MAD Charts: A Comprehensive Guide

Jul. 17, 2022 3:44 AM ETDTE, IBM, ITW, JNJ, MMM, SPG, TGT, XOM11 Comments
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Long Only, Dividend Investing, Dividend Growth Investing

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Summary

  • MAD Charts are a key part of our dividend investment strategy.
  • If it's the first time you see them you might be wondering how they work.
  • This guide will give you everything you need to know.

Written by Sam Kovacs

Introduction

It is rare that we write an article which doesn't include at least one of our MAD Charts.

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I've been meaning to write a comprehensive guide for our members for a while.

For the past 16 days, I've been at a yoga center in India with my girlfriend, doing 6 hours of yoga everyday.

I am very thankful that I have had my obligations to the Dividend Freedom Tribe to momentarily get away from a few of the yoga classes.

I'm blessed that I feel like I'm taking a break from life when I'm working.

I most definitely don't want to join the class today, which makes it the perfect time for me to write up the guide on the MAD Charts, so let's dive in.

(Note: depending on when you read this, the charts may no longer be timely, but the concepts exposed will be.)

The philosophy behind the charts

MAD Charts emerged as the visual representation of the investing philosophy which we have applied for years.

It relies on two core ideas:

  1. buy low - sell high
  2. mean reversion

We noticed, throughout the cycles, that stocks tended to have dividend yields which oscillated within a certain range. For the most part they would hug a certain range, and exceptionally would diverge either above or below that range.

Let's first demonstrate this with a fictitious stock which pays a flat dividend (no growth) of $1 per share (annually).

You might notice over a period of time that the stock yields mostly between 3% and 5%.

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The shrewd investor would decide that it is a good idea to buy when the stock yields more than 5%, and sell when it yields less than 3%.

Of course most of the stocks we buy grow their dividends. If this growth comes from sustainable growth in the underlying business, then the growth in dividends should translate into growth in value and therefore price.

Note that this isn't automatic, as market participants aren't only concerned about a stock's dividends, and during different stages of different cycles, certain stocks, certain sectors, will go in and out of favor.

So over a number of years, the price at which a stock yields 5% goes up. Today the company pays $1 in dividends, so when it costs $20 per share, it yields 5%.

In 5 years the dividend has been gradually increased to $2 per share. So when it costs $40 per share it yields 5%.

This can be seen in the example below.

A price which is overvalued today, might be undervalued in a few years.

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This is shown by the blue line above. Over time, quality businesses increase in value. With time, the market realizes this and price catches up.

So our dividend philosophy revolves around buying stocks which will increase in value (through dividend increases which act as a proxy for revenue and cashflow increases), but we want to buy them when they are undervalued.

We're also interested in selling them when they become extremely overvalued, especially when there are better alternatives available.

It is our opinion that even when it seems as if "this time is different", the pendulum always swings and mean values return. There are exceptions, which will be studied in this guide.

Let's get cracking with building a MAD Chart from scratch.

Building a MAD Chart from scratch.

In this guide, we'll be working with the MAD Chart for Illinois Tool Works (ITW) which serves as a good example because it has multiple deviations above and below its "normal range".

First, we will collect daily dividend yields for the past 10 years. We will then look at this dataset and ask:

  1. What is the minimum yield during this time frame?
  2. What is the maximum yield?
  3. What was the median yield?

For ITW, the minimum yield was 1.95%, the maximum yield 3.82%, and the median yield 2.44%.

That means that during the past decade, half of the time ITW yielded between 1.95% and 2.44%, and the other half if yielded between 2.44% and 3.82%.

We could go as for to say that between 1.95% and 2.44% it was relatively overvalued, and between 2.44% and 3.8% it was relatively undervalued.

(Note: we go further with MAD Charts by breaking down into quartiles, looking at the 25th percentile yield and the 75th percentile yield. ie: The yield which was below 25% of all yields, or below 75% of all yields during the period)

We then want to display this information graphically, so how do we go about that?

We answer the following questions:

At what price would ITW be trading today if it yielded its 10 year minimum yield of 1.95%? Based on the yearly dividend of $4.88, we can work out an inferred price of $250.

At what price would it be trading if it yielded its 10 year max yield of 3.8%? The answer is $127.

What about if it yielded its median yield of 2.44%? The answer is $200.

We then calculate these inferred prices based on all historical dividends during the past 10 years.

For instance, in 2013 when the annualized dividend was $1.52 per share, the minimum and maximum yields would give us inferred prices of $40 and $78 respectively.

Once we have all these values, we can paint in the chart.

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When the price line goes through the pink and red areas, it means the stock was yielding less than its 10 year median yield.

When the price line goes through the light blue and blue areas, it means the stock was yielding more than its 10 year median yield.

The differentiation between the blue and the light blue (and between pink and red) break up the history into quartiles rather than halves.

As such, we can say that the two middle quartiles (pink and light blue) form the "fair range" for a stock. The core 50% of the time, the yield is in this band.

For ITW this range is between 2.27% and 2.73%.

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The annotations on the above chart, give the investor more detail of how to understand the different ranges.

Finally we just need to rub our crystal ball and project dividends into the future to be able to see where the trend is going.

The difficulty lies in picking the dividend growth rate which we will use to project forwards.

We use the minimum of the 1 year, 3 year, and 5 year dividend CAGR.

This is a conservative way to stick with the trend.

If the rate has been accelerating in the last year vs the past 5 years, then it lags slowly into the projection.

If the rate has been slowing in the last year vs the past 5 years, then it shows instantly in the projection.

Better safe than sorry in this sort of exercise.

So for ITW we project at 7%, which is the 1 year growth rate for the stock, despite the dividend having grown at double digit CAGR over the past 3 and 5 years.

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So there you have it, exactly how a MAD Chart is built from scratch.

Now how do we use them?

Using MAD Charts

MAD Charts can be used as a starting point in determining "Buy" and "Sell" targets for dividend stocks.

However it is important to remember that they are a tool, and there are many exceptions and workarounds which I'll try to cover here.

Using MAD Charts with no alterations

So when can we use the charts as is for setting "Buy" and "Sell" targets?

Only when the historical dividend growth rate has been consistent AND future growth is in line with historical growth AND these numbers match our "required dividend growth rates". (For more on required growth rates, read this previous entry)

For instance Johnson & Johnson (JNJ) is a prime example.

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The stock has grown consistently at a 6% to 6.5% CAGR for the past decade, and is extremely likely to continue growing at this rate for years to come.

Using the values from the MAD Chart would serve greatly. Note how in 2020 the price only dipped into the deep blue area briefly, and how in 2017 it only dipped momentarily into the red area.

Of course, there are times when the price deviates significantly from the core area, as we have seen over the past 2 years for JNJ.

If you think that "this time is different", take a look at the 20 year MAD Chart (same concept but over 20 years instead of 10 years).

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You'll notice that in 2003, JNJ traded at similar yields to today, and one would have been best of selling and buying something else, as 4 years later, the price would be pretty much flat.

Using MAD Charts when growth rates slow down

Look at the MAD Charts below, and you'll see a trend.

3M (MMM) MAD Chart

IBM (IBM) MAD Chart

Exxon (XOM) MAD Chart

What do they have in common?

In the first half of the past 10 years, the growth rate was higher than in the second half.

See how the "stairs" in the top of the red area are initially steep (reflecting high dividend increases) and then taper off over time.

In these cases, you cannot use the MAD Charts at face value, but rather you need to ask: what will growth rates likely be going forward?

In the case of 3M (MMM) it is unlikely that it will return to double digit dividend growth, which is why we sold it at $200 despite it being still in its historical "fair range". We believed that the historical range was overstated because of the higher growth in the first part of the decade.

On the other hand with IBM (IBM), I believe 5% growth will be achievable going forward, this is less than in the first few years of the past decade, but more than the past few years. Therefore we need to stop and think for ourselves at what price would we like to buy IBM, without being too concerned for the historical numbers.

For Exxon (XOM) given that at current oil prices it will likely start growing at an interesting rate again, the historical ranges might still be good markers for entry and exit points.

Here's the key point: MAD Charts give you a rearview mirror of the market.

History doesn't repeat, but it rhymes. So the past can be an indicator of the future, but you need to adjust your expectations to reality.

Using MAD Charts when growth rates accelerate

If dividend growth rates can slow down, they can also accelerate.

When this happens, investors will be best served by adjusting their buy and sell ranges higher.

Let's look at Target (TGT) for instance.

When you take the 10 year MAD Chart, it seems very overvalued.

We have it as a sell above $250. The stock topped slightly above that level.

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But surely the MAD Chart would have suggested we make it a sell much earlier? (full disclosure: in 2021 prior to the dividend increase, we suggested starting to sell at $200 was a good idea, this was then revised following the dividend increase).

The big 32% dividend increase in 2021 signaled to us that Target was changing its course and would be increasing the dividends at a higher rate in the future.

This has so far been correct as TGT just increased their dividend by 20%.

So from a 4% CAGR between 2015 and 2020, it shifted to a 26% CAGR between 2020 and 2022.

A nifty trick we can do when this happens, is to look at a shorter, 5 year MAD Chart to get an idea of a more recent range.

This still doesn't show the full picture because the high growth period is only 2 years, but is already more accurate.

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Here you would see that TGT is trading at the valuation it was pre-pandemic, before anyone knew they would shift gears in their dividend policy. This to me looks undervalued.

Using MAD Charts after a dividend cut

After a dividend cut, MAD Charts adjust automatically to reflect it.

For instance, when DTE Energy (DTE) cut its dividend, following the spin-off of its midstream business, the ranges on the MAD Chart went down to reflect this.

Since then, the dividend increased 7%. This has been DTE's long term growth rate, and the rate at which one can expect the utility to keep going.

The price hasn't gone down, but rather continued to increase following the spinoff.

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We can consider DTE's 2.7% yield to be quite overvalued given the growth rate, which is enough to justify selling it.

Another example is Simon Property Group (SPG).

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When SPG cut its dividend, it wiped out over 5 years of dividend progress.

The stock reacted sharply as a result, making new lows in valuation even relative to the new, lower dividend.

This was clearly an overreaction, in hindsight.

When the dividend is cut, the main question is : why? and the second question is: what next?

In SPG's case it was a panic cut. What was to come next was to increase the dividend back quickly to reach prepandemic level within 8 months.

In DTE's case, it was due to a spin-off.

What is important is to not get sucked in following cuts into stocks which will not have the ability to continue growing their dividends. Otherwise the charts will adjust and if the growth profile is unchanged, the ranges will continue to serve as good guides.

Conclusion

MAD Charts are a powerful tool for dividend investors, but let's not forget that they are just a tool. They are a great starting point to evaluate value in dividend growth stocks, but investors must use discernment to get the most out of them.

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