Most people want their investments to do well, that’s a given. The daydream of being able to live off your investments is one of the key tenets of the financial independence community. For many people, this simply means they want stock prices to go UP.
Unfortunately, there can be months, years, and sometimes even decades when stocks don’t “go up”.
For individuals living off investment returns, this solution isn’t to delude ourselves into dreams of ever rising prices…but to balance capital appreciation with a reasonable dividend income. That, and a lot of patience.
If done correctly, dividends can provide cash flow for a nice lifestyle, and you won’t be forced to sell assets in down markets to pay for your lifestyle.
But where can a person find such investments? The S&P 500 now has a yield under 2%. A yield that low makes living off investment income alone a rather difficult proposition.
The Dividend Aristocrats
The secret of course isn’t to find the highest yielding investment possible (that’s just a recipe for disaster), but to instead look for investments that can continually grow income year after year.
If you’ve been investing for very long at all , you’ve probably heard of the Dividend Aristocrats — companies from the S&P500 that have been paying continuously growing dividends for 25 years (or more). These are the titans of industry, unfazed by little things like recessions and economic “bumps”.
Currently, the Aristocrats index is 51 companies, and you can buy into this group of companies through the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) that holds them.
But how do they perform? In the past the Dividend Aristocrats outperformed the S&P500 by a reasonable margin, but in recent years they’ve only just matched the S&P 500. Furthermore, dividend yields on the Aristocrats are not noticeably higher.
So what happened?
It’s probably a case of too much money chasing too few investments. Rising prices aren’t a good thing when it comes to investment returns. Once an idea gets popular, the strategy is quickly ruined by too much capital chasing it. That’s probably the case here.
Everybody and their grandmother invests in S&P 500 index funds now…which jacks-up the price of the Dividend Aristocrats (and other components). While the yield is slightly higher for the Aristocrats than the greater index, the difference between the two seems negligible.
It’s unfortunate that the strategy doesn’t appear to be working in recent years, but the ETF has only existed since 2013. That’s not a very long time period when it comes to dividend growth. Over longer time periods (and more recessions), the Dividend Aristocrats have done better.
Almost But Not Quite
But what about all the other companies that *are not* part of the S&P500 and those that don’t have a record quite as prestigious as the Aristocrats? There must be many other companies that don’t quite fit the bill, but are still excellent companies. Where are those guys?
Think about it — each of the Dividend Aristocrats must have had many years outside the index where they grew dividends and didn’t have the mass popularity they do now. Presumably these companies wouldn’t be priced at quite as high a premium.
An index for such a group of companies already exists… it’s called the Nasdaq Dividend Achievers.
To become a part of this index, companies must pay growing dividends for the past 10 years (or more). Despite requiring a significantly shorter time period than the Aristocrats, this is no mean feat — this means the Achievers were able to raise dividends throughout the Great Recession.
The yield on these funds is only ever so slightly higher than the S&P500, but total performance has lagged the S&P 500:
The Dividend Achievers don’t actually seem to achieve. In recent years, performance has been even worse than the Aristocrats group. So what gives? Why all the underperformance by such good companies? Aren’t they appreciated by the market?
Why The Underperformance?
One possible explanation for the underperformance is the Achievers are so focused on raising dividends that they’re neglecting reinvesting in the business. Such neglect would not show up in the short term. But, over time this behavior would lead to underperformance and eventually smaller dividend growth (or worse — dividend cuts).
Such a situation is exactly why I sold my Telus shares last year. While I liked the Canadian cell industry for it’s profitable oligopoly-type economics and growing dividends, things had gotten to the point where continuing payout growth (and a continually rising payout ratio) seemed financially destructive. That wasn’t a situation I wanted to live with, so I decided to exit that investment.
Another possibility is that the quality of the Dividend Achievers is actually quite poor in aggregate compared to the S&P 500. They simply can’t compete with the excellent companies in the S&P 500, who already sport excellent dividend growth.
The difficulty here is that we can’t really tell what’s from the index level. We’re stuck accepting both good companies and bad companies with the index.
Historical research has show that dividend growth stocks have outperformed all other classes of investments over a very long periods of time, as detailed in books like The Future For Investors by Professor Jeremy Siegel . But that conclusion doesn’t seem to jump out at me in the short term when looking at these indexes.
I’m certain that within the index there are companies that outperform AND manage to pay out growing dividends, but based on current performance these indexes seem like a poor way to find them.
So what are my lessons learned?
- Business quality matters. It’s not just about capturing a growing dividend stream. Management still has to make smart decisions with capital to meet or beat the S&P500.
- S&P 500 dividend growth is already quite robust, because most components of the S&P500 are dividend payers. Trying to find companies that beat it is hard.
- The difficulty of making it into the Aristocrats index seems to provide a quality filter that isn’t present in the Achievers index. Those who survive the longest seem to be strongest.
- “Diamonds in the rough” may exist in the Achievers index, but their performance is masked by poor performance of poorer companies.
- For the past 9 years we’ve existed in a period of continuous economic growth and a rising stock market. Dividend payers tend to be more defensive investments that hold up better under falling market conditions.
Perhaps we’ll again see better performance from these strategies once the market turns. I would like to revisit this investigation after we enter another bear market to see how performance compares.
Most enterprising investors want to look beyond the basic performance of the major indices, and I’m with you there. I want to open up the machine and see how it works….to find the investments that really matter.
But finding or compiling enough data is always a challenge. Fortunately, there IS a source of such data!
It’s a truly wonderful source of data, that breaks down dividend growers into 3 categories — Dividend Champions (25+ years), Dividend Contenders (10-25 years), and Dividend Challengers (5-9 years).
While the Dividend Champions spreadsheet is definitely less restrictive than the indexes mentioned in this post, I consider that a good thing. Companies like REITs are included, and actual dividend growth rates are given significant attention.
If you’re even slightly interested in investing in individual dividend growth stocks, I highly recommend taking a look.
[Image Credit: Flickr]