In Part 1 we looked at some of the history of the recent elevated interest in dividend growth investing and dividend stocks in general. In this article, the discussion continues with other parameters that help define the tremendous variability in approaches to investments in this area.
Lastly, there will be a review of the most popular variables and metrics that are used by many investors to try to pick the best companies to achieve their respective goals. During this discussion, the principles, rules and/or metrics that are used by our Model Portfolio will be given.
The first part of this discussion will focus on (1) the typical universe of companies that investors review in order to make their selections; and (2) the minimum initial requirements that are popular for many portfolios.
Starting Universes of Companies
If a screening tool is being used to select candidates, there will be a particular universe that will be used by that tool. Typically, this universe will be some subset of all stocks traded on the major US exchanges, for which the tool has adequate data covering all of the variables that exist within the tool.
Screeners vary somewhat in the universes that are used. Outside of these starting universes, there are three popular universes that are used by many investors. These are (1) the CCC lists; (2) the S&P 500; and (3) various list of index constituents. These are discussed below.
The CCC Lists. The CCC lists, as they are called, are companies culled from the major exchange listings that have at least 25 years of continuous dividend increases (111 champions as of 2015); or at least 10 years of increases (257 contenders); or 5 years of increases (372 challengers).
The origin and composition of these lists were presented in part 1. These listings come from an analysis of all companies traded on a major exchange in the US. This includes certain foreign companies whose ADRs are not listed in the pick sheets, but most foreign companies are not included in this universe.
The S&P 500. Another popular universe is the S&P 500 itself. The S&P 500 is group of 500 widely held stocks on the New York Stock Exchange, and is intended to represent the whole US Stock Market. They are chosen by a Standard & Poors committee, and there is significant movement of companies into and out of this group.
The S&P 500 also selects stocks from different sectors such that the group has the same proportion as they are represented in the domestic economy. Again, the main purpose of the S&P 500 grouping is to represent the total stock market as closely as possible.
Dividend Index Constituents. As noted last month (history of the interest in dividends), the major data providers have created many different lists of dividend payers. Mergent has its “dividend achievers” both domestically and internationally. Also, Standard and Poors’s created its “dividend aristocrats” and Dow Jones’s made a list of “select dividend payers”.
Each of these data providers have created several dozen different lists of dividend payers, and has created related indexes which are then licensed to the mutual fund industry. In any case, such lists provide a fertile basis for researching and selecting companies for a dividend growth portfolio.
Some of the investment management firms have created specialized dividend growth lists. For example see UBS’ list, called Dividend Rulers.
There are certain very popular categories of dividend payers that were excluded from the various listings mentioned above. These categories of assets were therefore left out of most indexes and the funds that have been based on these indexes.
Over the years, Congress has created legislation that allows industries in certain favored sectors to convert to a structure that is tax free, from a corporate standpoint. However, these legislatively defined companies must then pay out a large proportion (typically about 90%) of their “earnings” to shareholders.
These dividend- paying structures include Business Development Corporations (BDCs), Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs).
All of these have special legislative requirements, can be either listed (tradable) or not, and must submit quarterly reports to the SEC. Also, there are numerous funds and ETFs which specialize in these types of corporations.
BDCs essentially operated similar to a venture capital or private equity firm, making loans to small and mid-sized companies. BDCs were created by Congress in 1980 as an amendment to the Investment Company Act of 1940.
MLPs were created around the same time, and are now restricted to natural resource and energy activities. MLPs have a two-tier structure, where there is a general partner and limited partners, who are called unitholders.
REITs are much older: they were created in 1960, and brought the benefits of commercial real estate investing to all investors, rather than just large financial intermediaries and wealthy individuals.
There are probably close to 400-500 funds and ETFs covering these three types of investments. Almost all dividend growth portfolios that are available for review will contain a few of these high-yield, income- oriented, legislatively-enabled types of companies.
Our Model Portfolio is restricted to the common shares of regular “C” corporations. It uses the universe of all domestic and foreign companies that are tradable in some manner on the US markets, or from a US-based platform.
About one-third of the companies in the Model Portfolio have foreign domiciles, where dividends are declared in non US dollars. In some years, currency exchange rates make dividend income gains very large. In other years (such as 2015), these income gains are paltry.
Minimum Initial Requirements
Many investors have certain preconditions on admission to their dividend growth portfolios. These are various measures or levels that each company must pass or else be denied membership in the portfolio.
Some of the most popular of these are credit ratings, yield levels, and valuations, each of which are discussed below.
Credit Ratings. Some investors require an investment grade credit rating from one of the major credit rating agencies. If such a requirement is in place, usually a credit rating of BBB+ (S&P) or better would be required.
Yield Levels. This is the variable where there is the most variation. First of all, there are those who require a minimum initial yield and those who don’t. Secondly, there are those who reach for high yields in their selections and those who don’t.
This usually divides investors into those who are willing to give up growth of the dividend for a higher starting yield and those that are not so willing.
At one extreme, there are those whose portfolios consist of companies that are expected to grow, and whose current yields are paltry. At the other extreme, there are those whose portfolios consist of very high yielding stocks, with very little prospect of income growth.
Valuation. There have been many attempts at measuring the extent to which a stock reflects good value. Some of these methods compare present price/value with historical levels, referred to as “relative valuation”.
Some methods use a computed metric, such as the discounted cash flow models and their relatives. Some use complex scoring schemes on a set of metrics. Every analyst has their favorites. 5 of the most popular ones are listed below:
Gordon Growth Model and other Discounted Dividend Models
These methods take all future cash flows from dividends and discount them back to the present in order to arrive at a value for a stock. If these computed values are lower than the current value of the stock, the company can be said to be undervalued and therefore a good buy. There are many variations of these discount models.
Value Line’s Safety Ratings
Value Line gives a safety ranking to about 1700 US traded stocks, which is intended to measure the total risk of a stock relative to other stocks. Stocks with Safety ranks of 1 (high) are often associated with large, financially sound companies.
S&P Quality Ratings
The S&P & Dow Jones Indexes has provided Earnings and Dividend Rankings, commonly referred to as Quality Rankings, on U.S. common stocks since 1956.
These Quality Rankings reflect the long-term growth and stability of a company’s earnings and dividends. These rankings are widely used and available in various data platforms.
Morningstar’s Star Ratings
Morningstar’s star system for stocks is different than the star system begun in 1985 for funds. The system for stocks is actually a discounted cash flow model attempting to predict a stocks expected return.
Graham Numbers
Graham Numbers were first proposed as an implementation of Benjamin Graham’s guidelines for buying a stock. The Graham Number puts a limit on the combination of the P/E Ratio and the Price/Book ratio.
These should average 15 and 1.5 respectively, giving a combination of 22.5. A company with a P/E ratio of 9, and a Price/Book ratio of 2.5 would also qualify, since 9 X 2.5 = 22.5.
The Model Portfolio has two preconditions: (1) its current yield must be more than the current 10 year average of the CPI (about 2.61%); and (2) it should not be valued at a significant premium to its historical/average level.
Conclusion
This discussion about initial portfolio requirements and starting universes of stocks shows that there is great variation in the approaches taken to dividend growth investing. These differences occur before a portfolio is actually constructed.
In a future article, the most popular variables/metrics that are used to select specific companies are presented. Yet more variation in approaches will be detailed, and all approaches will be compared to the Model Portfolio.
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