We’ve all heard that famous stat, that dividends are responsible for something like 32% of the S&P 500’s total return1. But are all dividends equal?
Obviously not.
Dividend portfolios, while a valuable investment option, aren’t foolproof. Your success with dividend portfolios, and the experience delivered to clients, hinges on a solid dividend strategy that aligns with their long-term investment objective.
AAMA has managed a dividend growth SMA since 1999, identifying dividend-paying companies that are suitable for a long-term, balanced growth investment objective (which we’ve found to be in line with the lion’s share of dividend-seeking investors). Through this history, we’ve identified four key factors to consider when evaluating dividend investments.
If you follow these factors, you aren’t guaranteed a certain level of return. You aren’t even guaranteed the highest yielding portfolio on the block (in fact, we can pretty much (compliance look away!) guarantee you won’t have the highest yielding portfolio, by design). But what you should have, at the end of the day, is a portfolio that is fundamentally sound, which may provide a yield that actually supports your long-term investment strategy.
Here are four key factors we believe dividend portfolios should revolve around:
Factor 1 — Yield and Security of Yield
For a dividend portfolio you need to look at dividend yield. That’s obvious. But what’s sometimes overlooked is the security of that yield.
It can be tempting to gravitate to ultra-high yielding stocks, but prudent investing calls us to take a step back and consider whether the company has a solid chance of maintaining and growing that yield.
What does that look like?
Start with the index yield (S&P 500, for example), and consider companies with yields above the index. Then, look at the payout ratio of those companies. At AAMA, we place a high premium on companies with low payout ratios. We focus on this metric because it helps us differentiate between companies with reasonable, sustainable dividends and companies whose dividend payment policy may be overextended, with less financial strength to support future payouts.
For example — company X has a 4.5% dividend yield, but sports a 90% payout ratio, and company Y has a 3.5% dividend yield with a 40% payout ratio. Which would you rather own? This is the first and most straight forward step to making the dividend universe more manageable. (The former carries a higher risk for dividend cuts if earnings decline. The latter has more room to increase dividends if earnings increase.)
Factor 2 — Balance Sheet Quality (Debt)
Once you begin to identify companies with sustainable higher-than-market yields, we believe the next check should revolve around balance sheet quality — or debt. AAMA likes to look at debt-to-EBITDA.
Acceptable debt levels will vary across sectors, particularly Utilities and similar segments that have ultra-stable revenue streams. But generally, companies with healthier balance sheets (lower debt in relation to their earnings) will be more fundamentally sound, which further enhances the chance that the dividend payout will be maintained or grown over time.
We layer this screen on top of the yield screen to further narrow the investment universe by quality.
Factor 3 — Valuations
Now that you have a shortlist of companies with solid dividends, filtered by balance sheet quality, it’s time to evaluate whether those companies are available at a relatively attractive price. To clearly assess value, AAMA makes a composite ranking of four valuation data points — Price to Sales, Price to Earnings, Price to Cash Flow, and Price to EBITDA.
Over the years, we’ve found these four components create a comprehensive picture of a company’s relative valuation. We seek companies with relatively lower valuations because they tend to deliver less risk to the portfolio, particularly in periods of market decline. When you own overvalued companies, your portfolio may be more sensitive to negative news, which can translate to higher potential downside risk.
We have found that most dividend-interested investors aren’t seeking market-like volatility. Screening for affordability can help reduce that volatility and establish a stable base for moderate growth. Also, as a fundamental strategist we subscribe to the general belief that relative valuation should be top of mind when making investment allocations, particularly in the presence of strong and stable earnings, which brings us to our next point…
Factor 4 — Earnings
At this stage, you have a basket of stocks that exhibit strong yield, yield that looks sustainable, solid financials, and that are available at a relatively reasonable price. The final screen involves identifying which of these companies are positioned to exhibit business growth, which in turn should support stock price growth and dividend growth.
A lot of data points come into play here. But the goal is simple: find companies that have grown their earnings and that are positioned to maintain or accelerate that growth in the future. In this step, we compare current earnings trends with prior earnings (identifying earnings growth stability), and then current earnings with analyst earnings projections (assessing expected future growth).
In addition to identifying companies with relatively strong growth projections, you can use these metrics to further validate stock price value and affordability.
A Solid Foundation For Dividend Growth
Like most things in life, these four factors don’t come together to form a silver bullet. Nor, do they lend themselves to a black box stock selection methodology. There are a myriad of other considerations that can come into play, such as market capitalization preferences and sector diversification — which should, of course, both be considered.
And like most other investment portfolios, the underlying metrics of each company will fluctuate as the business ebbs and flows with the market. However, with these four factors in focus we believe it is possible to design and manage a quality dividend growth portfolio, if you have the time to compile, filter, and assess the data consistently.
If you don’t have the time, but like the process we’ve outlined above, you can check out AAMA’s Dividend Growth strategy (SMA model). Or, if a more broadly diversified and accessible investment vehicle is preferred, AAMA’s High Dividend Growth ETF strategy. Click here to review a full list of AAMA investment strategies.
We would be happy to walk you through the process in greater detail, help you assess where the strategy might fit into your current investment mix, and discuss how dividends could play a role in your clients’ investment objectives.
Click here to send us a message, or reach out directly at engage@aamamail.com. We’d love to speak with you.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
1S&P 500 Dividend Aristocrats: The Importance of Stable Dividend Income
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