biggest returns of all. Clearly, more data were required.

To collect this data, I took as my study population the 265 Dividend Achievers — that is to say, all those companies that have raised their dividends for at least 10 years — in order to study the link between risk-adjusted historical returns and subsequent total returns. (This list naturally includes the Dividend Aristocrats.) Taking Nick’s conclusions into consideration, I wished to test the hypothesis that whereas short-term risk-adjusted outperformance would bear little relation to future returns, intermediate to longer-term risk adjusted outperformance would have at least a weak positive correlation to future long-term total returns.

To examine this relationship, I started with the 20-year daily total-return history of each of the 265 Dividend Achievers (from Yahoo! Finance), including adjustments for splits and dividends. From these, I calculated trailing Sortino ratios, using total returns over 1- to 10-year time periods up to the present, with volatility calculated by taking the standard deviation of annualized monthly returns over the time period. Risk-free rates were calculated on a daily basis using yearly averaged 10-year rates from I then calculated the annualized total return of each stock for 1- to 10-year time periods up to the present on a daily basis, and measured the correlation between:

The trailing Sortino ratio of the stock on each day, and The subsequent annualized total return.

I repeated this process for each one of the Dividend Achievers — all 265 of them — and then averaged them. Here are the results:

The 20-year total return data of these 265 companies show that while short-term, risk-adjusted total returns bore little relationship to future annualized total returns, outperformance over greater time periods tended to produce a pronounced inverse relationship. That is, the better the trailing 5-year or 10-year risk-adjusted total return, the worse the subsequent total returns over the next several years. Note that this doesn’t represent total returns on a relative basis; of course, returns would be expected to look relatively underwhelming after a period of outperformance. These results indicate that total returns looked paltry on an absolute basis when buying Dividend Achievers after they had a good run.

That’s all well and good, I suppose you might say, but there isn’t much actionable data here that you probably didn’t already know: the point is to buy stocks low and sell high, right? Well, the data here support that theory: that you should buy quality stocks when they’ve underperformed, and avoid them (or sell them) when they’ve outperformed. Buying Dividend Achievers based upon even long-term outperformance seems to set you up for disappointing results over time — a result that actually might be counterintuitive, as strong total returns ought to suggest the strength of the underlying enterprise (and vice versa).

What about selection bias? That these results were generated using Dividend Achievers is probably no mistake; selection bias alone would have already weeded out companies in true distress (as they probably would have cut or suspended dividends, causing them to be removed from the index). To help alleviate this, I constructed a simulation to compare 2 hypothetical scenarios: in one, an investor purchases only the 25 Dividend Achievers each year with the lowest trailing 5-year Sortino ratios and holds each basket for 5 years (we’ll call him the Value investor, for lack of a better name); and in another, an investor purchases only the 25 Dividend Achievers each year with the highest trailing 5-year Sortino ratios and does the same (hereafter — the Performance investor). The result? The Value investor wins by a long shot, with annualized total returns of 11.6% over the past 20 years versus only 7.8%.

Even that result, though, doesn’t address selection bias, since it doesn’t capture the possibility of underperforming companies cutting or suspending dividends. To this end, I constructed a series of Monte Carlo simulations to mimic this effect; for the underperforming companies, I performed the same simulation, but this time with a random 5%, 10%, 15%, and 20% of the companies each year going to zero in 5 years — not merely underperforming, but representing a complete loss of the investment (or “dropout” as I’ve termed it below). The results are here:

The results are stark: for the Dividend Achiever Value Strategy to have underperformed the Performance Strategy — or even the S&P 500 — over the past 20 years or so, about 15-20% of the holdings of any given portfolio would have to go to zero. While it is certainly possible that one of the bottom-performing 25 Dividend Achievers might underperform, or even suffer some tremendous catastrophe that caused its stock to become worthless, it seems highly unlikely that a full one-sixth to one-fifth of these would suffer that same fate at once (or all within the same 5-year window). Barring a tremendous stroke of bad luck, an investor following the “Value” strategy almost always outperforms the “Performance” strategy — who, I also note, still manages to outperform the S&P 500 in terms of total return over this time frame.


The above exercise serves to demonstrate that buying Dividend Achievers or Aristocrats is not a fool-proof plan, and that a focus on such quality companies is probably best served by being a bit contrarian. Chasing past performance appears to be a set-up for disappointment, and in fact, an investor might do well instead to do their due diligence on Dividend Achievers or Aristocrats that are suffering impairments in total risk-adjusted return.

Caveats to this study are multiple, but include the fact that I didn’t take into consideration dividend growth rates, underlying earnings, or other factors into account. This was somewhat intentional, as I wanted the results to be relatively “blinded” as to the quality of the company at the time of purchase other than considering its previous 5-year risk-adjusted performance. That being said, it is possible that an investor who focused on those fundamental factors or factors related to valuation might easily avoid chasing performance. However, while a value or contrarian strategy might be a useful way of selecting a Dividend Achiever or Aristocrat, chasing performance decidedly is not.

Finally, here’s a list of those companies whose recent 5-year performances have recently disappointed. Provided they continue to pay out growing dividends, these stocks might be worth your time to investigate further.




SJW Group


Energy Transfer Partners LP


Verizon Communications Inc.


CenterPoint Energy Inc.


AT&T Inc.


Xilinx Inc.


Maxim Integrated Products Inc.


Tootsie Roll Industries Inc.


Invesco Ltd.


International Business Machines Corp.


Xcel Energy Inc.


Wal-Mart Stores Inc.


Vector Group Ltd.


Microsoft Corp.


Analog Devices Inc.


Duke Energy Corp.


Telephone & Data Systems Inc.


Automatic Data Processing Inc.


The Coca-Cola Co.


Jack Henry & Associates Inc.


Cintas Corp.


The Kroger Co.


Connecticut Water Service Inc.


The Gap Inc.


Kimberly-Clark Corp.

Disclosure: I am/we are long NKE, MSFT, WMT, KR. 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.