A Powerful Screen For Dividend Growth Investors

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Includes: ALSN, BA, BAH, BFIN, CAKE, CE, CHS, CPB, CPF, CVS, DAL, ETN, GLW, GT, HBI, HOG, IBM, IPG, IR, KALU, LYB, MEOH, MGA, MPX, OMC, SAIC, UNP, VIG, WHR, WOR, WYN
by: Andres Cardenal, CFA
Summary

Dividend growth investing can be remarkably profitable in the long term.

Picking the best dividend growth stocks is about more than looking at the company´s track record.

Factors such as dividend payout ratio and total capital distributions are important variables to consider.

Introducing a quantitative system focused on dividend growth stocks and generating market-beating backtested performance.

These kinds of systems can be remarkably valuable for investors in search for investment ideas backed by objective and time-proven data.

Dividend growth investing is one of the most popular investing strategies around, and for good reasons. Academic research has proven that companies with solid and growing dividends tend to deliver attractive returns over the years.

After all, dividends don’t just provide cash flows to investors, which is a big advantage on itself. Dividend payments say a lot about a company’s fundamental quality. Companies that are distributing growing dividends are consistently generating more cash flow than they need to retain in the business, and this has important implications in terms of total returns.

When it comes to picking the best dividend growth stocks, variables such as dividend growth rate, payout ratios, and capital distributions through both dividends and buybacks can make a big difference in returns.

A quantitative system won’t tell you everything you need to know before making an investment decision, and it’s important to always do your homework and take a look at the business behind the numbers. Nevertheless, these kinds of systems can be remarkably valuable when it comes to identifying attractive investment ideas for further research.

By The Numbers

The quantitative system looks for high-quality dividend growth stocks based on the following set of criteria:

To begin with, dividend yield must be above the industry average. Dividend yields vary substantially across different industries and sectors, a 3% yield is not particularly high for big companies in the consumer staples or utility sector, but it’s substantially above average in the tech industry.

This is because cash generation, capital needs, and reinvestment opportunities are materially dissimilar across industries. Since dividend yields are relative, the system looks for companies paying above-average dividend yields according to industry standards.

Dividend growth can be even more important than dividend yield. Even if the dividend remains stagnant - or declining - the dividend yield can increase because the stock price is moving in the wrong direction.

Besides, dividend growth provides important information about the company’s financial strength and management level of confidence regarding the future of the business. Companies that distribute growing dividends to investors are generating more cash than they need, and management is saying to the market that it believes that the business is solid enough to distribute growing cash payments.

For this reason, the system requires the dividend growth rate over the past three years to be above 10% annually.

A company’s dividend growth track record is clearly relevant, however, it’s ability to sustain dividend growth into the future is even more important. In that spirit, the dividend payout ratio is required to be below 50% of earnings in order to guarantee that the company can comfortably continue raising dividends in the future.

Among the companies that meet the specified criteria, the system then selects the 30 stocks with the highest capital distributions, meaning dividends plus buybacks as a percentage of market capitalization.

Many relatively young companies tend to prioritize buybacks over dividends, since buybacks provide more flexibility while the business is still growing. As the company matures and cash flows are more stable and predictable, dividends usually start absorbing a larger share of excess cash flows. This means that companies with big buybacks today can be the ones with big dividends tomorrow.

The backtesting assumes that positions are equally weighted and the portfolio is rebalanced annually. The portfolio carry cost is assumed to be 1% per year to account for trading costs and other expenses. The benchmark is the massively popular Vanguard Dividend Appreciation ETF (VIG).

Backtested performance is quite promising. Since January of 1999 the portfolio recommended by the system gained 15.29% per year, significantly outperforming the Vanguard Dividend Appreciation ETF and its average annual return of 9.7% per year in the same period.

Data and charts are from Portfolio123.

The system is more volatile than the benchmark, since it has a higher standard deviation and a higher maximum drawdown over the backtesting period. On the other hand, risk adjusted returns are also superior, the system beats the Vanguard Dividend Appreciation ETF in terms of both Sharpe Ratio and Sortino ratio. System alpha is a very respectable 5.88%.

Portfolio Recommendations

The table below shows the 30 stocks currently picked by the system, including market capitalization, dividend yield, dividend growth rate in the past 3 years, and dividend payout ratio.

Name

MktCap

Dividend Yield%

3 Yr Dividend Growth %

Payout ratio %

Boeing (BA)

$184,486

2.21

30.99

48.49

International Business Machines (IBM)

$150,432

3.69

14.13

48.14

Union Pacific (UNP)

$108,626

1.93

16.4

42.75

CVS Health Corp (CVS)

$79,470

2.55

23.61

39.5

LyondellBasell Industries NV (LYB)

$45,114

3.15

18.52

37.3

Delta Air Lines (DAL)

$39,905

2.18

77.84

18.33

Eaton Corp (ETN)

$35,860

2.95

10.72

37.19

Corning Inc (GLW)

$29,233

1.84

11.46

25.93

Ingersoll-Rand PLC (IR)

$22,472

2.01

17.42

40.58

Magna International Inc.(MGA)

$21,659

1.85

16.04

18.8

Omnicom Group Inc. (OMC)

$16,638

3.33

20.51

43.83

Celanese Corp (CE)

$14,683

1.7

38.01

28.2

Campbell Soup Co (CPB)

$14,234

2.96

22.3

49.54

Whirlpool Corp (WHR)

$12,131

2.61

17.98

38.6

Wyndham Worldwide Corp (WYN)

$11,382

2.06

19.91

40.61

Harley-Davidson (HOG)

$8,578

2.86

18.56

44.96

Goodyear Tire & Rubber (GT)

$8,089

1.71

83.71

10.07

Interpublic Group of Companies (IPG)

$7,846

3.57

25.99

46.55

Hanesbrands Inc (HBI)

$7,740

2.83

43.15

34.22

Allison Transmission Holdings (ALSN)

$6,350

1.35

12.62

26.47

Booz Allen Hamilton Holding (BAH)

$5,585

1.77

15.73

36.36

Methanex (MEOH)

$5,361

1.9

11.9

37.04

Science Applications International (SAIC)

$3,354

1.59

30.34

32.32

Worthington Industries (WOR)

$2,777

1.84

20.63

29.34

Cheesecake Factory (CAKE)

$2,316

2.31

19.17

36.32

Kaiser Aluminum (KALU)

$1,865

1.81

14.47

40.42

Chico's FAS Inc. (CHS)

$1,121

3.76

10.06

48.93

Central Pacific Financial Corp. (CPF)

$903

2.41

55.36

42.37

Marine Products Corp (MPX)

$473

2.06

25.99

48.99

BankFinancial Corp (BFIN)

$281

2.06

73.8

47.37


The portfolio is quite a diversified collection of companies with different sizes and in all kinds of sectors. Market capitalization ranges from $281 million for BankFinancial to almost $185.5 billion for Boeing. Investors looking to leverage on quantitative data to find attractive investment opportunities in dividend growth stocks have plenty of variety to choose from.

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.