The ABCs of Dividend Investing: Part II, Dividend Growth Is Vital

In our previous blog on dividend investing, we offered some of our dividend research and a general theory on how to think about the importance of both dividend yield and dividend growth.  In this edition, we will share some of our insights into how different combinations of dividend yield and growth act in various kinds of stock markets.

When most people think of dividend-paying stocks, often they incorrectly think that such companies are unusual.  The truth is among the 500 stocks in the S&P Index, nearly 400 of them pay a dividend.  What makes a company valuable, according to our research, is that it has raised its dividend persistently and consistently over a long time.  We do not place hard limits on these descriptors because we do not want to eliminate companies that have persistently and consistently raised their dividends but not on a calendar basis. United Technologies (UTX), for instance, increases its dividend every six quarters; thereby, having years where it does not increase its dividend on a calendar basis.  The every-six-quarters approach is consistent and persistent, but UTX does not make the lists of dividend stars because of the occasional calendar miss. 

Our research in the dividend world began with the utility sector in the late 1980s.  That early research revealed some surprising results. 
Over any longer period, say five to ten years, the companies with the lowest dividend yields and the highest consistent dividend growth were the top performers.  For example, Company A had a current dividend yield of 6% and long-term average annual dividend growth of 4%; Company B had a current dividend yield of 7% and  long-term annual dividend growth of 2%; and Company C had a current dividend yield of 8% with no recent dividend growth.  In almost every period we studied, Company A would outperform Companies B and C on a total return basis, even though on a dividend yield basis, it did not appear to be as attractive as the other two companies.  In essence, the market was willing to pay for dividend growth -- if it was consistent and visible.  

         

We found the same phenomenon worked in almost all the major industry sectors, including those with low dividend yields.  It did not always work on a one or two year time frame, but given enough time, it was clear that investors were willing to pay up for a faster growing dividend, as long as the growth was consistent and enduring.  As a result of this, in the early-1990s, we restructured our main dividend investment strategy away from a focus on high dividend yield with modest dividend growth and partitioned the portfolio into three separate sub-portfolios.  Today our Cornerstone Portfolio (our main dividend strategy) is not one monolithic portfolio where all the stocks have similar features.  It contains three different kinds of dividend companies, which we call sub-portfolios A, B, and C.  The division into three sub-portfolios has made Cornerstone more of an all-season investment style. 

	Dividend Yield	Dividend Growth
Sub-Portfolio A	Near the average yield of S&P 500	Dividend growth higher than S&P 500
Sub-Portfolio B	Yield much higher than S&P 500	Dividend growth at approximately the rate of inflation.
Sub-Portfolio C	Above average dividend Yield	Dividend growth approximately the same as the S&P 500

Sub-Portfolio A

Sub-Portfolio A stocks (average yield, above average dividend growth) possess a characteristic that has dramatically improved Cornerstone’s annual returns over the last 15 years: Portfolio A stocks tend be driven more by their own results and less by what is going on in the overall markets. As long as Portfolio A companies are hitting their earnings and dividend growth targets, they will normally outperform the average stock when the markets are trending sideways or are in a bull market.  These stocks normally fare poorly in bear markets. 

Sub-Portfolio A stocks most often come from Consumer Cyclical, Tech, and Industrial sectors.

Sub-Portfolio B

Sub-Portfolio B stocks are just the reverse of Sub-Portfolio A stocks.  Portfolio B stocks have a much higher than average dividend yield combined with dividend growth at about the rate of inflation.  Inclusion of these stocks in the portfolio helps us in two ways: 

1. They often have a dividend yield twice the rate of the average stock.
2.  They almost always perform well relative to the average stock in slow growth environments or in bear markets.      .

Sub-Portfolio B normally lag the average stock in strong bull markets.  Portfolio B stocks are mostly filled with Utilities, Telecommunications, REITs, and Energy stocks

Sub-Portfolio C

Sub-Portfolio C stocks are our favorite stocks of the three portfolios, but they are the rarest.  They combine a higher than average dividend yield with at least an average annual dividend growth rate.  These stocks are usually the most undervalued of all stocks in the portfolio from the perspective of our valuation models.  That is because these companies are usually facing some sort of headwinds or uncertainties. 

Our models are good at finding these companies, but their attractiveness is always clouded by a big question mark hanging over them.  That is where our investment strategists become critical.  It is their job to dig deeply into the company and determine if the headwinds are temporary or permanent.  Portfolio C companies can do well in any kind of market, especially if the question mark is removed.        

Weighting the Three Sub-Portfolios

The weightings of each of the sub-portfolios within the total portfolio are not left to chance.  We increase or decrease the weightings of each sub-portfolio based on a combination of the readings from our valuation models and how the markets are reacting to unfolding fundamental and economic data.  The table below shows how much we have shifted portfolio weightings over the last twelve months.

  

Sub-Portfolio Weightings

July 2012 vs. July 2013

	July 2012	July 2013
Sub-Portfolio A	22.0%	39.0%
Sub-Portfolio B	41.0%	23.0%
Sub-Portfolio C	37.0%	38.0%
Total	100%	100%

We made these shifts because we recognized that continued U.S. economic growth, even though it has been modest by historical standards, had finally led to significant increases in investor confidence.  Investors were no longer rushing indiscriminately in and out of stocks as each round of new bad news (Europe is crashing!) or good news (Employment numbers are up!) hit the headlines.  Instead, their increased confidence was causing them to differentiate their investing based more on the fundamentals of each company, which was favorable for Sub-Portfolio A companies and modestly unfavorable to Sub-Portfolio B companies.    

The sizable shift that we made in cutting back on the high dividend yield, low dividend growth stocks in Sub-Portfolio B and adding to the above average dividend growth companies in Sub-Portfolio A has already proven itself to be the right move.  It was not something, however, that we did overnight.  We saw the trends, we read our models, and we began a gradual shift that speeded up in March and April of this year.

Constructing a portfolio of three different types of rising dividend companies allows us to stay true to a high-quality, rising dividend strategy, while rebalancing the dividend growth versus dividend yield weightings in the overall portfolio in recognition of changing market conditions.

Back to that Pony

Last time we said some people have accused us of having a "one trick pony" investment strategy.  We hope what we have shared here answers that accusation.  In addition, dividends in one form or another have been around as long as investing itself.  We are not at all worried that companies will stop paying dividends.  True, over the years, the percentage of companies paying dividends has waxed and waned.  But there have always been hundreds of solid, dividend-paying stocks somewhere in the world.   

In our next edition of the ABC's of Dividend Investing we will discuss some basic general investing principles we have learned over the years, as well as some of our buy and sell criteria.

Clients, officers, and directors of DCM own UTX.