7 Ways To Beat Market: Dividend Growth Update

About: ProShares S&P 500 Dividend Aristocrats ETF (NOBL), Includes: SPY
by: Ploutos

In an ongoing series of articles, I have highlighted five buy-and-hold strategies that have historically outperformed the S&P 500. In this semi-annual update, I have added two additional strategies.

Even as this historically long economic expansion sets new records, many Americans have failed to participate in the equity market outside of employer-sponsored retirement plans.

Investors should understand simple and easy-to-implement strategies that have been shown to outperform the market over long time intervals.

The fourth strategy I will discuss in this series of articles is consistent dividend growth investing which has seen these stocks produce higher risk-adjusted returns over time.

While outperforming over long time intervals, this strategy has lagged through the first half of 2019. When including the correction in the second half of 2018, the strategy has outperformed over the last year.

Many academics subscribe to the Dividend Irrelevance theorem that states that, in a world with no taxes or costs of financial distress, dividend policy is irrelevant. After all, an investor could simply sell a portion of their portfolio to create a liquidity stream and would not need to rely on dividends from their portfolio holdings. Given the double taxation of both corporate profits and shareholder dividends, some muse that dividends are inefficient altogether.

This article will demonstrate that the Dividend Aristocrats (NOBL), constituents of the S&P 500 (SPY) that have paid increasing dividends for more than 25 years, have generated higher total returns than the broader market. The graph below shows that the Dividend Aristocrats (white) have outperformed the broad index from which they are drawn, the S&P 500 (orange) by 2.17% per year over nearly 30 years.

Dividend aristocrats versus S&P 500

Dividend policy is far from irrelevant. If you simply divided the U.S. stock market into dividend-payers and non-dividend payers, you would see that dividend payers have produced higher returns (roughly 2% more per year) with roughly 1/3 less volatility over the modern history of the U.S. stock market.

The conceptual framework that suggests that dividend policy is irrelevant ignores the behavior of company management. Poor managers can not only risk a company's ability to pay dividends but also expose a company to financial ruin. In "The Bright Side of Paying Dividends: Evidence From Stock Price Crash Risk," authored by Jeong-Bon Kim of University of Waterloo, Le Luo of Huazhong University of Science and Technology, and Hong Xie of the University of Kentucky, the authors demonstrated the negative correlation between dividend payments and stock price crashes. The paper suggested that a firm's commitment to dividend payments reduces agency costs and lowers the risk of large-scale stock price drops.

Dividend stocks outperform non-dividend paying stocks over time, but the highest yielding stocks can occasionally be value traps that fail to pay sustainable dividends to investors. Again, if you broke the U.S. stock market into deciles based on dividend yield, the highest dividend yielding cohort would produce inferior absolute and risk-adjusted returns to lower yielding cohorts. Hopefully, Seeking Alpha readers understand the need to ignore the siren song of simply buying stocks based on yield alone. Historically, that strategy has also underperformed; buying stocks with sustainable dividend yields has generated better long-run performance with lower risk. What better way to demonstrate dividend sustainability than to pay increasing dividends for multiple business cycles? Investing in the Dividend Aristocrats is not a particularly high dividend strategy, but owning the underlying companies has delivered risk-adjusted outperformance over time. If you are interested in the total return of your money like I am, this has been an exceptional strategy over time.

In a period stretching back nearly 30 years, the Dividend Aristocrats have produced market-beating performance with less variability than the broader index through a combination of Downside Protection and Upside Attainment.

Downside Protection

In a period stretching back nearly 30 years, the Dividend Aristocrats have produced market-beating performance with less variability than the broader index through a combination of Downside Protection and Upside Attainment.

Notably, the Dividend Aristocrats outperformed the S&P 500 in every down year for the broad market in the sample period - including 2018 - gleaning part of the strategy's outperformance through lower drawdowns in weak market environments. Below is a table of full year returns for the S&P 500 Dividend Aristocrat Index and the S&P 500. Down years for the S&P 500 are bracketed.

Dividend Aristocrat performance by year In the six down years for the S&P 500 since 1990, the S&P 500 average return was -15.5%, but the Dividend Aristocrats fell by an average of just 2.1%

Upside Attainment

Excluding those six pesky down years, the S&P 500 has risen in 23 of 29 years, producing a 16.9% average annual return in those years. In those same years, the Dividend Aristocrats have produced a 15.4% average return. That is a pretty good story, in down years for the broad market, you lose 2%, but in up years, you produce 15% returns.

The business model of Dividend Aristocrats must be inherently stable and produce continual free cash flow through the business cycle, or these companies would not be able to maintain their record of paying increasing dividends for decades. While this means that these companies are prone to lower drawdowns, they can still generate strong total returns.

Driven by the outperformance in the second half of 2018 in a down market, the Dividend Aristocrats outperformed for the full year last year. So far in 2019, in a strong bounce-back for the market, the Dividend Aristocrats are lagging despite a healthy 15.9% first half total return. For the trailing one year - inclusive of the second half 2018 swoon for stocks and the first half 2019 rally - the Dividend Aristocrats are besting the market (14.3% vs. 10.4% total returns).

Constituent-Level Performance

While I prefer to buy the diversified Dividend Aristocrats in pre-packaged form through the exchange-traded fund, there are value-seeking, dividend-focused investors on Seeking Alpha that prefer to pick stocks that supplement their portfolio. Once a month, I provide Seeking Alpha readers an update on constituent-level performance. Drilling deeper into the constituent-level returns, the table below depicts all of the Dividend Aristocrats with year-to-date total returns through mid-year. Of the 57 constituents, 51 have posted positive total returns this year.

Dividend Aristocrats at Mid-Year Source: Standard & Poor's; Bloomberg


Looking again at the historical annual returns of the strategy, another notable factor of the Dividend Aristocrats strategy is that when it underperformed the S&P 500 by the largest differential (1998, 1999, and 2007), the market was headed towards large overall losses (e.g., the tech bubble and the Great Recession). At mid-year 2019, the Dividend Aristocrats are underperforming, but not by a significant margin (and part of that underperformance is a reversal of outperformance during the December swoon). Market bulls have to hope that the underperformance of the Dividend Aristocrats in 2019 is more akin to 1995-1996 when a moderating Fed successfully extended the economic cycle with a reversal in the Fed hikes of 1994. Market bears might point to the recent underperformance of the Dividend Aristocrats as relative froth in the broad market. I would lean towards the former camp - the level of underperformance to this point in 2019 is not material like the underperformance that preceded previous corrections. The Dividend Aristocrats, like yesterday's article on Low Volatility stocks, will tend to outperform in the correction phase of the business cycle and keep pace in the upswing. This combination of downside protection and upside attainment has been a winning trade for dividend growth investors over time.

Disclosure: I am/we are long NOBL. 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.

Additional disclosure: Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.