Published by Nick McCullum on July 19th, 2017
The goal of any investor is to either:
- Maximize returns given a fixed level of risk
- Minimize risk given a fixed level of desired returns
Investors in the accumulation phase tend to fall under the first constraint, while retired investors invest with the second criterion in mind.
There is a third approach – maximizing risk-adjusted returns.
This means that an investor has no cap on the amount of risk they will assume, as long as they are adequately compensated for this risk by excess investment performance.
So how do we measure risk-adjusted returns?
The Sharpe Ratio is the generally-accepted metric used to measure risk-adjusted returns.
Finding stocks with strong prospects for above-average risk-adjusted returns can be difficult. One way to identify these businesses is by looking at their historical risk-adjusted returns.
With that in mind, this article will use various time periods to analyze the risk-adjusted performance of the Dividend Aristocrats, a group of high-quality dividend stocks with 25+ years of consecutive dividend increases.
1-Year Risk-Adjusted Returns
A 1-year time period is generally too short to identify any meaningful investment trends.
However, this analysis still calculates 1-year risk-adjusted returns for Dividend Aristocrats, as there are important observations that can be made from this time period.
First, it’s important to understand the metric that we’re dealing with. For those unfamiliar with the Sharpe Ratio, it is calculated as follows:
For the risk-free rate of return, the 10-year government bond yield is generally used. That convention will be followed in this analysis. Right now, the 10-year U.S. government bond yield is 2.3%, which is the figure that will be used in our Sharpe Ratio calculations.
With all that in mind, here are the top 10 Dividend Aristocrats by 1-year risk-adjusted returns.
The first observation that can be made from this data is this: the Sharpe Ratios contained in the table above are far higher than what can be expected for equity securities over long periods of time.
These elevated Sharpe Ratios are caused by the unique characteristics exhibited by the broader equity markets over the past year: above-average returns combined with a volatility level that is much below historical norms.
In the table above, stocks rank highly because they either have very high returns, very low volatility, or some combination of the two.
Stocks with fantastic returns include:
- General Dynamics (GD): 43.4% 1-year return
- C.R. Bard (BCR): 38.1% 1-year return
- Franklin Resources (BEN): 35.6% 1-year return
- Illinois Tool Works (ITW): 34.1% 1-year return
None of these returns are sustinable over long periods of time, or else these companies would eventually grow to consume the entire global economy.
Stocks with extremely low volatility include:
- 3M (MMM): 10.8% 1-year standard deviation
- McDonald’s (MCD): 13.2% 1-year standard deviation
- Illinois Tool Works: 13.8% 1-year standard deviation
- General Dynamics: 14.4% 1-year standard deviation
These standard deviations are well below what investors can reasonably expect over long periods of time.
For context, the S&P 500 ETF (SPY) – a diversified basket of large-cap stocks – has had a 10-year annualized standard deviation of about 16%, much higher than some of the stocks in the table above.
Looking at the best-performing Dividend Aristocrats on a risk-adjusted basis over the past year gives insights into some of the hottest dividend stocks right now.
However, buying the ‘hottest’ stocks is not a winning investing strategy. It is important to have an element of contrarianism as an individual investor.
With that in mind, we can gain insight by looking at the bottom 10 Dividend Aristocrats by risk-adjusted returns (shown below).
Many of the companies on this list are experiencing some sort of business- or industry-specific problem that has turned investor sentiment quite pessimistic.
For Federal Realty Investment (FRT), rising interest rates are playing a role in the stock’s poor performance.
Importantly, each of the issues hurting these company’s stock prices is temporary in nature. Many are potential buys right now, and several have been ranking highly in recent editions of the Sure Dividend and Sure Retirement newsletters.
In this short 1-year study of risk-adjusted returns, Sharpe Ratios were primarily determined by return (not volatility).
As we lengthen the time periods under investigation, I suspect that low volatility Dividend Aristocrats will begin to rank more highly for two reasons:
- Returns will become more normalized over long periods of time
- Recession-resistant stocks tend to have lower volatility, and recession-resistant stocks performed well during the 2007-2009 financial crisis (which falls within a 10-year time sample). This combination of lower volatility and higher 10-year performance should improve risk-adjusted performance.
Moving on, the next section measures the risk-adjusted performance of the Dividend Aristocrats on a 3-year basis.
3-Year Risk-Adjusted Returns
3 years ago, the economic environment was considerably different than it is today.
Three of the main differences are:
- Oil Prices: 3 years ago, oil prices exceeded $100 (although they had already dropped noticeably off previous highs). Since oil is trading around $44 today, it is likely that some of the worst-performing Dividend Aristocrats during this time period will come from the energy sector.
- Governmental Changes: The election of Donald Trump last November resulted in a jump in financials and defense stocks. It will be interesting to see the impact of these changes on the 3-year risk-adjusted performance of the Dividend Aristocrats.
- Interest Rates: The Federal Research has hiked interest rates three times in the past ~20 months or so. While this hasn’t necessarily impacted bond yields yet, is it only a matter of time before the changes to the Fed’s benchmark rate trickles down to market interest rates. Investor sentiment towards interest-rate-sensitive businesses (which includes banks, insurance companies, and any highly leveraged business) has had an impact on shareholder returns during this time period.
With all this in mind, here are the 10 Dividend Aristocrats with the highest Sharpe Ratio over the past 3 years.
While returns during this time period are still higher than long-term averages, volatility has moderated to more reasonable levels. The only stocks in this list that have lower standard deviations than what investors can expect over long periods of time are McDonald’s and Cincinnati Financial (CINF).
Again, looking at the best-performing stocks is not the best place to find investment opportunities.
Instead, opportunities can be found by looking to the poor performers, as valuations are generally lower and investors can generate higher proportional earnings and dividends from the same invested amount.
Here are the Dividend Aristocrats with the worst 3-year Sharpe Ratios.
The list of poor-performing Dividend Aristocrats continues to be populated by businesses experiencing some sort of temporary trouble.
New additions include Emerson Electric (EMR) and Dover Corporation (DOV), whose customers are struggling amid low oil prices; Chevron (CVX), another victim of low oil; and Archer-Daniels-Midland (ADM), an agricultural behemoth whose revenues and margins are under pressure thanks to a prolonged downturn in agricultural commodity prices.
By and large, the issues being experienced by these companies are highly likely to be temporary. Moreover, investor pessimism has changed more than fundamentals more most of these businesses – which means that valuations are more compelling based on traditional metrics such as the price-to-earnings ratio, the price-to-book ratio, and the price-to-cash-flow ratio.
The next section discusses the risk-adjusted performance of the Dividend Aristocrats with the best 5-year risk-adjusted returns.
5-Year Risk Adjusted Returns
The 10 Dividend Aristocrats with the highest Sharpe Ratio over the previous 5-year period can be seen below.
One company that I would expect to have some of the strongest risk-adjusted returns has just entered the top 10 for the first time in this analysis: Johnson & Johnson (JNJ).
Johnson & Johnson is the world’s largest healthcare corporation. Its unique combination of strong long-term total returns and low stock price volatility give it an excellent chance of ranking highly among its fellow Dividend Aristocrats.
As before, I also present the 10 worst Dividend Aristocrats for 5-year risk-adjusted returns:
Many of the same names populate the list.
Wal-Mart (WMT) joins the list, also due to the pressures imposed by eCommerce disruptors. T. Rowe Price (TROW) and Coca-Cola (KO) are also members of the bottom 10, due to an industry shift towards passive investment products and increasing consumer awareness of the health effects of sugary drinks, respectively.
Importantly, there are only three Dividend Aristocrats with negative risk-adjusted returns.
Positive Sharpes Ratios indicate that a diversified basket of dividend stocks is almost certain to outperform government bonds on a risk-adjusted basis, which supports our belief that dividend investing is one of the best methods for long-term wealth creation.
The next section compares the risk-adjusted performance of the Dividend Aristocrats in this analysis’ most important time period – over the past 10 years.
10-Year Risk-Adjusted Returns
A 10-year performance lens is much more indicative of long-term total returns than any other time period in this analysis. This is particularly true because a ten-year lookback from today’s date contains the most recent market recession: the 2007-2009 financial crisis.
With that in mind, the 10 Dividend Aristocrats with the best risk-adjusted performance over the past 10 years can be seen below.
While there is a degree of consistency, these 10 companies are considerably different than the 10 best companies using a 5-year performance history. In addition, these 10 companies are highly aligned with those that I would expect to perform well through difficult operating environments.
These two facts together suggest that much of the risk-adjusted outperformance exhibited by these businesses occurred during the 2007-2009 financial crisis.
Qualitatively, this makes sense. Many of the companies on this list have fundamental, intuitive reasons for recession outperformance. Consider the top 5 companies in particular and note how a recession – which tightens the disposable income of the average consumer – effects these companies:
- McDonald’s: Consumers are likely to spend money at McDonald’s instead of a more expensive, full-service restaurant experience.
- Hormel Foods: Consumers may shift spending from more expensive groceries – Whole Foods (WFM), for example – and purchase any of Hormel’s extensive lineup of affordable products, which includes their flagship SPAM canned meat.
- Sherwin-Williams (SHW): Consumers are more likely to invest in paint rather than more expensive overhaul renovations.
- C.R. Bard: As a designer, developer, and manufacturer of medical and surgical equipment, Bard’s sales are generally unaffected by recessions as consumers are unlikely to defer necessary medical expenses.
- McCormick (MKC): Recessions cause consumers to cook more of their meals at home, which increases spice sales and boosts McCormick’s financial performance.
Similar qualitative characteristics that improve recession performance can be seen by looking at the remaining 5 Dividend Aristocrats in the table above.
Moving on, here are the 10 Dividend Aristocrats with the worst risk-adjusted returns over the past 10 years.
Only 3 Dividend Aristocrats had a negative Sharpe Ratio (which means that they outperformed the current 10-year government bond yield over the past 10 years), while only 1 Dividend Aristocrat had a negative total return.
This Dividend Aristocrat is Target, which has returned -0.1% annualized to its shareholders over the past 10 years.
Target’s 10-year historical performance has been significantly impaired by two major business-specific events. These are its credit card data breach and its botched expansion into the Canadian markets. If it weren’t for these events, Target would almost certainly have delivered positive total returns.
The remainder of these Dividend Aristocrats are being harmed by either:
- Low oil prices (Exxon Mobil, Chevron)
- Low non-oil commodity prices (Nucor (NUE), Archer-Daniels-Midland)
- Low interest rates and the movement into passive investment products (Aflac (AFL), Franklin Resources)
- Drug distribution price wars (Cardinal Health (CAH))
All said, the temporary issues harming these businesses mean that passive, contrarian investors should perhaps take an interest in these stocks.
Ranking the Dividend Aristocrats by risk-adjusted returns over varying time periods revealed some intriguing results.
Over 1- and 3-year time periods, many of the best performers were those that are benefiting from short-term price run-up and a temporary, market-wide reduction in overall volatility levels.
Over a 5-year time period, many of the best performers were companies that tend to thrive during bull markets but perform quite poorly during bear markets. Lowe’s (LOW) is one example of a company with these characteristics.
It is only when looking at the Dividend Aristocrats through a long-term lease (10 years) that the truly recession-resistant stocks begin to stand out. The 10-year performance of defensive staples like McDonald’s, Hormel, and Sherwin-Williams stands out among this group of high-quality dividend stocks.