What This Strategy Aims To Do
This equity-income strategy seeks to own shares of dividend-paying companies for which we expect good dividend growth in the future. Achieving an above-average yield would be desirable, but to the extent investors must choose between high current yield or prospects for strong dividend growth, this strategy prioritizes growth prospects.
Why It’s Worth Considering
The benefits of owning securities that have high interest or dividend yields is undeniable, and we discuss these in connection with our “Sweet Spot Equity Income” model. But we cannot expect the market to offer a free lunch. High yield carries costs or baggage the most noteworthy being the risk that the expected future income stream will not materialize. Our Sweet Spot model addresses this through risk management protocols. But there is another drawback to high yield not addressed by that model: Higher yields, even where secure, tend to be associated with expectations of lesser rates of future divided growth. This model aims at that.
It can often be a challenge to get investors excited about future dividend growth prospects. This is a major source of frustration to gurus who wish they could persuade audiences and readers to be less yield obsessed and more appreciative of “total return,” which is income received plus/minus changes in the value of the assets.
It’s a bit easier to make a case for total return when prospects for price change are negative, as with junk bonds. Accepting a 4% yield instead of an 8% yield is an easy sell if the investor expects price stability for the 4%-yielding security but, say, a 20% loss in value for the high-yielder. The challenge comes in persuading an investor to accept a 2% yielding security whose value is expected to rise 20% in lieu of a 4% yielder whose value is expected to be steady. The 4% yield is real. It’s here. It’s now. While future dividend payments are never certain, investors are often willing to treat them as if they are because relative to much of what goes on in the stock market, this forecasting burden is seen as modest. But the expectation of the 20% gain for the 2% yielder, that’s another matter. That requires a leap of faith many don ‘t feel comfortable taking, so 4% in the hand is often preferred to 2% now that may or may not turn out to be a lot more.
There are, however, good reasons for investors to be less dismissive of expectations for future growth and really think about how to make such expectations as credible as possible.
For starters, prospects for growth are the essence of equity investing. Stocks always compete for capital against fixed income, and in one sense, stocks start with a handicap: The probability of suffering an unrecoverable loss of principal is far greater for stocks. The naive observer might, therefore, assume that to compensate investors for greater risk, stocks would typically have dividend yields above what could earned in the fixed income market. Actually, though, its the opposite. Most stocks have yields below fixed-income levels and many stocks pay no dividends at all. To attract any money at all, the equity market must offer prospects for enough dividend growth to offset the day-one yield disadvantage (a stock yielding 1% starts out looking shabby next to a ten-year bond yielding 1.5%, but income on the latter can’t grow. If the company’s dividend triples over the course of ten years, the shareholders will have been very handsomely compensated for having assumed the extra equity risk.) That the market in general and in connection with dividend-paying has risen as it has in the past suggests that many are seeing such expectations realized in the real world.
Mr. Market is pretty good at assessing dividend growth prospects. In an effort to make companies with prospects for strong growth equally appealing as companies with lesser growth prospects, the dynamics of supply snd demand operate such as to cause shares of good growers to be priced with lower day-one yields.
Another issue is the potential for rising interest rates in the future.
One way to address this is through higher-yielding shorter-“duration” investments that provide better opportunities to offset principal losses with greater reinvestment income (interest on interest). You can aim for this using our “Sweet Spot Equity Income” and/or “REIT Dividend Trader” strategy.
This dividend-growth model addresses a different aspect of rising interest rates. If rates do rise in the future, the most likely catalyst for that will be improved economic activity. Assuming such a scenario becomes a reality, it is reasonable to expect higher corporate sales and profits. It would also be reasonable to expect higher profits to translate to stronger dividend growth. That’s an important potential edge viz. fixed income. If Rates rise, the principal value of those securities must decline (in which case, the only way to recoup losses would be to hold until maturity or hope for a bad economy and a shift to lower rates). You need not think that way with dividend growth stocks. You can pursue opportunities to invest in shares for which the rising dividend more than offsets the decline in value that would be necessary the level of income is contractually fixed.
How We Do It
Among those who pursue a strategy like this, many screen and/or rank on the basis of historical dividend growth rates (in addition to the usual tests involving minimum yield and dividend risk). We don’t do it that way.
This is one of the more blatant instances in which the legalese mantra about past performance not assuring anything about the future is especially apt. In fact, not only are we unable to count on strong dividend growth continuing into the future, there are many who believe in the notion mean reversion, in which the winners in the past become losers in the future and vice versa. If you ever invested in a hot growth stock and found that things turned sharply south after you got in, that was likely an example of having been smacked by mean reversion. (Don’t assume you were done in by a high growth stock P/E. Had the company been able to deliver on the bold growth expectations that are often “baked into” the high P/Es, things would have probably turned out well even though you paid accepted a high valuation. The pain, when it comes, more likely comes from unfulfilled growth expectations.)
This past (which is all we know) versus future (which is all we care about) conundrum doesn’t apply only to high-flying growth stocks It applies to dividend growth as well. So be careful about falling in love with stocks on these dividend aristocrat-type lists that get there because the company raised its dividend every year over the past however many years the list proprietor wants to examine.
There is no perfect or correct way to analyze future growth. But whatever we do, we believe it makes most sense to incorporate the work product of experts who look, not just at historical data but relevant qualitative factors as well, and to the extent we do examine historical data we look at the factors we believe have higher probabilities of bering relatively more stable over time.
So in addition to basic filters involving recent dividend payment history and sector concentration, we screen a large-capitalization universe (one that tends to be more stable in general) based on yield: We set an allowable range consistent with what believe identifies stocks priced such as to reflect investment community expectations of good future dividend growth). We also screen based on a minimum threshold as per a Quality ranking system.
From among the passing stocks, we select the 20 that rank highest under an Sentiment (on the part of wall Street analysts) based ranking system.
The model is refreshed weekly and stocks are sold (and replaced) if or when they no longer qualify under yield or quality standards we establish. Stocks may also be sold based on criteria relating to performance or diversification (i.e., to prevent excessive sector concentration).
Is It Suitable For You?
Interest-rate risk is present, but in contrast to the situation with fixed-income, The prospect of dividend growth can offset some of this, as can, to a lesser degree, potential for additional earnings from dividends you receive, that can be reinvested at rising rates.
Equity income strategies are typically assessed on the basis of prospects for current income and/or dividend growth. This strategy aims directly at the dividend growth preference. This is not to say it won’t or can’t benefit from a respectable dividend yield, but expect a much lesser yield here than in our higher-yielding “Sweet Spot Equity Income” and/or “REIT Dividend Trader” strategies.
- Risk would be low in comparison to most basic stock strategies due to use of quality-oriented fundamental factors but is no less then medium by Income standards due to the non-contractual nature of dividends.
- Compared to other dividends, risk is reduced by efforts to emphasize stronger companies, those more capable of generating good dividend growth
- Although turnover is likely to be low relative to most strategies that hold stocks, it is likely to be high relative to what many see from ETF-based income strategies.
- Even so, the strategy is suitable for most brokerage-cost arrangements