Published on December 27th, 2019
This guest contribution series is by Trond K. Odegaard, MBA; CEO at VikingDividendIncome LLC.
This is part one of a three-part series discussing portfolio construction/management using dividend growth stocks. In this first installment, we’ll dive into theoretical considerations to show the art of the possible. In subsequent installments, we’ll dive into practicalities – more of a how-to primer.
Portfolio Management Approaches
There are probably as many different approaches to portfolio management as there are breeds of dogs. The very popular indexing approach, instituted by John Bogle and Vanguard, is based on a belief in the efficient market hypothesis developed by Eugene Fama and others back in the 1960’s. In its simplest form it says that you can’t beat the market, the market is ‘always’ fairly priced. There have been more phD theses written on this topic than almost any other in finance. But is the market, or more to the point, are individual stocks, always fairly priced? If so, how does one explain the tremendous gyrations in the market, day-to-day and week-to-week. Does underlying value really jump around that much? If stocks are not always fairly priced, how can we discern when they are not?
Other approaches, inherently begging to differ with the efficient market hypothesis, include growth stock investing, value stock investing, yield oriented investing, and sector rotation. Growth stock investors don’t mind paying up for the next best thing, and are willing to bet on the come (an old horse racing expression). If they’re right, they win big, if not, they lose big. Value stock investors like a good deal; they’re bottom fishers looking for that cheap out-of-favor stock that pays a nice dividend and/or that will appreciate when everyone else recognizes its value. Yield oriented investors want cash flow. They live on a diet of MLPs, royalty trusts, BDCs, CEFs, REITs, and mREITs. They don’t expect much if any price appreciation, they just want to garner that high distribution – and they hope the dividend won’t be cut. Though so often it is. Sector rotators buy stocks in sectors they think are coming into Wall Street’s favor, and sell those that they think are becoming disfavored – given the particular phase of the economic cycle or other factors in the economy. Sector rotators explicitly recognize the volatility and cyclicality inherent in the market, and try to profit from it.
Lastly – a classic – dividend growth stock investing, is mostly a buy-and-hold approach that invests in companies that have paid a growing dividend for x number of years. For example, so-called Dividend Aristocrats have paid annually increasing dividends for 25 consecutive years; Dividend Kings for 50 years. Dividend Achievers have done this for 10 years. Now, one could just buy a collection of these stocks, with no further analysis, and assume the future will be like the past. You’d do at least ok, and probably even well over a five-year timeframe. However, by applying fundamental analysis to these stocks, and identifying those that are currently healthy and that are also currently fundamentally undervalued, one can in principle do much better. By applying technical analysis, to obtain a better entry point, you should be able to do better yet. That is, of course, if you don’t buy into the efficient market hypothesis. All this assumes inefficient markets.
But the basic idea is this: buy solid companies, which are both investor friendly and have the wherewithal to pass along that friendliness in the form of cash to investors. Then reinvestment of the growing dividends, compounding, and price appreciation, will be your friend too. These are good friends to have. This approach has much to recommend it. I’ve been investing for over 35 years, and was in the investment business for 20 years, and this is the second-best approach I’ve found (the best involves active management of dividend growth stocks).
The empirical research establishes that Dividend Kings and Aristocrats do better than an indexed approach over a long timeframe – and that they do especially well during market downturns. But you can do better than Kings and Aristocrats, without taking more risk. I didn’t accept that their low yield was the best that could be done. And if you think about it, it isn’t necessary for a company to annually increase the dividend – as the Aristocrats and Kings have. You expect a company to increase the dividend annually during normal and good times. But in a recession, it’s only necessary that they don’t cut the dividend. My concern, and maybe it’s yours too, is to have a floor on my income. Something my family and I can depend on. In good times, the dividend will grow – but in bad times, I just want the companies in my portfolio to hold the dividend steady. By relaxing the requirement for continuous annual dividend increases going back through to the last recession to ‘merely’ not cutting the dividend, the universe of companies in which to invest is increased – and so is the yield opportunity. You can find a study of how a portfolio of such stocks performed during the Great Recession here.
Active Management Approach
Next, we’ll discuss an approach using dividend growth stocks paired with active management to capture return from price volatility. The goal is to have the best of all worlds: a portfolio of dividend growth stocks to provide a floor of dependable, secure dividends in bad times, with likely dividend growth during good times and the potential for significant realized gains from active management. We will accomplish this goal by employing fundamental analysis and technical analysis. The underlying belief is that not only does price fluctuate around value, but that undervalued and cheap stocks can be identified and price volatility can be captured. Not every time, never with complete certainty, but consistently enough to make the effort worthwhile. This active approach is particularly suitable for tax advantaged vehicles such as IRAs, where realized gains are not penalized.
A little bit of simple math helps make the basic ideas clear. The foundational return equation is:
Equation 1: Total Realized Return ($ in your pocket) = [Book Value*Dividend Yield*Dividend Capture Efficiency] + [Dividend Growth Return] + [Book Value*Weighted Average Price Return*# of Portfolio Turns].
First, a few words about terms in the equation: Total Realized Return ($ in your pocket) is the cash from both dividends and realized gains. Book Value is the purchase cost of the portfolio. Dividend capture efficiency is the percent of dividends captured versus the potential amount available. It will be 1 in a buy-and-hold portfolio, since no cash is held under these circumstances, and 0 if you go to cash and stay there all year. This is a term that doesn’t even appear on the radar in a buy-and-hold portfolio, but it is a friction that can become important in an actively managed portfolio. Weighted Average Price Return is the total realized gain divided by the total dollars sold (at cost). It is both a realized value and a hurdle rate to be managed. # of Portfolio Turns has its conventional meaning depicting portfolio activity.
Dividend Growth in any year is only about 1/40 of the Dividend Yield term, so we can ignore it for the moment. Here’s an example for a 5% yielding portfolio with an expected 5% average dividend growth rate: 0.05*1.05 = .0525, the return increment is 0.0025. Divide this by two, assuming the increase occurs over the course of the year. Only a 0.00125 increase versus the initial 0.05, or 1/40th. Over the course of 15 years, amazingly, this rate of compounding will double the effective yield of the portfolio [1.05^15 = 2.1]. But in any one year, it is a negligible component.
Note that the approach discussed herein is focused on realized return through dividend capture and price volatility capture. To capture price volatility means to realize gains on appreciated positions. Unrealized gains are nice, but they don’t put food on the table. Unrealized gains are ephemeral. Here today, gone tomorrow. Realized gains, when reinvested, increase the base upon which dividends and further gains are earned. Unrealized gains do not. They sit idle. So, in the equations shown herein, recognize that the Book Value term is ever increasing from the gains realized and reinvested. This provides a boost to dividend generation that the equation doesn’t show explicitly, but that is properly regarded as a beneficial side-effect of active management and an offset to dividend capture inefficiency.
Dropping the dividend growth term for now, and collecting the common term (Book Value), we obtain:
Equation 2: Total Realized Return ($ in your pocket) = Book Value * [Dividend Yield * Dividend Capture Efficiency + Weighted Average Price Return * # of Portfolio Turns].
We identify two interesting special cases. First, in a buy and hold approach, you would add back in the dividend growth term, since over time it’s a significant driver of total return. Dividend Capture Efficiency would be 1, since you’re never in cash and never miss an ex- dividend date. # of portfolio turns in theory essentially goes to zero in any given year, so the second return term would drop out. But realistically, since these are not only dividend growth stocks, but also undervalued stocks, realized gains would eventually be taken. So, over a 5-year horizon we would expect a meaningful return from realized gain. But why wait? You and I might be dead in five years. If the market is willing to cooperate, and if price does gyrate around value, and if this volatility can be captured, these gains are available this year. Perhaps even this month. And these gains can become an annuity, to be harvested methodically, not just as a one-time capture event. Again, as long as the market cooperates. But as they say, make hay while the sun is shining.
A second special case occurs when the Weighted Average Price Return ~= the Dividend Yield. We can then simplify Equation 2 further to illustrate some key points:
Equation 3: Total Realized Return ($ in your pocket) = Book Value * Dividend Yield * [Dividend Capture Efficiency + # of Portfolio Turns].
In the process of capturing gains, if you can avoid being in cash for too long (before re-investing in a new ‘cheap’ stock) and missing ex dividend dates, the Dividend Capture Efficiency should be close to 1 – what it would be in a pure buy-and-hold portfolio.
Note: Having said this, there are times in the market when holding some cash, even a lot of cash, is exactly the right thing to do – when the weekly SPY MACD peaks, for example.
If you can, say, obtain 1 portfolio turn in a year, then 1 plus 1 = 2 inside the square brackets in equation 3, and you would double the return versus a pure buy-and-hold. Two portfolio turns would triple the return versus a pure buy-and-hold. That’s the potential of this approach. An ideal year would be one where Mr. Market goes sideways or trends up, with tons of volatility. Up one month, down the next, up the next month: 10 or 15 points on the SPY, up and down, down and up, is all that’s needed for this to work.
A Pony Express Analogy
A simple analogy will help illustrate and solidify the main points made so far. Imagine we’re going on a long horseback ride. It is long enough that we’ll want fresh horses along the way – rather like the Pony Express. We’ll hop from our first horse as it gets tired, onto a fresh one (and so on and so forth), and in the process not fall off and break our neck. What does this trip require? It requires a stable of strong horses, knowledge about when one is tired and when another is fresh, and not falling off as horses are exchanged in mid-flight. Think of a company that has a good yield (say, greater than 4%) and that will likely maintain its dividend through bad economic times with no cuts. This is a strong horse. You want a horse like this in your stable. This is where assessing dividend safety, using fundamental analysis, enters in. For my money, there’s nothing like looking at cash flow. It tells you 90% of what you need to know. Cash flow pays the dividends, not earnings. Cash flow pays the debt, not earnings. And companies will always pay debt before they pay dividends, if push comes to shove. Companies with consistently growing cash flows, well in excess of the dividend payments, and with a reasonable debt level relative to their equity and relative to the cash flows, are what you want in your stable. You can learn more about my approach to dividend safety here.
But any of these strong horses in the stable may be tired. Before you saddle up, you want to determine whether the horse is tired or fresh. A stock that is undervalued based on long term (5 years) fundamental analysis is the first requirement for being ‘fresh’. But you also want that stock to be cheap, at the lower end of its near-term trading range. This is where technical analysis enters in. If a stock is both undervalued and cheap, then it’s fresh and ready to ride. In part 2 of this series, we’ll discuss how technical analysis can be used to pick good entry points, trying to avoid that bad taste in your mouth from having the price of a stock drop as soon as you buy it. Lastly, think of hopping from one horse to another as selling one stock that has become rich, to rapidly buying another stock that has become cheap – thus not sitting in idle cash and degrading the dividend capture efficiency. Technical analysis is used here too, and in the third installment, we’ll discuss taking gains as part of an active trading strategy. This, in short, is the game to be played: we want to have only strong horses in our stable, and saddle up and ride only fresh horses, and then adroitly jump from a tiring horse to a fresh one.
In our next guest article, we’ll discuss how to use technical analysis to select cheap stocks and identify entry levels.