Sunday, January 17, 2016

Dividend Growth Portfolio—An Investment Strategy in a Volatile Stock Market

In Jim Puplava’s Big Picture: Forecast 2016,[1] his prediction for year 2016 is that 2016 will be similar to 2015 except with much higher volatility.  To invest in a high volatility market, one strategy is investing in dividend-growth stocks.

In this article, we will touch upon the following topics:
  • Advantages of dividends
  • How to find trustworthy dividends
  • How to spot risky dividends
  • Investment ideas

Table 1. Dividend Growth Stocks Outrun the Competition Over Time
Source: Ned Davis Research

Advantages of Dividends


The advantages of dividends include[3,25]
  1. Provide a steady stream of income
    • This income is steady and dependable
      • Dividends on most stocks are paid every quarter. The income provides a return you can count on regardless of stock market conditions or price fluctuations.
  2. Provide an inflation hedge
    • These dividends can increase over time providing investors with a greater source of income and an inflation hedge.
    • You don't get this with a bond. Bond values can erode with inflation, making the interest and principal worth less as a result of inflation
  3. Have historically produced higher total returns than non-dividend paying stocks[2]
    • As shown in the book Mergent's Dividend Achievers, superior dividend paying stocks have not only outperformed the S&P 500, but they have also fluctuated less in down markets (see Table 1).
  4. Have also been less volatile historically
    • They tend to fluctuate less and hold up much better in down markets[12]
      • In declining markets, investors gravitate to more defensive issues such as dividend payers in search of refuge in a storm.
  5. Provide investors with better corporate governance
    • Studies have consistently shown that there is a direct link between good corporate governance and control with dividend payouts.
      • Once a company implements a dividend paying policy, they seldom abandon it.
    • Dividend payments have to be included in cash flow and budget projections each year.
    • Dividends more closely line up with company earnings and cash flow.
      • Management is reluctant to pay out dividends—or increase them for that matter—if the earnings aren't there.

How to find trustworthy dividends


Without saying, the companies you are investing in should:
  • Have strong balance sheets
    • While earnings can be subject to various adjustments, a positive free cash flow means a company has invested what it needs to maintain its business and has money left over to spend on dividends.
  • Can handle a slowdown in the economy both domestic and abroad (if they do business overseas)
    • Look at how much debt the company is carrying and whether it needs to tap capital markets to meet its commitments.
To spot good and reliable dividends, what should you look for? Here are the factors to consider:[4,6]
  • Management strategy
    • They tend to have good management with solid corporate governance
      • Management prioritized dividend growth as a key element of its shareholder value proposition
    • They tend to have strong cash flow and earnings growth
  • Historical record
    • For example, McDonald’s has increased its dividend every year for the past 39 years.
    • Sectors
      • In studying the S&P 500 over the last 53 years, Siegal[5] found 20 superior companies in three kinds of industries: consumer staples, pharmaceuticals, and energy.
        • Even in market downturns, both utilities and consumer staples normally are holding up relatively well.[23]
  • Brand name and market share[5]
    • They are large and mature companies
      • Once the business becomes mature and a brand name is established with a dependable customer base, they have less of a need for major capital expenditures, which consume earnings and cash.
      • They have less of a need to come up with revolutionary new ideas or new products to stay profitable
        • They are past their growth phase and tend to have lower R&D requirements
    • They tend to be in businesses that provide a product that people continually consume.
    • They tend to have a strong brand franchise that engenders repeat business and customer loyalty.
      • This is also the reason they tend to enjoy higher profit margins on the things they sell.
  • Valuation and stock trend
    • Buy low. So, your decision should be based on analyst's target price (vs. current stock price)
  • Higher dividend yield
    • Choose stocks offering dividend yield which remains at a higher premium in relation to the 10-year Treasury rate
    • To achieve the highest returns over a long time, you need to look for companies that consistently INCREASE their dividends.[8]

How to Spot Risky Dividends


When pursuing higher yield, you should also avoid risky dividends. It’s best to be on the lookout for warning signs of a dividend cut early on, because by the time it’s finally announced, much of the damage to a stock has already been done. A cut in dividends could be imminent if you find:[7]
  • A spiking yield
    • Ironically, an indication that a cut is imminent is a spiking yield
    • What’s “high” in terms of yield (a stock’s annual dividend rate divided by its share price) depends on the industry;
      • For instance, 4% for a utility stock is fine, but it invites skepticism in a faster-growing tech company or a more-economy-sensitive industrial company.
      • If a stock that usually yields 4% all of a sudden yields 6%, and the cause of that burgeoning yield is a falling share price, it could be an indication that Wall Street doesn’t believe that the dividend is sustainable and that a reduction is in the offing.
  • High payout ratio
    • What’s “high” in terms of payout ratio (the amount of a company’s earnings paid out in dividends) depends on the industry.
      • The average payout ratio for S&P 500 stocks is currently 37%.
      • Tobacco stocks can pay out the majority of their earnings in dividends because a long-term decline in demand for their product means they’re not spending a lot on factories and equipment, yet the business remains profitable and generates tons of cash.
      • But in general, anything above 70% to 75% should raise eyebrows—or at least initiate some research.
        • Companies carrying too much debt—they will be forced to choose between protecting their credit rating and protecting their dividend--will cut the payout every time.

Investment Ideas


In an environment of rising interest rates and lower liquidity, Uncommon Wisdom Daily Team recommends choosing[9]
  • High quality over low quality
  • Dividend growth over high dividend yield
  • Liquidity over leverage
  • Large caps over small caps
    • Large-cap companies tend to do better in times of uncertainty, which we definitely are seeing now.
  • Yield on Cost[26]
    • Keep track of the yield based on your cost basis

In [8], David has offered his Dividend Growth Portfolio for retirement in 2016. As usual, before you invest, do your own research. The investment ideas list here is just your reference—if you invest in any stocks discussed here, you take your own risks.



If you prefer to invest in ETF with the theme of dividend growth, there are some choices:[10,24]
  • NOBL (ProShares S&P 500 Dividend Aristocrats ETF)
    • The only ETF that invests exclusively in large-cap S&P 500 companies with the best track records of year-over-year dividend growth (25 straight years as a minimum).
    • Has 52 holdings, a current yield of 2.2% and a low expense ratio of 0.35%
  • SDY (SPDR S&P Dividend Index NYSE)
    • Tracks the S&P High-Yield Dividend Aristocrats index
      • Uses a much wider net — 1,500 possible stocks vs. 500. So in the tradeoff, investors get more total holdings and a wider range of company sizes.
      • Owns the highest-yielding S&P 1500 index constituents that have managed to increase their dividends for at least 20 straight years
      • Has a 50/50 split between large caps and small/mid caps
    • Has a total of 101 holdings, a dividend yield of 2.7%, and a low expense ratio of 0.35%.
  • O’Shares ETFs[24]
    • OUSA (USA)
    • OEUR (Europe Non-hedged),  OEUH (Europe Currency-hedged)
    • OASI (Asia Non-hedged),  OAPH (Asia Currency-hedged)

References

  1. Jim Puplava’s Big Picture: Forecast 2016 – Shelter in a Storm
  2. O'Shea, Peter & Worrall, Jonathon, Beating the S&P with Dividends: How to Build a Portfolio on Dividend Paying Stocks, by Peter O'Shea & Jonathan Worrall, John Wiley & Sons, 2005, p.42.
  3. The Investment Constant (FinancialSense)
  4. 4 Safe Dividend Stocks to Buy as 2016 Starts With Market Rout
  5. The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New
  6. Mergent's Dividend Achievers
  7. 5 Stocks at Risk of Dividend Cuts in 2016
  8. Dividend Growth Portfolio - 2015 Was A Good Year With Bad News At The End
  9. Don’t Get Too Spooked by This Sell-off
  10. What to buy as the market dips…
  11. Ned Davis Research
  12. The 80-year-old fad: Dividend investing comes back into vogue
  13. Free cash flow
    • If you own a Charles Schwab account:
      • Log in to your account, click on "Research," and enter a ticker symbol
      • To the right of the stock's "Summary" page, click on "Statements," then select "Cash Flow Statement"
  14. Bear Market Risks Increasing At Rapid Rate (01/15/2016)
  15. 9 Good Dividend Stocks to Buy During the Market Selloff
    • ABBV, AMGN, BA, CMCSA, HD, JPM, MSFT, NLSN, WEC, 
  16. Four Strategies for Navigating the Equity Environment Ahead (PIMCO)
    • Dividends can be a more stable source of returns, but there’s a caveat: stocks that simply offer yield may struggle in a rising rate environment. 
    • This reinforces the case for a global dividend portfolio (which can benefit from investing where rates are lowest or decreasing around the world) and a focus on companies growing free cash flow and management committed to dividend growth.
  17. Seeking Alpha Market Currents Dividend News. [Online Database].
  18. Wall Street Journal. Dividend Declarations. [Online Database].
  19. Merrill Lynch’s Top Dividend Alpha US Stocks Picks for the Rest of 2016
    • KHC, NEE, EPD, HES
  20. A Counter-Trend Rally? Knowing Your Risks (Travel to Wellness)
  21. Can Big Oil Continue to Pay Dividends?
  22. Merrill Lynch Says No Value in Energy: Only 2 Dividends Safe Now
    • With the exception of two companies, Merrill Lynch lowers the dividend outlook for all large cap U.S. oil
  23. Jim Puplava’s Big Picture: The Risk to Dividends – Know What You’re Buying
  24. ‘Shark Tank’ for Stocks
  25. How to Navigate a Range-Bound Market (The WisdomTree Blog)
  26. Dividend Stock Investors: Pay Attention to Your ‘Yield on Cost
  27. 3 Low Volatility Dividend Stocks To Make Staying The Course Easier
    • JNJ, GIS, PEP
  28. The 10 Most Recession-Proof Dividend Aristocrats
    • 1. MCD 2. WMT 3. ABT 4. GWW 5. BDX 6. ED 7. KO 8. JNJ 9. ADP 10. CLX
  29. Two Dividend Stocks We Favor (AAII)
    • ETN, PG

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