Low
interest rates have propelled dividend income investing to greater popularity in recent years than at any time in the past six decades.
Despite dividend-investing's recent popularity, many investors still only look at one facet of the power of dividend investing:
dividend yield. These investors point to the fact
that dividends have represented 40% of the total return of stocks since 1960 and that many dividend stocks yield more than short-term Treasury bonds. But that is where they stop, and in doing so, they miss an important quality of dividend investing: dividends
are more than income, much more.
The most important element of
dividend investing is the statistically significant long-term relationship between dividend growth and price growth. Understanding this relationship is the key to
unlocking the true power of dividend investing.
Dividend
Growth Drives Price Growth
Comparing dividend growth with price growth is among the most convincing ways of determining the fair value of a stock. One important reason is that dividends are real cash, which can't be masked by clever accounting tricks.
Furthermore, corporate boards of directors approve dividend hikes only at rates they believe the company can easily afford. They know investors take a dim view of dividend cuts. This makes a company's long-term dividend growth rate a solid indicator of its long-term value, and, ultimately, it long-term price growth.
Since 1960, the correlation between the dividend
growth and price growth of the Dow Jones Industrials has been over 90%. This close relationship between prices and
dividends enables investors to make educated guesses about the fair value of the DJIA.
Losing
Sight of the Dividend
If long-term dividend growth is predictive of long-term price growth, why do so many
investors abandon dividend-centric investing during hot markets?
The reason,
perhaps, is one of simple math. In 2013,
the total return of the S&P 500 was nearly 30%. Dividends represented only 2% of that
total. During times of significant
market increases, the contribution of dividend yield to total return seems so
small that investors wrongly conclude that dividends are no longer
important.
It is
during these hot markets that many investors stop watching their
dividend valuation metrics and opt instead for whatever the popular
opinion is among the gurus on CNBC, the touts from the Wall Street Journal or,
heaven forbid, whatever is being discussed in their local newspapers.
In doing
so, they eventually find themselves licking their wounds on the sidelines of
some future bear market.
About 20 years ago, we developed a simple model that calculates the fair value of a stock or the market based primarily on dividend growth along with a dash of earnings growth and changes in interest rates. We discussed this model in last week’s blog.
At the beginning of 2013, our Dow Jones Industrials (DJIA) model indicated that stocks were about 25% undervalued. The undervaluation was caused by the hangover from the Great Recession of 2008-09, which left prices well under their fair values.
At the beginning of 2013, our Dow Jones Industrials (DJIA) model indicated that stocks were about 25% undervalued. The undervaluation was caused by the hangover from the Great Recession of 2008-09, which left prices well under their fair values.
Since last year was such a big year for stocks, to determine if the market has anything left in its tanks, we need to assure ourselves that dividends and prices are still linked. If they are, the market has room to move higher. If, on the other hand, stocks
are moving independently of dividends, we should become much more cautious, and perhaps start moving towards the exits.
Dividend Growth vs. Price Growth in 2013
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| Sector-by-Sector Dividend Growth vs. Price Appreciation in 2013 |
The chart
above plots the relationship between the median dividend growth (horizontal
axis) and total return (vertical axis) for the nine market sectors in the S&P 500 for calendar year 2013.
It doesn't
take more than a casual glance at the chart to see there is a correlation
between the dividend growth and total return data. At first glance, the market appears to be doing the kind of job we would expect it
to.
Upon a closer
look, however, there are two sectors that don't display a true symmetrical fit: technology (XLK) and energy (XLE). These two sectors' high median dividend growth rates were not proportionately rewarded with high enough price growth. As we
pierce into both of them, however, we see that there is something unusual going on that
distorts the relationship between dividend growth and rate of return.
1. Energy
in 2013, the Energy
sector (XLE) had dividend growth second only to Technology, but was near the
low-end of total return. Breaking
down the Energy sector a bit more provides an explanation for this
phenomenon.
About half
of the sector is made up of smaller businesses under the sub-sectors of
"Exploration and Development" and "Drillers". Dividends for these companies have exploded
because of the boom in the U.S. oil shale business.
The large
increases in these companies' dividends are not reflected in the overall total return
for the sector because they are overshadowed by the larger companies, such as
Exxon Mobile (XOM) and Chevron (CVX), who have significantly slower dividend
and price growth.
When you
look specifically at these smaller, higher dividend growth companies, it
becomes clear that they have been rewarded for their growth. In 2013, the SPDR S&P Oil & Gas
Equipment & Services ETF (XES), which consists primarily of these two
sub-sectors, was up nearly 30%. Over the
past 3 years, dividend growth for XES has averaged over 31% annually.
2. Technology
The chart
also shows that Technology (XLK) did not get rewarded fully for its high dividend
growth.
The reason for this lies in the dividend history of the Tech sector. Technology
companies do not have a long history of paying and increasing their dividends. Indeed, in the late 1990s and early 2000s,
many technology companies went on record saying that they would never pay a
dividend.
That has
changed in recent years, but the new attitude toward dividends has come largely from pressure from shareholders. Shareholders have rightly asked for their fair "cut" of the cash flows that Tech companies have been generating.
Some of the
larger technology companies, such as Microsoft (MSFT) (2.6% yield and 16.3% three-year average annual dividend growth) and Intel (INTC) (3.4% yield and 13% three-year annual dividend growth), have become significant dividend payers. Cisco (CSCO), which began paying a dividend in
2011, raised its dividend 54% last year.
However, investors
still remain somewhat skeptical that the technology stocks will
continue to be dedicated dividend payers. As a result, the market did not fully reward the tech sector for its
dividend growth in 2013.
Having
spoken to many of the large technology companies, we are convinced that they are firmly
committed to the dividend. Therefore, we believe the Tech sector may be among the best places to look for bargains.
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| Sector-by-Sector Dividend Growth vs. Price Appreciation in 2013 (excluding XLE & XLK) |
Removing
the energy and technology sectors from the chart makes the correlation between dividend growth
and price growth for the seven remaining sectors even more obvious than in the previous chart. A linear regression of the above data reveals
a significant relationship with an r-squared of near 0.80.
What Does It Mean?
Even in a
year where price appreciation dwarfed dividend yields, the tight correlation
between relative dividend growth and price growth was almost symmetrical. The way the market paid for dividend growth in
2013 indicates that it is operating rationally. If it were not, the correlations between price growth and dividend growth for the sectors would have been random.
Finally, as reported in our last blog, our DJIA valuation model is indicating that stocks are about fairly valued. The big year in 2013 closed the gap on valuation, but did not send stocks into an overvalued condition.
Finally, as reported in our last blog, our DJIA valuation model is indicating that stocks are about fairly valued. The big year in 2013 closed the gap on valuation, but did not send stocks into an overvalued condition.
There are
many commentators who are suggesting that dividend investing has run its course
and will not be successful in the future.
This is the crowd we have named the Divi-dont’s. We, on the other hand, remain convinced, as we
have been over the last 20 years, that dividends are actually
growing in importance. Therefore, we
proudly count ourselves as members of the Divi-do’s.
Employees and clients of DCM own all of the above listed securities.
Employees and clients of DCM own all of the above listed securities.
