Beating The Market With Dividend Growth Stocks

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Includes: AMAT, AUO, AVGO, CMA, EAT, FBHS, GT, HII, HOPE, IRS, KW, LRCX, MAN, MGA, RF, SHI, SPTN, STI, SWKS, TCF, TRN, UNP, VIG, WPP, WYND, ZION
by: Andres Cardenal, CFA
Summary

Dividend growth stocks tend to outperform the market in the long term.

Picking the best dividend growth stocks is about more than just looking at the company's track record of dividend payments.

Variables such as dividend payout ratio and total capital distributions are key factors to consider.

Introducing a quantitative system focused on dividend growth stocks with strong potential to raise dividends in the future.

These kinds of systems can be remarkably valuable tools for investors in search for investment ideas supported by objectively quantified data.

Dividend growth investing is one of the most popular investing strategies in the market and for good reasons. The strategy is straightforward and effective, even more important, the statistical data shows that dividend growth stocks tend to produce attractive returns over the long term.

To begin with, dividend payments generate consistent cash distributions from the portfolio, and this is much appreciated by investors, especially those with recurrent income needs, such as retirees or investors approaching the retirement phase.

Besides, dividends make overall portfolio returns more stable and predictable over time since dividends are a more predictable source of returns than price fluctuations. This is especially true in a volatile market environment.

Perhaps even more important, dividend payments say a lot about a company's fundamental quality. If a company is distributing consistently growing dividends to investors, this means that the business is generating more cash than it needs to retain. This is a clear sign of underlying financial strength.

The following chart from Hartford Funds and based on data from Ned Davis Research shows how companies initiating new dividends and raising their dividends year after year tend to produce market-beating returns over the long term.

Source: Hartford Funds

When it comes to picking the best dividend growth stocks, looking at a company's history of dividend payments is not enough. Variables such as dividend growth rate, payout ratios, and capital distributions through both dividends and buybacks are remarkably important to evaluate a company's ability to sustain dividend growth in the future.

In that spirit, the following paragraphs are introducing a quantitative stock picking system focused on dividend growth stocks with strong potential to sustain growing dividend payments in the long term.

Dividend Growth By The Numbers

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

To begin with, over the counter stocks and companies with a market capitalization level below $300 million are excluded from the investable universe to guarantee a minimum size and liquidity.

Then the system considers only companies with a dividend yield 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 sectors, but it's substantially above-average in the tech sector.

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.

It's important to keep in mind that the system is focused on dividend growth, not dividend yield. However, it still makes sense to look for companies with above-average dividend yields since this shows that management is inclined to distributing a large share of excess free cash flow to investors.

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

A company's ability to sustain dividend growth into the future is crucial. For this reason, the dividend payout ratio is required to be below 60% of earnings in order to guarantee that the company can comfortably continue raising dividends in the years ahead.

Among the companies that meet the specified criteria, the system then selects the 25 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 as a method for cash distributions while the business is still growing and cash flows are unpredictable.

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.

Summing up the stock selection criteria:

  • Over the counter stocks and companies with a market capitalization below $300 million are excluded.
  • Dividend yield needs to be above the industry average.
  • Average dividend growth rate needs to be above 10% annually in the past 3 years.
  • The payout ratio has to be below 60% of earnings.
  • Among the companies that meet the criteria above, the system selects the 25 names with the biggest total cash distributions when considering dividends and buybacks together.

Backtested Performance And Recommended Stocks

The backtesting assumes that positions are equally weighted and the portfolio is rebalanced every four weeks. Trading expenses are assumed to be 0.2% per transaction, and the benchmark is the Vanguard Dividend Appreciation ETF (VIG).

Backtested performance is quite promising. Since January of 1999, the portfolio recommended by the system gained 14.98% per year, significantly outperforming the Vanguard Dividend Appreciation ETF and its average annual return of 9.71% per year in the same period. System Alpha amounts to 4.56% during the backtesting period.

Data from S&P Global via Portfolio123

In plain English, a $100,000 investment in the Vanguard Dividend Appreciation ETF in January of 1999 would currently be worth around $583,000, and the same amount of capital allocated to the portfolio of dividend growth stocks recommended by the quantitative system would have a much larger value of $1.4 million.

Practical Considerations And Recommended Stocks

By its own nature, a quantitative system is always backward looking, and past performance does not guarantee future returns. This particular system is intended as a source of potential ideas for further research, as opposed to being a quantitative portfolio for investors to replicate.

For example, some companies can have exceptionally high dividend yields and dividend growth rates because of a special dividend in a particular year. This means that current data is not reflecting the company's true dividend potential going forward.

The quantitative system does not include any sector-diversification criteria, and the portfolio is far more concentrated than the benchmark. Even if the system outperforms the benchmark in terms of risk-adjusted returns as shown by the Sharpe ratio, the quantitative system portfolio is more volatile and it tends to do worse than the benchmark in a bear market environment.

Dividend stocks, in general, are quite exposed to interest rate risk since many investors consider dividend stocks and fixed income alternatives like similar and competitive choices to some degree. If we enter a period of rising interest rates over the years ahead, this will probably have negative implications for dividend stocks across the board.

The main takeaway is that a system such as this one can be a remarkably valuable tool to find investment ideas in dividend growth stocks with attractive quantitative attributes for further research, this is remarkably different to blindly replicating the portfolio recommended by the system. Importantly, investors should evaluate these stocks from a holistic perspective, considering their weaknesses and strengths beyond their dividend characteristics.

The table below shows the 25 stocks currently picked by the system. To provide more information, data in the table also includes market capitalization, dividend yield, dividend growth rate in the past 3 years, and dividend payout ratio for the companies in the list.

Name

Mkt.Cap ($ Millions)

D.Yield

D.Growth

Payout Ratio

Union Pacific Corp. (UNP)

$113,416

2.08

11.17

19.14

Broadcom (AVGO)

$98,050

2.95

53.41

23.22

Applied Materials (AMAT)

$36,646

2.15

14.47

18.26

SunTrust Banks (STI)

$28,751

3.19

23.55

31.57

Lam Research (LRCX)

$24,075

2.8

52.43

17.61

Regions Financial (RF)

$17,362

3.4

21.92

24.6

Magna International (MGA)

$16,798

2.65

13.12

18.24

WPP (WPP)

$13,858

7.2

10.32

39.56

Comerica (CMA)

$13,139

3.03

10.31

20.54

Skyworks Solutions (SWKS)

$12,909

2.09

27.27

26.48

Zions Bancorporation (ZION)

$9,351

2.47

40.1

27.14

Huntington Ingalls Industries (HII)

$9,267

1.6

36.08

18.6

Fortune Brands Home & Security (FBHS)

$6,194

1.83

14.47

26.51

Goodyear Tire & Rubber (GT)

$5,396

2.76

25.99

27.72

ManpowerGroup (MAN)

$5,140

2.49

23.81

20.74

Sinopec Shanghai Petrochemical (SHI)

$4,955

10.21

65.36

37.78

Wyndham Destinations (WYND)

$4,036

3.95

18.34

34.08

AU Optronics (AUO)

$3,994

11.7

282.45

57.33

TCF Financial (TCF)

$3,752

2.67

14.47

31.89

Trinity Industries (TRN)

$3,484

2.18

11.1

11.59

Kennedy-Wilson Holdings (KW)

$2,825

4.29

24.11

47.37

Brinker International (EAT)

$1,982

2.98

10.72

48.62

Hope Bancorp (HOPE)

$1,977

3.68

12.62

43.58

Irsa Inversiones Y Representaciones (IRS)

$791

10.06

142.45

11.58

SpartanNash (SPTN)

$674

3.84

11.2

30.91

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.