AAPL AIN'T CHEAP . . . MSFT IS

• 1. In my recent book, The Hidden Power of Rising Dividends (available at Amazon), I argue that very few individuals or professional investors are confident in how to calculate the intrinsic value of a stock.

• 2. The typical stock investor today has largely become a trend follower. Put another way, they are really momentum investors.  

• 3. I have been in the investment business for nearly 50 years, and I have learned many people who admit to being momentum investors, find that they cannot pull the trigger to buy or sell when the momentum trend changes. In failing to sell at the right time, most of them become "stuckholders."

• 4. In my many years of exploring every classical and "wild hair" investment strategy I could find, I have found that many slow-growing stocks can be valued very precisely. Most companies; however, require a deep dive into their fundamentals, looking for "tell" signals. Finally, valuing very fast-growing companies is always an educated guess at best.

• Last time, I showed valuation guesstimates on PepsiCo (PEP) and Coke (KO). These are both slow growing, high dividend-paying companies with powerful brands. My models predict that Coke (KO) is modestly overpriced and PepsiCo (PEP) is significantly underpriced when using year-ahead estimates.   

• This time I am comparing Microsoft (MSFT) and Apple (AAPL). The valuation correlation metrics for these two tech stocks are much more difficult to find because dividend growth alone does not offer high correlations for either stock. For Apple, earnings growth offer a 90%+ correlation with stock prices over the last decade, and gives us a decent guesstimate of the company's current valuation. 

• For Microsoft, it is necessary to use a proprietary valuation model that includes some portion of dividends, earnings, and interest rates. The chart below shows the remarkable tightness between MSFT's actual stock price (red line) and the model's annual predicted price, shown in green. Currently, the model says MSFT should trade at approximately $422 per share. It is currently trading for near $430. At least in this first step, MSFT would appear to be about fairly priced.

The picture for Apple indicates a bit more risk.

Apple's correlation model shows that its actual price of $239 per share, shown in red, is clearly higher than its predicted price, in green, of $206. 

Based on historical data over the last 13 years, my models are saying MSFT is selling about where it should be, and AAPL is selling nearly 15% higher than its fair value. But as I said last time, "the future is in the future" for all stocks, so we must plug in next year's estimates for both companies to determine if that makes any difference.

Using the mean forecasts from Wall Street analysts, my model predicts a year-end 2025 price of $483 for MSFT and $228 for AAPL. That would offer an approximately 12% gain for MSFT and a relatively flat rate of return for AAPL in the coming year. Indeed, selling at $239, AAPL is already trading above my modeled $228 predicted year-end 2025 price. 

I own both stocks and do not have plans at this time to sell either. However, seeing Apple's valuation does cause me some concerns that I had not thought through before I began this exercise. MSFT, on the other hand, looks even better than I would have guessed. As I said last time, this is not Wall Street research. I am using simple correlation models to arrive at the price estimates I am showing. Thus, this article should not be viewed as investment advice, but just a simple analysis of fundamental data within each company that is highly correlated with changes in its annual stock price. 

 

Simple Dividend Model Says PepsiCo Is Better Value Than Coke

1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. In a recent post, I showed mathematical valuations of Coke and PepsiCo based on their last 15 years of price and fundamental data. As it turned out for both companies, dividends alone had the highest correlation with their prices over this period.

3. I chose Coke (KO) and PepsiCo (PEP) for my first valuation calculation because both are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Since they are so dominant and so similar in their products and marketing, most people assume they are both always about fairly valued because they are so large and their products are a staple of everyday life for many people. 

4. Last time I showed a chart for each company as shown below. The green line on each chart is the actual annual price over the last 15 years. The red line is the predicted price my model calculates. A closer look at the two charts shows that PepsiCo's current price is about 9% lower that its predicted price, based on the correlation between its dividend and price growth over the last 15 years. Coke, on the other hand, appears to be selling about 9.5% above its predicted price using he same metrics. 

Studying the two dividend correlation charts suggests PepsiCo is clearly the better value. But, as I said last time, my dividend correlation model is looking only at historical data. The future is in the future for all stocks. So, let's take a swing at estimating the future growth of both companies. Remember, dividend growth alone trumps all other indicators for these two stocks, and in both cases the correlation between the companies' dividends and stock prices is over 90%.

 

In valuing Coke and Pepsi, I am using a simple linear regression model that measures the average changes of prices versus dividends for each company over the last 15 years, and then performs annual standard deviations to determine how tight the fit is. This model generates what is known as a correlation coefficient, or R2. Both Coke and Pepsi have R2s between annual price and dividend growth above .90. Put another way, annual changes in dividends for both companies has been able to explain over 90% of the annual changes in their stock prices. It's not perfect, but few investment professionals will be willing to bet you that this .90 correlation between prices and dividends is going to change very much in the coming year or years.  

A linear regression calculation, as the name implies, assumes that the movement of prices v. dividends will form a line. The important things about lines is they all have a slope and slopes have formulas. Thus, here in November 2024, if we have a good prediction or guess about how much each company will increase its dividends in 2025, (both have unbroken strings of increasing dividends for over 50 years) we can plug that figure into the formula and have a predicted stock price for the coming year.

PepsiCo's linear regression formula is .52+35x, where x is next year's dividend. PepsiCo's current indicated dividend is $5.42. For this analysis let's just increase PepsiCo's dividend by 7%, which is its average increase of the last five years. Here are the results of the formula:

.52+35 x 5.80 = $203.52

This simple regression model is projecting that PepsiCo's price will reach $203.52 by the end of 2025. That would be a rise in the price of over 20%. Remember, this is a model, not an analytical projection of what I think the price will be. But, with a correlation so high, one might think of it as a ballpark figure of the upside potential of PepsiCo.

Coke's dividend growth over the last five years has averaged only 3.5%. Plugging dividend growth of that level into the regression model for Coke gives us a 2025 best guess price of $67.25, only slightly above today's selling price. 

As always, this is not a Wall Street type deep dive type valuation analysis of either company, and it should not be taken as investment advice. This is just a mathematical look at financial data for both companies that has had a very high correlation over the last few years. Using this simple analysis, PepsiCo is our clear winner. 

Someone might want to break the news to Warren Buffett. He holds a tremendous amount of Coke.

Next time I will compare two other name-brand blue chip stocks in the tech industry sector. That will be a tougher challenge because dividends probably won't work as well in these companies, and I will have to dig deeper to determine is any of the companies' fundamental data have a tight correlation with prices. If there is a fit, it should also give us an idea of how fairly valued some of the techs are after their huge run over the last two years. 

Until next time.

If you would like to offer companies for me to value using this correlation process, please send me a note at info@gregdonaldson@gmail.com.

Thanks to several of you who informed me that my colors were wrong on the charts last time. 

I own Pepsico.

Using Simple Mathematical Calculations to Value Coke vs. PepsiCo

 1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. My journey of valuation discovery was always about finding methods that worked, not just focusing on dividend investing, although for many companies, dividends are the best indicator.

3. Over the next few months, I am going to do a series of valuation comparisons of great companies of our country and the world. These comparisons will describe the various methods I have found to be helpful. The first two are Coke and Pepsi.

4. Coke and Pepsi are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Most people are in one camp or the other, but these two companies are very similar in many ways. My blindfolded taste test can't tell them apart.

5. Since they are so dominant and so similar in their products and marketing, I have found that most people assume they are almost always efficiently priced and valued at about the same level. In this first look at the tools I have learned to use, a surprise may be in store for you.

 In valuing Coke and Pepsi, I am using a multi-stage correlation model. This model computes a correlation score, called R2, for eight different fundamental indicators for each company, such as earnings, dividends, sales, profit margin, GDP, etc., compared to changes in the company's annual stock prices. With both companies, the correlation, R2, between their annual dividends and stock prices is above 90%, and overrides the need to include any of the other fundamentals. Very simply, this means that over the last 15 years, the annual changes in the dividends for each company were able to explain 90% of the annual changes in its price. 

Next, look at each chart and note that stock prices are on the vertical axis and dividends per share are on the horizontal axis. The red line is the actual annual price over the last 15 years and the green line is the predicted price using the correlation formula. Here is where the model begins to talk. While these two companies are very similar in what they do, they are not similar in prospective valuation. PepsiCo's chart shows its current selling price of over $175.00 is well under its predicted price of $190.44. Coke's story is just the reverse. It is currently selling for over $68 per share, but its predicted price says it should sell for $63.74.

Remember, this analysis is pure math. It is not a deep analysis of each company's intrinsic value. This is just a statistically significant computation comparing the changes in each company's annual dividends with changes in their annual stock prices. Yet, with 90+% correlations for both companies, to ignore what the dividends are saying would be unwise. Indeed, these computations are saying Coke is over 15% more expensive than PepsiCo. A spread that wide would seem to favor PepsiCo at present. Next, however, we all know that the market always looks ahead. Next time I will share with you howe we can adjust the current valuations for a look into the future. In the meantime, let's just see how the the two stocks perform over the next few months.   

Dividend Watch: A Bar Bet You Will Win

• Here's a bar bet you can win:  What is the ratio of S&P 500 company dividend hikes to cuts year to date?
• Oops, I forgot the coronavirus has made bars and bar betting taboo for most of us.  Save this one until they open.
• While the dividend news has been much better than almost any of your bar buddies would guess, there is some not-so-good news creeping in. 

First the good news: Through last Friday, 369 companies have paid a dividend in 2020.  Of these dividend payers, 124 increased their dividends at a median rate of 8%.  

Now, the bad news: 39 S&P 500 companies have suspended, cut, or eliminated their dividends since the first of the year.  More on this later.  

Back to the good news: Dividend hikes have outnumbered cuts by over three to one.  That tidbit of dividend news will win you the drink of your choice at a time and place when you once again can have social distance with friends and colleagues.  The financial media has been so full of bad dividend news that most people will bet just the opposite of what has actually happened.

Back to the bit of bad news: Bloomberg now estimates that cumulative S&P 500 second quarter dividends will fall by approximately 2% from last year.  Bloomberg also is now forecasting that total dividends for the S&P 500 in 2020 will be slightly less than 2019.  I'll keep you posted on changes in the estimates as we traverse the rest of the year.  

We look for dividend news to calm down for a few weeks.  Dividend news is often announced at regular quarterly earnings reporting intervals.  These meetings will not return to full throttle until July.

As the country opens and people begin to move toward some level of normalcy, the economic picture will either become clearer or even more opaque than it has been for the last three months.  We said early on that the dividend actions of major American corporations would tell us a lot about how destructive the coronavirus would likely be to the economy for the long-term.  We believe the dividend actions year to date by major American companies are telling a much more positive story than the "things will never be the same again" crowd who know very little about economics and even less about the truth. 

Sources: Marketbeat, Simply Safe Dividends, Seeking Alpha, Bloomberg, Value-Line

       

Dividend Watch: New Data Show S&P 500 Dividend Payments Still Rising

• The percentage of S&P 500 companies paying dividends continues to be much better than was predicted two months ago.
• Dividend increases are running almost 3 times that of dividend cuts.
• Many companies are specifically committing themselves to honoring their dividends.

The news on dividend payments by S&P 500 companies continues to be better than many experts predicted in the early days of the coronavirus outbreak.  The table below shows the dividend actions of companies that either made a dividend announcement from March 1 through today, or paid a dividend during this time.

Dividend Actions by S&P 500 Companies 
March-May 4, 2020

Dividend Paid	Dividend Increased	Dividend Decreased
361	98	35

We are approaching the end of the initial round of dividend actions by S&P 500 companies since the onset of the virus, and so far the news is good for the overall stock market and income investors.  We are awaiting only nine companies that pay irregular dividends, usually annual or semi-annual payers, and 16 companies that did not make dividend payments or declarations in March or April.  We should be able to log the remaining companies over the next six weeks.  Remember, seventy-nine companies do not pay a dividend. 

        Even though the number of companies cutting dividends are the most in many years, we are not even close to the number of cuts in the 2008-2009 Great Recession.  This has surprised many observers because the economic impact of the massive country-wide shutdown is having a more negative effect on the overall U.S. economy than did the Great Recession.  Of even more interest, many companies are taking the unusual step of promising their shareholders that they are committed to paying their dividends and will cut them only as a last resort. The following are statements from some of the largest companies making these types of public statements:

United Parcel (UPS): Our dividend remains a high priority and is a hallmark of our financial strength. We are confident our actions will continue to enable us to fund the business and support shareowner interest.

Coke (KO): We will of course continue to focus on protecting the progress we made on working capital and free cash flow in 2019. And in this context, our capital allocation priorities remain very much focused on investing wisely to support our business operations and continuing to prioritize our dividend. Specifically, with regard to the dividend, we currently have no intentions to change our approach.

IBM (IBM): The key here for investors I think are two questions. One, in any of these scenarios, do you still have the strength of your cash, your liquidity position to ensure that you can, one, invest in your business to make sure as you come out of this—that you can emerge stronger. And two, can you maintain your capital allocation and your commitment to our investors with regards to the dividend, and both of these [we answer] emphatically, yes.         

Starbucks (SBUX): To further enhance our financial flexibility, we have also temporarily suspended our share repurchase program and are taking steps to defer capital expenditures and reduce discretionary spending. We do not expect to reduce our quarterly dividend.

Caterpillar (CAT): "We continue to expect our strong financial position to support the dividend. As a reminder, Caterpillar has paid a quarterly dividend every year since 1933 through a variety of challenging business conditions. We remain committed to returning substantially all our free cash flow to shareholders through the cycles." – CEO Jim Umpleby

Exxon Mobil (XOM):  After all, Exxon and its predecessors have paid uninterrupted dividends since 1882, and management continues to emphasize that "a reliable growing dividend" 

remains a priority.

Chevron (CVX): “Chevron’s financial priorities remain unchanged. Our focus is on protecting the dividend, prioritizing capital that drives long-term value, and supporting the balance sheet.” – Chevron CFO Pierre Breber

        Some of these companies, such as the oil companies, would almost certainly have to borrow to pay their dividends.  That might seem risky, but Exxon recently reaffirmed their continued dividend payments, indicating that nearly 70% of their shareholders were either individuals who count on the dividend income or long-term investors who seek stable growing income. 

        The dividend story of 2020 is still in the early stages, and the recent positive trends could change if the country's economy takes too big a hit from the shutdown and the virus, but the story thus far has been much brighter than observers were predicting.  We believe this is an indication that stocks have seen their lows and will continue to push higher.
        The other bit of good news is that total dividends paid by S&P 500 companies is still higher than it was a year ago.  With few exceptions, the companies cutting dividends have not been big dividend payers compared to the average S&P 500 company.  Thus the cumulative dividend increases from companies hiking their dividends has more than offset the dividends lost resulting from the cuts, even though the cuts on a percentage basis have been higher.

Dividend Watch: Dividends Aren't Dead

        In 2009, shortly after the government required all banks to cut their dividends, we created what we named the Dividend Watch to track dividend announcements and actions of all companies in the S&P 500.  It was our opinion that the overall stock market was overreacting to the financial problems that appeared to be narrowly focused in the banking sector.  We held this view because a look at the long-term dividend payment records of the S&P 500 revealed that companies are very reluctant to cut dividends.  Indeed, in the 50 years from 1958 to 2008, dividends had been cut by over 1% in just 5 years.  During this same period, stock prices had fallen in 16 years and earnings had fallen 13 times.  Annual changes in prices and earnings on a percentage basis were about 2.5 times that of changes in dividends.  We were hopeful that the Dividend Watch Report could act as a barometer for not only the stock market but also for the overall economy.  If few companies in the S&P 500 Index, other than banks, cut their dividends, it would signal that most companies believed they could navigate the crisis with minimal ill effects and continue to pay their dividends.  
        Our Dividend Watch Report soon revealed that few companies, beyond the banks, would cut their dividends in 2009.  In fact, many companies were actually increasing their dividends.  The surprising number of companies hiking dividends allowed us to become more bullish early in 2009 about the near-term prospects of the overall stock market and, to some extent, the U.S. economy.    
        We are again firing up the old Dividend Watch Report in the current coronavirus pandemic.  The current pandemic will affect many more companies than did the 2008-09 banking crisis, but we again believe that corporate America will surprise us with dividend actions that are more positive than is now being priced into the stock market.  As we release this 2020 Dividend Watch blog, Wall Street analysts predict that S&P dividends will be cut approximately in the range of 33%.  
        Our analysis runs from March 1 to the present.  Early March was when the full impact of coronavirus exploded into our collective consciousness.  We'll track the dividend announcements on a weekly basis. 
      

Dividend Actions by S&P 500 Companies In March 2020.

Dividend Paid	Dividend Increased	Dividend Decreased
43	10	18

From March 1 through today, approximately 30% of S&P 500 companies announcing dividend actions have cut or suspended their payments. (18 of 63).  We suspect that some companies that have announced suspensions may reinstate their dividends later in the year after the full effects of the Covid 19 economic damage has been assessed.  We'll track reinstatements if and when they occur.  Companies cutting their dividends have been centered in three industries: Travel and Leisure, Oil and Gas, and Retail.  Among the big names that have announced cuts or suspensions are Ford Motors, Delta Airlines, Marriott, Carnival Cruise Lines, GAP, Occidental Petroleum, and Boeing.
        As you will note in the table above, 10 companies have raised their dividends during this time.  The biggest hikes so far have come from Dollar General at 12.5% and General Dynamics at 7.84%.
        We have long believed that dividends are the linchpin tying individual investors and corporations together.  With stocks careening all over the place, it would appear that traders and speculators are betting that companies will break this bond.  We believe the bond will hold and provide an undergirding to the overall stock market.  

Greg Donaldson, Founder
Donaldson Capital Management   

Hot News Comes and Goes, But Dividends Are Forever . . .

Investors are constantly inundated with the latest regional conflict, political debate, economic data and interest rate predictions. All of this information represents the collective viewpoint or “consensus” of investors at any given point in time.

Over the many years we have spent studying the markets, the truest thing we know is that the consensus is already priced into the market... and the consensus is almost always wrong. If an investor believes the economy and earnings will be better in the future, they will “vote” with their money. In aggregate, all of those votes create the price level for a particular stock. If the consensus comes true, you won’t see much of a change in the markets and prices will generally drift sideways.

What changes the price of stocks are the things that the consensus doesn’t already expect. Therefore, the only way to make excess risk-adjusted returns is either:

1) Find where the consensus is wrong.

2) Look outside the box.

ABCs of Dividend Investing: How to Navigate the Current Sell-off

Since the beginning of the year, stocks have fallen by about 5%.  The modest pullback has many investors wondering whether a full out “correction” (drop in prices by 10% or more) is on its way.  

When the inevitable fluctuations in stock prices come, investors are all left with the same question: What should I do with my portfolio?

At Donaldson Capital Management, we have a particular strategy for handling market upswings and downswings.

What Is An ABC Portfolio?

As many of you are familiar, we invest only in dividend-paying stocks but we break down our portfolios into three types of dividend-paying stocks.  For those of you who are not familiar, we structure our portfolio into A, B and C stocks.  

Below is a summary of each sub-portfolio and it’s specific characteristics.  You can read about each sub-portfolio in more detail here.

Our primary investment model (“Rising Dividend-Cornerstone”) is comprised of all three types of dividend stocks.  

Regardless of what type of market we are in, a portfolio of A, B and C dividend stocks will have at least one group that performs better-than-expected.  This type of portfolio significantly outperforms

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. 

Dividends: Still The Best All-Season Investment Strategy

Stocks, during the last six years have been, shall we say, . . . unpredictable: surging bull market in 2007, bear market retreat in 2008-2009, then a powerful bull market over the last three years.  As we celebrate the surprisingly good performance of stocks in 2012, we are now being buffeted by the annual year-ahead prognostications of the financial media and Wall Street strategists. Will they be any better at predicting 2013 than they were at predicting 2012?  I don't think so.

Indeed, who correctly foresaw the wild ride we have been on over the last six years, ten years, twenty years etc?  Nobody I know.  That is the reason I became a dividend investor approximately twenty years ago.  It was then that I first learned that dividends had produced nearly 50% of the total return for stocks since the end of World War II.  I also discovered that dividend growth was only about one-third as volatile as earnings or prices, and thus were far more predictable than either.

In summary, dividends offer a cash return, they generate half of the total return of stocks, and dividends are among the most predictable financial data for many companies because dividends are set by the board of directors.

All of us at Donaldson Capital Management are pleased that so many investors have discovered dividend investing.  We think most of them will stick to it, and they will be rewarded for it over the years.  I am troubled by one trend I see, however.  Too many investors appear to be focusing on the current dividend yield alone.  Our research has convinced us that a combination of dividend yield and dividend growth is the best all-season investment strategy.

Recently, I was speaking with my son, Justin about assisting me with some analysis of the volatile stock markets we have been navigating in recent years.  DCM has lots of data analysis equipment, such as Bloomberg and Value-Line, but we do not have what is called a data mining resource.  Justin, is a co-founder of a machine learning company, Big ML.com, in Corvallis, Oregon.  He is a part of group of six tech scientists who are experts in the field of big data, or, as I still like to say, artificial intelligence.  Justin always fusses at me when I use that term.  He says he works in the field of machine learning.

BigML.com has a very accessible and easy to navigate website that can crunch huge quantities of data and generate a "bottom line", so to speak, on about any data set you can throw at it.  A very interesting data mining study they have made is on who survived the Titanic disaster by sex, age, location on the ship.  Some of the finding are intuitive.  One group who disproportionately survived will surprise you.

Justin took me through a few examples of how to assemble the data I wanted to study and how to build a model at BigML.com.  I have been practicing for months and I think I understand what is happening in the data mining process.  Let me say I have heard many lectures from Justin about algorithms.  They are the mathematical T's in the road that the computer "learns" to navigate by looking at all the data from many different angles all at once.  There, let's see how much trouble I get into with him with that explanation.

This week, I did some modeling to determine what fundamental factors have been the best predictors of success for the 500 stocks in the Standard and Poors Index. The fundamental data I used for each of the 500 companies was the annual growth rates of sales, earnings, and dividends over the last five years.  I also included the average annual dividend yield, average annual price to earnings ratio, return on invested capital, and bond ratings.  Below is a picture of the model I built using Justin's website.  I am not going to try to explain everything that you will see.  I will write additional blogs in the future that will help to further explain what is going on in the model.

The model (below), at first glance, looks like an upside down Christmas tree. Indeed, it is called a tree, a decision tree.  Each of the bulbs on the tree are called "nodes" and represent a group of companies in the S&P 500 with similar return and fundamental data characteristics.

Let's get to the good stuff.  That is the heavy black line connecting the first four  balls or bulbs from the blue ball at the top of the model.  You might think of this black wavy line connecting the balls or nodes as the road to success.  The model is not just picking the stocks that have performed the best over the last 5 years.  It is identifying the best performing stocks that can be explained in association with their fundamental data.

On the right side of the model, is a color coded description of the nodes that the black wavy line is passing through, and the numerical levels that the model has identified as a dividing line between the better performing  stocks and the less successful stocks.

Please move below the chart for a simple description of the model's determination of what kinds of stocks have been winners and why.

          

The model starts with 500 companies.  The average annual return over the last five years of this group on an unweighted basis is +3.6%.   The first dividing line, or node, between better performing stocks and the lesser performing stocks is market capitalization, or how big the company is.  The model shows on the right of the chart that the dividing line is roughly at $4.3 billion in market cap.  In general, stocks larger than $4.3 billion in market cap performed better than smaller stocks.

The next node is somewhat illogical that it shows up so early.  The model is saying that stocks with dividend growth greater than a minus 25.65% did better than stocks with dividend growth higher than that level. That would seem to be a duh, but it is essentially kicking out most of the bank stocks, which were forced to cut their dividends dramatically in 2009 and fell sharply in price.  The next node we cross through is 5-year average P/E, and the critical level is 12.80x.   That is a slightly lower 5-year average P/E for our winning stocks than that of the S&P 500 as a whole, but not significantly.

At this point we have eliminated about half of the original 500 stocks, but we don't know much yet about the nature of the winning stocks.  All we really know is that big stocks did better than little stocks.  The difference in P/E is not material, and the dividend growth node is not helping us at all.

That is about to change.  The black, windy road to success just crossed into an node that reveals that stocks with average annual dividend growth of greater than 10.75% were big winners.  This dividing line also cuts the number of remaining stocks to only 98.

In one of the most rambunctious times in the memory of most of us, big stocks that increased their dividends at least 10.75% per annum produced an average annual return of 9.83%, nearly 3 times the rate of return for the average stock in the S&P 500.

But wait, there is more "We'll double your order if you order now."  Forgive me.  I have watched too much Holiday television.  There is more and the defining characteristic of the next node, as shown on the right, is the dividend yield.  I did not show the value of the node because it is at first a bit of a surprise. Stocks that have make it through this node  has a dividend yield of LESS than 2%.  Stocks that successfully passed through all the nodes thus far produced an average annual rate of return of 13.4%.  But wait, that's not more, that's less.  Yes, it is but that is one of the things we have been saying for the last decade: While dividend yield is important, it is not the main driver of success.  Dividend growth is a better predictor of winning stocks if the growth is consistent and persistent. The problem with low yield,  high dividend growth stocks is that high earnings growth is a must to continue the high dividend growth.  Thus these stocks are much more volatile than higher yielding stocks with lower dividend growth.

There you have it.  Over the last 5-6 years, a time as chaotic as any we have seen since the 1930s, the winning recipe in the stock market has been dividend related. We are not surprised by this.  This is the same trend we have observed over the the last 20 years. It is also what the data reveals for the 40 previous years.

Importantly, as we said earlier we discovered many of the dividend principles we still follow today in the early 1990s, a time when dividend investing was out of favor.  We went looking for ways to deal with volatility after the crash of 1987.  It was not until the early 1990s that we began to understand the importance of dividends.  The following paragraph was contained in our quarterly letter mailed to our clients on January 15, 1993.  One might say it sounds like we wrote it last week.  If the truth be know, we probably wrote it or at least shared it with a client or a prospect today.  Well there is another duh.  We are sharing it here.

"We believe that companies with growing dividends will ultimately draw the attention of Wall Street and institutional investors, as well.  This is because a rising stream of income in a slow growth, low interest rate environment will, undoubtedly, become more and more valuable, causing prices to rise on such companies.  Thus, in our judgment, an investment strategy aimed at increasing income is likely to produce capital growth, as well."