Finding The Most Undervalued Dividend Aristocrats

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Includes: MCD, MMM, PG
by: The Part-time Investor
Summary

The Dividend Aristocrats have beaten the market over the past 10 years.

Taking valuation into account to narrow down which Aristocrats to buy might have given even better results.

PAAY is a system which can identify which stocks are undervalued.

Using PAAY with the Dividend Aristocrats can produce better results than just buying the Aristocrats as a whole.

The Dividend Aristocrats is a group of stocks from the S&P 500 which have raised their dividend for at least the last 25 years in a row. This list includes blue chips stock such as McDonald’s (MCD), 3M (MMM), and Proctor & Gamble (PG). As new stocks achieve the 25th year of dividend growth they are added to the list. And if any of them cut their dividend they are removed. A stock can also be removed due to a merger or a buyout.

For a present list of the Dividend Aristocrats you can visit this website: July 2019 Dividend Aristocrats List: 25+ Years of Rising Dividends

Over the past 10 years the Dividend Aristocrats, as a group, have outperformed the market.

https://static.seekingalpha.com/uploads/2019/6/30/saupload_Aristocrats-performance.png

(Source: S&P 500 Dividend Aristocrats - S&P Dow Jones Indices)

This is without any consideration for quality of the company, valuation, earnings, debt, etc. A simple system of buying each and every company on the list as they are added, and selling any company that is removed, would have beaten the market by 1.58% over the past 10 years.

FerdiS wrote an excellent article on Seeking Alpha recently in which he used David Van Knapp’s system to rank the present-day Aristocrats by quality. The article showed that almost all of the Aristocrats are very highly ranked. For the most part they are all high quality companies. But let’s face it. If you’ve raised your dividend each and every year for 25+ years in a row almost by definition you must be a quality company.

But I think it is essential that valuation of these companies must still be considered. Some of these companies, as high quality as they may be, might still be overpriced. Their stock prices might be too high to purchase. Even great companies, if bought at too high a price, can give poor relative returns. So yes, buying all of the Aristocrats would have worked well, but what if valuation had been taken into account? What if you only bought the Aristocrats that had a good value? Could the results have been better? To try to get an answer, I ran a backtest to see how someone would have done if they used PAAY to buy only the Aristocrats with the best value.

PAAY

Before I get into the backtest, let me explain my PAAY system.

Many stocks can trade within a fairly consistent range of yields over time. But if you find a stock that is trading at a higher yield than it usually does it may be an indication that it is undervalued. There can be two reasons for an above-average yield: the price is down or the dividend has increased. Or, of course, it could be a combination of the two. If the price is down, and yet the business prospects are unchanged, then this could be a good buying opportunity. If the dividend has increased, and the stock price has not yet risen to keep up with the increased dividend, this again gives you an opportunity to buy more shares and increase your dividend income at a relatively low price. Therefore, tracking the dividend yield and comparing it to the historical average of that stock can highlight times when it may be undervalued. I call this Percent Above Average Yield (PAAY). Take the present yield, subtract the historical average yield, and divide the result by the historical average yield (and multiply by 100 to turn it into a percent) to come up with the PAAY. The higher the PAAY, the more undervalued the stock may be. The lower the PAAY, the more overvalued it may be. The P/E ratio, P/B value, P/S… these can all be manipulated, while dividends cannot. So, a valuation system based on the dividend yield seem to me like it would be the most reliable.

Backtest Method

I used the following chart from the Suredividend website (July 2019 Dividend Aristocrats List: 25+ Years of Rising Dividends) to determine which stocks were aristocrats at the beginning of each year of the study.

https://www.suredividend.com/wp-content/uploads/2019/01/Historical-Dividend-Aristocrats-1989-2019-e1548711842429.png

Starting in the year 2001, the PAAY for each Aristocrat stock was determined and the top 15 were bought. $10,000 was invested in each stock. They were held for one year, sold at the end of the year, and then the PAAY for all the Aristocrats was recalculated for the beginning of the next year and the process was repeated. For this study the 1-year PAAY was used.

For comparison, the process was carried out each year for the 15 Aristocrats with the lowest PAAY to see how the best-valued stocks (high PAAY) did compared to a portfolio comprised of the worst valued stocks (low PAAY). And finally, both portfolios were compared to the returns of the S&P 500.

I KNOW!!! SURVIVORSHIP BIAS! Before anybody gets all riled up, I’m aware that this is a problem with this study. There are Aristocrats which I could not include in the study because the companies were no longer around (due to mergers and acquisitions). However, both the high PAAY portfolio and the low PAAY portfolio are made up from the same group of survivors. And they are being compared to each other. So, I think this partially remedies (though not completely) the survivorship bias problem. And even with the inherent survivorship bias and the troubles with all backtests, I think valuable information can still be gleaned from these results.

Results

The following chart shows the returns for all three portfolios for each year of the study, and the total average return. If anybody wants to see the full results, including the results for each and every stock bought throughout the study, please contact me and I will send it to you. But it’s too much data and would be too confusing (and too hard to read) to put it into this article.

All the stock results were calculated using the DRIP return calculator found at , DRIP Returns Calculator | Dividend Channel, with the assumption that all dividends were reinvested. The annual returns for the S&P 500 were taken from S&P 500 Total Returns by Year since 1926.

High PAAY

Low PAAAY

S&P

Port. Value

Port. Value

Port. Value

Year

Annual return

$150,000.00

Year

Annual return

$150,000.00

Year

Annual return

$150,000.00

2001

12.87%

$169,302.00

2001

-2.41%

$146,387.00

2001

-11.89%

$132,165.00

2002

-13.96%

$145,673.08

2002

-5.81%

$137,876.06

2002

-22.10%

$102,956.54

2003

28.41%

$187,052.98

2003

15.48%

$159,222.03

2003

28.68%

$132,484.47

2004

19.59%

$223,696.66

2004

19.85%

$190,825.48

2004

10.88%

$146,898.78

2005

3.80%

$232,197.13

2005

2.48%

$195,560.50

2005

4.91%

$154,111.51

2006

14.99%

$267,006.58

2006

21.20%

$237,025.84

2006

15.79%

$178,445.72

2007

4.31%

$278,516.34

2007

4.36%

$247,366.49

2007

5.49%

$188,242.39

2008

-25.06%

$208,728.10

2008

-23.72%

$188,702.70

2008

-37.00%

$118,592.70

2009

32.16%

$275,862.02

2009

6.19%

$200,382.14

2009

26.46%

$149,972.33

2010

13.89%

$314,192.13

2010

22.86%

$246,192.17

2010

15.06%

$172,558.17

2011

10.08%

$345,871.07

2011

6.95%

$263,312.37

2011

2.11%

$176,199.14

2012

12.19%

$388,035.06

2012

16.53%

$306,825.62

2012

16.00%

$204,391.01

2013

30.80%

$507,565.38

2013

30.68%

$400,965.86

2013

32.39%

$270,593.25

2014

15.89%

$588,241.21

2014

11.87%

$448,565.85

2014

13.69%

$307,637.47

2015

-5.65%

$555,009.50

2015

-0.31%

$447,175.30

2015

1.38%

$311,882.87

2016

19.72%

$664,453.68

2016

13.20%

$506,223.31

2016

11.96%

$349,184.06

2017

20.89%

$803,258.05

2017

15.09%

$582,612.40

2017

21.83%

$425,410.94

2018

-4.15%

$769,890.71

2018

-1.97%

$571,142.71

2018

-4.38%

$406,777.94

2019

9.99%

$846,782.26

2019

11.55%

$637,094.46

2019

12.74%

$458,601.45

Ave Annual return

9.53%

Ave Annual return

7.64%

Ave Annual return

5.82%

The High PAAY (undervalued) portfolio produced a final value of $846,782.26, and an average annual return of 9.53%, while the low PAAY (overvalued) portfolio produced a final value of $637,094.46. and an average annual return of 7.64%. Interestingly, both the undervalued and overvalued Aristocrat portfolios produced a better result than the simple S&P 500 portfolio, which had an ending value of $458,601.45, and an average annual return of 5.82%.

I only included the summary data in this article to try to keep it from being overwhelming with the data from over 300 stocks. Anybody who wishes to see the raw data can look at the blog I posted for this purpose.

Discussion

I have become more and more convinced that PAAY is an excellent and very useful method for determining valuation, and to help decide which stocks to buy. Every backtest I’ve run, and more importantly, my own experience with my own real money portfolio in which I have used PAAY to reinvest most of my dividends has shown me that looking for stocks with high PAAY is a excellent way to identify some great buying opportunities. Combining this with the quality of the Dividend Aristocrats and you have a very simple, yet very effective investment plan.

The Dividend Aristocrats is a high quality group of stocks. To raise your dividend every year for at least 25 years in a row, or more, I figure you must be a quality company. And the fact that both of the Aristocrat portfolios in this study, even the portfolio of overvalued stocks, outperformed the S&P 500 shows that just buying quality dividend growth stocks will produce market-beating results. But adding in the PAAY system, to identify the best-valued Aristocrats, made the results even better. As the results show, the undervalued Aristocrats outperformed the overvalued Aristocrats by almost 2% a year, which came out to a value of over $200,000 more by the end of the study.

Conclusion

I have continually stated, and I reiterate it here, that investing doesn’t have to be hard. Find quality stocks and buy them when they are undervalued. Simple. With the Dividend Aristocrats (and/or the Dividend Champions) you have a group of quality stocks easily available to you. And if you do a few simple calculations to determine the PAAY of each you won’t have a hard time figuring out which ones are undervalued, and therefore which ones you should consider buying.

Thank you for reading my article. I welcome your comments and criticisms.

Disclosure: I am/we are long MCD, PG. 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.