Seeking Alpha

Not All Dividend Kings Are Noble

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Includes: ABM, CINF, CL, DOV, EMR, FMCB, FRT, HRL, LOW, MMM, NDSN, PG, TGT
by: Mario Glogović, CFA
Summary

During the first seven months, the Strategy that combines dividends with net repurchases outperformed the equally-weighted group of 26 Dividend Kings by 4.73%.

In terms of total cash flows to shareholders, there are significant differences between the individual Dividend Kings.

The strategy systematically exploits mispricings connected with the underappreciation of share repurchases.

Some Dividend Kings continually dilute their owners. Thus, the net change in the outstanding shares has to be an integral part of any yield focused strategy.

The strategy focuses on total cash returns to shareholders and not just on the dividend distributions.

Source

The famous Dividend Kings are a group of high-quality dividend stocks that have increased their dividends 50+ years in a row. Currently, there are 26 Dividend Kings.

All these companies have an extraordinary track record. However, in terms of the total cash flow distributions, there are vast differences.

Dividends are only one side of the story. The net change in outstanding shares is the other side. In the current environment, buybacks are usually more important than dividends. However, investors routinely overlook share dilutions and underappreciate stock repurchases. When we see the big picture of all flows, we realize that not all companies treat their shareholders in the same way. In a nutshell, we could say that not all Dividend Kings are so noble.

When It Comes to Share Dilution or Reduction, Not All Dividend Kings Treat Their Shareholders Equally

Although all these companies pay dividends, they do not retire or dilute their share in the same manner. When the net change in the number of shares is taken into account, one can avoid companies that continuously dilute their shareholders by increasing the number of outstanding shares.

By using the shareholder yield, which combines dividends with the net change in the number of shares (net buyback), an investor can avoid companies that:

  • Dilute their shareholders by granting their employees significant new shares in the form of share or option compensation.
  • Regularly raising capital via equity issuance to fund dividend payments (and in some cases repurchases).

Combining Dividends With the Decreasing Number of Outstanding Shares, We Can Invest in the Most Rewarding Companies

There are two crucial elements for sustainable long-term outperformance:

  1. The sustainable process exploits systematic investor expectation errors. In this strategy, the error is connected with the underappreciation of share repurchase (explained in my first article on the shareholder yield topic).
  2. The sustainable investor has a long-term horizon and a willingness to be different.

To utilize the predictive power of dividends and net buybacks, Not All Dividend Kings are Noble (the Strategy) invests only in the ten companies with the highest shareholder yield. The strategy is rebalanced annually on the first day of the year.

If on the first day of this year, one invested in the 10 Dividend Kings with the highest net cash distributions (shareholder yield), until the end of July, he would outperform the 26 Dividend Kings by 4.73%. During the same period, the same strategy outperformed the S&P 500 by 2.45%.

Source: Portfolio Visualizer

Why Share Repurchases Are So Important

During the second quarter, the S&P companies distributed $117 billion via dividends, and during the first quarter, approximately $206 billion via buybacks (buyback data for the second quarter is still not available). However, one part of these distributions was financed with newly issued shares. Unfortunately, a lot of U.S. companies behave in this fashion, and this is the case for some Dividend Kings.

During late 1990, buybacks have surged and surpassed dividend payments. Since then, repurchases account for approximately 60% of the total cash distributions. For example, during the last year, the S&P 500 companies distributed 35% of the net income via dividends, and 49% via stock repurchases. The detailed statistics of the cash distributions are available on the following link.

A lot of companies have changed their cash distribution channel from dividends to repurchases to reward investors with a more favorable tax treatment. Thus, by selection companies purely on the dividend yield, one misses companies that distribute high amounts of cash via equity buybacks.

Such structural market changes require strategy adjustments. The strategic goal is to harness the predictive power of net buybacks and utilize it in the separation of the top-performing from the under-performing companies. In other words, besides dividends, the net change in the outstanding shares (net buyback) is used as a second and critical factor for the market outperformance.

This Strategy Successfully Recognized Top Performing Dividend Kings

Net buyback yield is a twelve-month change in the total outstanding shares. Net buyback yield is negative if the company dilutes its shareholders and is positive if the company decreased its total outstanding number of shares. According to the data that was available on 1/1/2019 (look-ahead bias was avoided), during the preceding four quarters, eight Dividend King diluted their shareholders. For the rest eighteen companies, the net buyback yield ranged from 0% to positive 5.4%.

The top three diluting companies were ABM Industries (ABM), Federal Realty Investment Trust (FRT), and Hormel Foods (HRL). These three companies diluted their shareholders by 5.7%, 1.8%, and 1% respectively. When the ABM's 5.7% dilution is combined with the 2.2% dividend yield, the shareholder yield is negative 3.5%. Although shareholders received the dividend, the company increased the number of shares in circulation by a higher percentage, which usually manifests itself as the downward pressure on the stock price.

The outstanding share increase is not bad by definition. For example, if new share issuance was conducted to collect capital for takeover or new capital investments, this could lead to higher profits. However, if a company pays dividends and at the same time issues new shares to finance these dividends (or buybacks), then this does not create any additional value for shareholders.

For example, Federal Realty Investment Trust (NYSE:FRT) has a history of shareholder dilution. The trailing yield for FRT is 3.4%. However, during the same period, this company increased its shares in circulation by 1.8% (by offering its shareholders the possibility to reinvest the dividends).

As I see it, the real cash flow for investors was only the difference between the two or 1.6%. The rest is a pure illusion because the company just sliced itself into smaller pieces, and the owners stayed the same. It is as one would slice a cake, not in 8 but 16 pieces. In whichever way we slice the cake, the total amount would still be the same.

In the table below, there are 26 Dividend Kings with their dividend yields, net buybacks yields (net change in the number of shares), and the sum of the two (shareholder yield).

Source: American Association of Individual Investors

At the beginning of this year, the average net buyback yield for the 26 Dividend Kings was 0.8%. This number was highly impacted by the shareholder diluting companies.

On the other hand, the Strategy avoided such companies by investing in Dover Corp. (DOV), Target (TGT), P&G (PG), Emerson Electric (EMR), Lowe's (LOW), 3M Co. (MMM), Nordson (NDSN), Colgate-Palmolive (CL), Farmers & Merchants Bancorp (OTCQX:FMCB), and Cincinnati Financial (CINF).

Its average net buyback yield was much higher, at 2.6%. The average dividend yield for the Strategy was 2.6% vs. 2.3% for the 26 Dividend Kings. Consequently, the average shareholder yield for the ten highest yielding companies was 5.2% compared to only 3.1% for the Dividend Kings group.

Source: American Association of Individual Investors

Below is a comparison test of Not All Kings are Noble (Portfolio 2) and the 26 Dividend Kings (Portfolio 1).

At the beginning of 2019, $10,000 invested in the Strategy resulted in $12,139 at the end of July. During this period, the maximum drawdown was 6.37%, and the standard deviation was 21.39%. On the flip side, $10,000 invested in 26 companies forming the Dividend Kings Group resulted in $11,661. However, the maximum drawdown (-5.01%) and the standard deviation (16.61%) were both lower.

Source: Portfolio Visualizer

During the first seven months of 2019, on $10,000 invested, dividend income for Not All Dividend Kings are Noble was $157, which was higher compared to $137 for the whole Dividend Kings Group. However, the largest difference was in share performance. The price return for the top ten highest yielding Dividend Kings was $1,982, and for the group of the 26 companies was $1,524.

Source: Portfolio Visualizer

Strategy Risks

Compared to the group of the 26 Dividend Kings, this strategy has a much more concentrated allocation. The Strategy has 10% single stock exposure, compared to on average, 3.85% for the equal-weighted portfolio of the 26 companies. Similarly, for the Not All Dividend Kings are Noble strategy, the exposure to one sector or industry could be significantly higher compared to the group of the 26 Dividend Kings.

However, to decrease the single-stock exposure, one could combine this strategy with the Mad Dogs of the Dow strategy. This strategy applies the same investment principles for selecting stocks included in the Dow Jones Industrial Average.

According to the quantitative tests, investing in companies with high shareholder yield generates the odds in the investor's favor. However, it is not suitable for everyone because it is not focused on the minimization of the tracking risk. Instead, it focuses on the long-term relative and absolute outperformance. This could lead to considerable return differences compared to the passive benchmark as the S&P 500 or to the whole group of the 26 Dividend Kings.

If you plan to use any part of this strategy, it is essential to adjust percentage equity allocation and the number of equity positions in your overall portfolio according to your willingness and ability to tolerate risk.

Anyone that wants to utilize the Not All Dividend Kings are Noble strategy does not need to wait until the next January. Monthly, I will publish characteristics for all Dividend Kings, so the updated list will be available for new investments or the annual rebalancing.

If you would like to follow updates of this simple, yet powerful strategy, please hit the "Follow" button on the top.

Additionally, feel free to post comments regarding what you would like to see in subsequent updates.

Until my next article, be patient with your investments and give them time to grow!

Disclosure: I am/we are long DOV, TGT, PG, EMR, LOW, MMM, NDSN, CL, FMCB, CINF. 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.