20 Dividend Stocks With Rock-Solid Dividend Growth Prospects

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Includes: ADM, AUO, CHS, CME, CPB, CVS, EAT, ETH, EVC, IPG, KSS, OGE, PDCO, PFG, PRU, SIG, TX, VLO, WEC, WPP
by: Andres Cardenal, CFA

Summary

Dividend investing can be a powerful strategy for superior returns.

Picking the best dividend stocks is about more than focusing solely on dividend yield.

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

Introducing a quantitative system focused on dividend stocks with solid dividend growth prospects. Backtested performance for the system is quite impressive.

As opposed to blindly replicating the portfolio recommended by the system, investors may want to consider this quantitative system a powerful tool to identify investment ideas for further research.

Dividend investing is one of the most respected investing strategies, and for sound reasons. Investing in dividend stocks makes a lot of sense intuitively, you don't need a PHD in economics to understand why companies making big cash distributions can be attractive investments in the long term. Besides, academic research has proven that companies with solid and growing dividends tend to deliver attractive returns over the years.

Dividends don’t just provide cash flows to investors, which is a big advantage on itself. Dividend payments also say a lot about a company’s fundamental health. Companies that are distributing growing dividends are consistently generating more cash flow than they need to retain in the business, and this obviously speaks well about the company’s fundamentals.

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.

The following paragraphs will be introducing a quantitative system based on stocks with strong quantitative indicators in these key areas. The system makes sense from a theoretical perspective, and backtested performance is remarkably encouraging.

A quantitative system such as this one won’t tell you everything you need to know before buying a stock. It’s important to always do your homework and take a look at the business behind the numbers in order to fully understand the investment thesis as well as the main risk factors and potential return drivers in that particular name.

Nevertheless, these kinds of systems can be remarkably valuable when it comes to identifying attractive investment ideas for further research.

System Design

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

To begin with, we exclude over the counter stocks and companies with a market capitalization value below 300 million from the universe. This has a negative impact on returns, since smaller stocks typically have a higher expected return. On the other hand, it makes the system more realistic and easy to implement by focusing on companies above a minimum size and liquidity level.

In addition to that, dividend yield has to be above 3% for a company to be included in the portfolio. This is not an exceptionally high dividend yield, as the system is focused on dividend quality over the size of the dividend yield. Nevertheless, we are still making sure that dividend yield is above average. As a reference, the average dividend yield for companies in the S&P 500 index is currently around 1.8%.

Dividend growth can be even more important than dividend yield. Even if the dividend remains stable, the dividend yield can increase because the stock price is falling. Besides, dividend growth provides important information about the company’s financial strength and management level of confidence regarding the future of the business.

When the company is rapidly raising dividends management is saying to the market that it considers 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 history of dividend payments is clearly important, however, it’s ability to sustain dividend growth into the future is even more crucial. In that spirit, the system requires the dividend payout ratio to be below 60% of earnings 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 20 stocks with the highest capital distributions, meaning dividends plus buybacks as a percentage of market capitalization.

Many young companies prioritize buybacks above dividends, since buybacks provide more flexibility while the business is still growing and demanding capital for reinvestments. As the company matures and cash flows are more stable and predictable over time, the company may be more inclined to allocating a larger share of free cash flow to dividend payments. This means that companies with big buybacks today are many times the ones with big dividends tomorrow.

Backtested Performance And Portfolio Recommendations

The backtesting assumes that positions are equally weighted and the portfolio is rebalanced every four weeks. The portfolio carry cost is assumed to be 1% per year to account for trading costs and other expenses, and the benchmark is the iShares Select Dividend ETF (NYSEARCA:DVY).

Backtested performance numbers are remarkably strong. Since January of 1999 the portfolio selected by the system produced an average annual return of 17.17% versus an annual gain of 9% per year for the iShares Select Dividend ETF. In cumulative terms, the system gained 1936.3% since the beginning of the backtest, while the benchmark ETF gained 415.55% in the same period.

Backtesting data and charts are from Portfolio123.

In simple terms, according to the backtesting data a $100,000 in the iShares Select Dividend ETF in January of 1999 would currently be worth around $515,600, and the same amount of capital allocated to the quantitative system would have a much larger value of $2.036 million.

Investors need to be careful when interpreting backtested performance, since the markets are always changing and past performance numbers do not guarantee future returns. Besides, system implementation can be more complicated and expensive than it seems to be. Even if trading costs are aggressively low nowadays, tax considerations can make a big impact in some particular cases.

For these reasons, we should always take backtested performance figures with a grain of salt, and only invest in a particular stock after we have done our homework and understand the main strengths and weaknesses in that particular company.

That being acknowledged, it makes a lot of sense to expect attractive returns when selecting companies based on their dividend payments, their dividend growth track-record, and their ability to sustain dividend growth into the future.

The table below shows the 20 stocks currently selected by the system. For more information, the data also includes market capitalization, dividend yield, dividend growth rate, and payout ratio for each stock in the portfolio.

Name

MktCap ($Millions)

Div. Yield%

Div. Growth%

Payout Ratio %

CVS Health Corp (CVS)

$64,521

3.14

22.05

30.9

CME Group (CME)

$55,479

3.85

11.98

49.06

Prudential Financial (NYSE:PRU)

$45,517

3.34

11.4

16.48

Valero Energy (VLO)

$40,326

3.44

38.67

30.55

Archer-Daniels-Midland (ADM)

$23,984

3.11

10.06

45.77

WPP (WPP)

$21,885

4.96

10.32

41.37

WEC Energy Group (WEC)

$19,493

3.58

10.06

54.49

Principal Financial Group (PFG)

$17,808

3.31

13.47

23.37

Campbell Soup (CPB)

$13,124

3.21

22.3

40.7

Kohl's Corp (KSS)

$10,676

3.84

12.14

42.84

Interpublic Group (IPG)

$8,971

3.59

23.74

48.41

OGE Energy (OGE)

$6,368

4.17

10.26

40

Ternium (TX)

$6,319

3.42

11.46

22.15

Au Optronics (AUO)

$4,552

3.9

282.45

16.66

Signet Jewelers (SIG)

$2,387

3.75

19.92

21.41

Patterson Companies (PDCO)

$2,194

4.49

12.96

41.26

Brinker International (EAT)

$1,735

4.06

12.31

54.04

Chico's FAS (CHS)

$1,098

3.96

10.06

42.1

Ethan Allen Interiors (ETH)

$653

3.2

22.67

58.09

Entravision Communications (EVC)

$420

4.3

17.59

8.32

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.