Travel To Wealth: 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]

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.

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

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).

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.

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

Jim Puplava’s Big Picture: Forecast 2016 – Shelter in a Storm
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.
The Investment Constant (FinancialSense)
4 Safe Dividend Stocks to Buy as 2016 Starts With Market Rout
The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New
Mergent's Dividend Achievers
5 Stocks at Risk of Dividend Cuts in 2016
Dividend Growth Portfolio - 2015 Was A Good Year With Bad News At The End
Don’t Get Too Spooked by This Sell-off
What to buy as the market dips…
Ned Davis Research
The 80-year-old fad: Dividend investing comes back into vogue
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"

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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.