Ahhh, the age-old debate of Dividend Growth vs. Index Investing vs. Total Return vs. Value. It is a debate that constantly ebbs and flows between investors and proponents of each style (and combinations of them) throughout time like the tides themselves. After some spirited debates with others in the forum comments about whether or not it is possible for DGI to outperform Index investing when an investor utilizes quality and historical data parameters to construct a portfolio, I decided to create a realtime portfolio to track this theory.
I have been "investing" since about the year 2000, and have seen the likes of the dot-com bubble, the real-estate bubble (and subsequent crashes), as well as many minor disasters and corrections, such as the oil panic and the flash-crash. I have had my own lessons of over-trading, trusting advisors/brokers, chasing yield, catching falling knives, and chasing past success along the way. I said "investing" since 2000, because, really, I wasn't investing back then, as I was young and naïve and still in school and had no real idea what I was doing and no experience of what can happen in the market. It was more, trade what's hot or buy and hope for me back then. But I always wanted to learn more about it.
Looking back, I have been lucky to have my early on experiences in my learning journey to continue to increase my knowledge and refine my investing philosophy as well as my psychology. Sometimes, when the going gets tough, the psychology part is much more important. Over time and with more experience, I increasingly turned to the philosophy of Dividend Growth Investing as a proven method for growing wealth over the long-term for the average investor.
My Learned Investment Philosophy
Over time, I developed a new, simple model for investment success. That model is exemplified by this simple statement:
Quality + Ongoing Business Profitability Growth + Dividend Yield + Dividend Growth = Success.
The key to this is that you have to have all 4 of these for it to work, and you have to start with Quality!
Diversification is another great way to mitigate risk, but it is a double-edged sword. The more you diversify, the less risk you have of one stock or sector tanking your returns, but on the flipside, the less chance you have of outperforming the market, and you may not be investing in your “best ideas.”
If you are trying to beat the market and attain alpha, you should screen your best ideas in order to achieve success, otherwise, you will only go further toward the "closet indexing" of choosing too many ordinary favored stocks.
Of course, different investors have different goals, and many dividend investors are happy to just generate a great yield to live off of that is safe and grows along with inflation, while not even worrying about total return or beating an index. If you are a young investor or have a portfolio to build and a way to go until you reach that point, you may wish to try to achieve these goals and get to a retirement crossover point faster if you balance your portfolio in the correct way.
Screening for Potential DGI Outperformers
As mentioned above, the first step in my process is screening for quality. This is a qualitative, rather than quantitative screen, so it is subjective to each investor. I have found that a long history of dividend growth, a strong balance sheet and higher credit rating, and a better dividend safety score have led to success for me. I start by utilizing Seeking Alpha legend David Fish's CCC List to look for potential stocks with a history of dividend increases (as well as it's multitude sortable parameters for each stock covering growth, payout, earnings, etc.). I cannot thank David enough for the work he has done in helping us DGI investors through the years. Additional parameters are credit rating, where anything under BBB+ is rejected (with exceptions for certain credit intensive business models such as REITs), and an analysis of dividend safety, taking into account payout ratios, FCF trends and other factors. Only the quality survive the cut. Sometimes a stock that proves to be non-quality will sneak through, but that's OK, because as long as we do this screen for every potential investment and diversify properly, one bad apple should not spoil the bunch over the long term.
The next step is evaluating ongoing business profitability growth. Now, this is obviously key to any investing in general, and much harder than just an input in a formula. It takes research into a business, reading earnings reports, examining numbers, evaluating moats and headwinds, and making a decision of whether or not growth can continue at a reasonable, steady, inflation beating pace (or more) in the future. Examining trends in EPS, FCF, Profit Margins, Shares Outstanding, Dividend Growth Rates, Payout Ratios, ROIC, and Book value are helpful here. There is no shortcut to learning how to do this. It is a lot of hard work, and sometimes, despite all your hard work, you will be wrong anyways with business innovation, disruptions, or sudden changes in the market environment or technology.
After that are Dividend Yield and Dividend Growth. For DGI proponents, this is always a delicate balance of individual needs and potential returns. A few lessons I have learned along the way are that:
1. Balance is Key - Aim for a broad mixture of different Dividend Yields and Growth Rates in the portfolio to further diversify and balance returns
2. Don't Chase Yield - Sometimes a lower yield is better. Yields can be high for a reason and can indicate risk in the future sustainability of the dividend.
3. The longer out your investment horizon, the more you should concentrate on DGR. If you are just starting, a lower yield, much higher DGR investment can eventually overtake a higher yield one in 30 years when you wish to retire. If you are getting closer to retirement, you may wish to concentrate on higher yield, less volatile investments.
Finally, we get to the area of historical performance of Total Return and Dividend Growth. This is another balancing act, wherein if you evaluate historical data of total return and dividend growth, high rates may mean that the stock is overvalued, or they could mean that it is an exceptional stock that is poised to continue outperforming in the future. It is another age old question of value vs. momentum/growth that has intrigued investors for ages. I am of the opinion now, that if you do enough pre-screening, and diversify your holdings, then prior total return and dividend growth rate can act as a positive predictor of future returns. I use a spreadsheet to compile and sort the historical total return and dividend growth rate information of the remaining stocks in order to choose the highest rated candidates for future investment.
Obviously, even the best stocks in the world are not going to get you an outperforming return if you buy them when they are over-valued. All of the above-stated principles are merely for screening and determining a solid stable of potentially outperforming stocks to evaluate further for fair value and purchase points. I usually try to buy when stocks are cheap on a per stock basis, based upon my fair value calculations. Fair values for each are calculated via Dividend Discount Method, Ben Graham Method, and Historical Dividend Yields, taking into account a discount rate calculation for each based upon current Risk-Free Rates, CAPM methods, and individual stock metrics. I usually try to make a buy once a month of whatever I feel is cheap or fair valued at the time, given my portfolio diversification goals and calculated target prices.
On to the Portfolio Challenge
Having said all that, the theory is just the theory and the proof is in the pudding. After spending many years honing my investment process, lurking on the comments at Seeking Alpha, and debating back and forth on different theories with others, I have decided to test it out in realtime. I am now of the opinion that a properly constructed DGI portfolio consisting of properly diverse companies that have been screened for quality, historical dividend growth, and total return can outperform an index as a whole and provide alpha over the long term, no matter what the starting valuation. (although returns would be maximized when purchased at value). Furthermore, if constructed properly, a DGI portfolio can add in the extra benefit of higher yield, lower volatility, and significantly less severe drawdowns, and you can achieve even greater benefits than just simple ALPHA. You also achieve peace of mind and the ability to stick to your strategy when times are the worst, because your portfolio has been proven to weather the most difficult storms.
This has been proven through backtesting of certain portfolios, but the problem therein is inherent hindsight bias. Finding great companies by looking at their past qualities, their past dividend growth rates, and their past total returns is easy. Of course, the hard part is identifying these quality companies in advance and holding on, never waivering.
The impetus for this article came about from discourse with others on the merits of investing in quality companies and DGI philosophy vs indexing and whether it is possible to outperform the market by evaluating past data and current prospects in realtime. The exact conversation that led to this was on David Van Knapp's recent article "What are the Highest Quality Dividend Growth Stocks?" The idea has been precedented by other previous well respected Real DGI portfolios such as DVK's own DGP and Mike Nadel's DG50.
Within the discourse, I presented a simple 8 stock portfolio that would have outperformed the SPY index over all periods over the last 25 years and had higher yield, lower volatility, less severe drawdowns, and higher sortino ratio. This simple portfolio was a backtested even weight portfolio of classic dividend champion stocks: MMM, JNJ, T, O, LMT, MSFT, CLX, and DUK, with dividends reinvested.
Obviously, this was a backtested choice, so the challenge was made to pick a portfolio in realtime to track that will outperform the SPY index and achieve similar benefits over the long term. Off-the-cuff, I picked several of the highest rated stocks from my watchlist to add to the basic portfolio and take the challenge of tracking it to see if it outperforms SPY over a 10 year period.
The DC-Realtime DGI Portfolio
The portfolio as (somewhat arbitrarily) picked from my watchlist in the comments thread on 3-14-2018 is as follows:
|Original Champion Picks|
|Ticker||Current Closing Price||Current Dividend Yield||Seeking Alpha Current 36 Month Beta||Sector|
|Additional Off-the-Cuff Picks Based on Watchlist Ranking Parameters|
|Ticker||Current Closing Price||Current Dividend Yield||Seeking Alpha Current 36 Month Beta||Sector|
|AAPL||$178.40||1.40%||1.11||Technology Consumer Products|
|BDX||$223.50||1.34%||0.84||Healthcare Medical Supply|
|BLK||$558.90||2.04%||1.34||Financial Investment Management|
|CB||$140.70||2.00%||0.84||Financial Insurance Multi-line|
|DIS||$103.90||1.68%||0.87||Consumer Discretionary Entertainment|
|HD||$177.40||2.31%||0.94||Consumer Discretionary Retail|
|TRV||$139.50||2.05%||0.81||Financial Insurance Property/Casualty|
|TXN||$109.90||2.24%||1.21||Technology Industrial Products/Chips|
|UNH||$225.30||1.32%||0.93||Financial Insurance Healthcare|
|V||$122.50||0.68%||1.45||Technology Financial Services|
The portfolio would have a 2.21% Yield, and a Beta of 0.9 based upon Seeking Alpha's own current yield and 36 month Beta on each individual component's page on the date of the comments. The yield is a bit lower and the Beta is a bit higher than some DGI portfolios, understandably so, because chose to expand the components of the portfolio off-the-cuff with more high growth, low yield DGI stocks in the above comment. At the time of the comments, it was still considerably higher than the benchmark SPY index yield of 1.73%.
Naturally, if I were concentrating upon current income or retirement at a closer date than 10 years from now, I would choose to invest in higher yield and less volatile components.
The portfolio will be a model portfolio tracked in the future for historical total return vs. the SPY benchmark. I have included the exact date and price/yield/beta information for future reference in order to keep detailed record, however, for simplification will use an equal-weighted starting portfolio assuming all dividends are re-invested and no re-balancing or sales occur. Periodic re-evaluations of performance metrics will occur via online backtesting tools with a monthly duration (while preserving the ability to do formal mathematical backtesting if needed). Any mergers, acquisitions, and spinoffs will be taken into account at the settlement and added to the portfolio tracking for total return calculations.
This started as a fun debate with others, and I hope that it proves to be an informative exercise for myself and Seeking Alpha regulars to participate in.
I will leave you with a quote from another Seeking Alpha article that I can not recall the source, but has stuck with me as good advice through the years:
Outperforming the market is hard (but that doesn’t mean it’s impossible).
The best investment process is the one that fits your personality enough to allow you to see it through any market environment.
The market doesn’t care how you feel about a stock or what price you paid for it.
Predicting the future is hard.
Nobody said it was easy to buy and hold a DGI portfolio that consistently beats the market. But it ABSOLUTELY can be done and it is not as hard as a lot of the people who argue against DGI on Seeking Alpha would suggest. I look forward to seeing if I can prove to do it in DC-Realtime!
Disclosure: I am/we are long MMM, JNJ, T, O, LMT, MSFT, CLX, DUK, V, MKC, VFC, TXN, UNP, ADP, NKE, AMGN, HD, DIS, BLK, CB, RTN, TRV, OZRK, BDX, UNH, NEE.