Dividend Growth Stock of the Month for January 2016, Bonus Edition — “Factors” in Stock Selection

This article begins Year 2 of the Dividend Growth Stock of the Month series. I want to begin 2016 with a discussion of what are known as “factors” in the academic world.
But before we get started, here are the Dividend Growth Stocks of the Month that I covered in 2015:

Month Company Article Link
January AT&T (T) January 20
February Digital Realty Trust (DLR) February 11
February Bonus Edition 71 Dividend Champions that Look Overvalued Right Now February 19
March Emerson Electric (EMR) March 12
April Coca-Cola (KO) April 17
May Bonus Edition Apple (AAPL) May 5
May T. Rowe Price (TROW) May 15
June Johnson & Johnson (JNJ) June 25
July Realty Income (O) July 24
August Procter & Gamble (PG) August 6
September Kinder Morgan (KMI) September 21
October International Business Machines (IBM) October 8
November Microsoft (MSFT) November 19
December Main Street Capital (MAIN) December 9

Disclosure: I own all of the stocks in the table except Kinder Morgan. That is a special case; for more details, please see this article.

What are Factors?
Factors are stock characteristics that studies have identified as being correlated with superior total returns over long time periods.

Academics have been studying stock performance since at least the 1950s. At first, stock performance was only associated with risk. You have probably seen the common risk-reward curve:

CaptureUnder this simple model, rewards are correlated with risk. The more risk you take, the more rewards you can expect.

That risk-reward model leads to common wisdom that we still hear today.

  • Want to be perfectly safe? Hold cash.
  • Want to settle for small returns with almost no risk? Buy AAA-rated bonds or government T-Bills.
  • Want to shoot for more rewards? Buy lower-rated bonds.
  • Want still higher returns? Buy stocks – but be aware that they are risky, and you could lose your shirt.

Since the 1950s, several factors besides sheer risk have been identified that help explain excess returns over time. Here is an overview of some of the factors.

Size

Academic studies have long shown that smaller-cap stocks historically have outperformed large-cap stocks over long periods of time. “Cap” refers to the stock’s total value in the market: Shares x price per share. For example, a mega-cap stock example is Apple (APPL): Its market cap is about $550 Billion. By comparison, Clorox (CLX) has a market cap of $16.5 Billion. Clorox is just 3% of the size of Apple in terms of the total value of all of its shares of stock.

S&P has an index covering smaller companies. The S&P 600 Index of small cap stocks has beaten the S&P 500 by 1.3% per year over the last 20 years, with slightly less volatility to boot.

Low Volatility

Perhaps surprisingly, stocks with low volatility have shown a long-term tendency to beat the market. The surprise is that low volatility usually means low risk. As we saw with the simple risk-reward model, higher risk has been historically linked to better returns.

But more recent academic research has shown that the least risky stocks tend to outperform the riskier stocks over long time periods.

Of course, readers familiar with Benjamin Graham’s concept of margin of safety will have no difficulty believing that “safer” stocks may well offer better long-term returns than riskier ones.

S&P has a Low Volatility Index that tracks this factor.

Over the past 20 years, it has outperformed the S&P 500 by an average of 1.1% per year.

Value

If you have read previous Dividend Growth Stock of the Month articles, you know that I make a big deal about valuation. Value is another academically recognized factor. Value stocks have outperformed the general market, in the aggregate, over long time periods.

S&P maintains a Pure Value Index drawn from the S&P 500. It has outperformed the S&P 500 by an average 2.9% per year since 1994, although it has done so at a “cost” of higher volatility.

Quality

This is not a factor that has full academic backing yet.

There are many characteristics of company quality, including gross profitability, growing profits, safety (low volatility, leverage, and credit risk), and payout (payment of a dividend). Of course, in dividend growth investing, we only consider dividend-paying stocks to begin with.

S&P has a High Quality Index, using its own proprietary methods for ranking quality. That index has barely outperformed the S&P 500 over the past 10 years, by 0.4% per year. Other quality indexes formulated by other companies may have better comparative records.

Growing Dividends

This is also not a factor from academia. It has been identified in practical studies by the investment industry. The fundamental finding is that investing in companies with long track records of continuously increasing dividends has been shown to outperform the general market over time.

Dividend Aristocrats are stocks selected from the S&P 500 that have increased their dividends for 25 years or more. The S&P maintains a Dividend Aristocrat index that, through back-testing, has been determined to have beaten the S&P 500 by an average of more than 2% per year since 1991.

Smart Beta

Within the mutual fund and ETF industries, the various factors just discussed are being marketed as a concept called smart beta.

In a nutshell, smart beta funds select and weight stocks to emphasize the smart beta factors. In the past few years, there has been a veritable explosion of smart beta indexes. Examples from S&P were given above for each factor.

Here is the S&P’s depiction of factors that it believes improve returns over time:

CaptureUsing Factors to Select Dividend Growth Stocks
The reason that this article is a “bonus edition” in the Dividend Growth Stock of the Month series is that I am going to use smart beta factors to select many of the stocks to cover in 2016.

Here’s how.

First off, of course, if you are a dividend growth investor, you are by definition capitalizing on the dividend growth factor. I will use David Fish’s Dividend Challengers, Contenders, and Champions (available in a pulldown menu under “Dividend Growth Investing” above) as a fundamental research source. David’s compilation shows that more than 750 companies have dividend increase streaks of 5+ years. The longest streaks are over 60 years.

Second, I cross-reference some leading smart beta ETFs with David’s stocks. The goal is to produce a list of stocks that exhibit not only sustained dividend growth but also multiple smart beta characteristics.

Please note that this is not a scientifically proven model of how to invest, how stocks will perform, or a forecast of future results. The goal is to build upon smart beta factor research to help identify dividend growth stocks for further analysis. The analysis is what we will do in each monthly article on individual stocks.

In an article last August, I performed the cross-reference just described between the Dividend Champions and the stocks in a variety of smart-beta ETFs.

These are the ETFs that I selected for the exercise.

CaptureIn addition, I applied a couple of hurdle rates to eliminate stocks with extremely low yields or dividend growth rates. These are the hurdle rates that I applied.

  • Minimum yield = 2.7%
  • Minimum 5-year dividend growth rate = 4% per year

Here are the results. All of the stocks in this table met the hurdle rates. Each X indicates that a stock appears in that ETF’s holdings. I have sorted the results by the number of X’s that each stock got.

CaptureAs you can see, 23 stocks garnered 3 or more points on this simple scoring system. Several of the companies were ones covered last year: Emerson Electric (EMR), Johnson & Johnson (JNJ), Procter & Gamble (PG), and Coca-Cola (KO) are all in the top 15.

We will get started later this month by selecting our first stock to study from the table above. Not all companies for 2016 will be selected this way, but many of them will be.

The first article for 2016 should be out in a week or two.

I wish everyone the best of success in 2016!

— Dave Van Knapp

10%-Plus Yields from Stocks Like Microsoft, General Mills, Pepsi, Etc. [sponsor]
Not only have I been personally making these "10% Trades" with my own money, but I've been encouraging my close friends and family to do the same with theirs. I'll be pulling the trigger on my next "10% Trade" in the coming days. Details here.