Last year, I wrote an article that took a deep dive into “smart beta.” That is the investment industry’s term for weighting portfolios according to certain investment “factors” instead of conventional weighting by size, which is called cap-weighting.[ad#Google Adsense 336×280-IA]The factors have been determined by studies of large groups of stocks to lead to better long-term returns.
Many of the studies are academic, while others have been produced by the investment industry itself.
A multitude of ETFs have been launched in the last few years to exploit smart beta factors.
Some concentrate on a single factor, while others are known as multi-factor ETFs.
There are now more than 500 smart-beta ETFs.
These are the most widely recognized smart beta factors:
• Low volatility
• Smaller company size
• Dividend growth
Two of the above six factors are not academically recognized, but rather have been derived from industry studies.
• Low volatility contradicts academia’s concept (embedded in Modern Portfolio Theory) that higher rewards are associated with higher volatility. Non-academic studies suggest otherwise.
• Dividend growth contradicts academia’s principle that dividends are irrelevant. Again, non-academic studies suggest otherwise.
In this article, I will utilize all of the factors except momentum, because it has a short-term orientation. Most dividend growth investors are interested in long-term results.
How Do You Find Dividend Growth Stocks with Smart Beta Factor Tilts?
In this article, I want to identify dividend growth stocks that qualify as smart beta stocks on one or more dimensions beyond dividend growth itself.
How I do this is to use smart-beta ETFs to identify stocks that display the various factors. Then I cross-check those stocks against David Fish’s Dividend Champions, Contenders, and Challengers.
The goal is to produce a list of stocks that exhibit not only sustained dividend growth but also one or more of the other smart beta characteristics. Theoretically, these should be highly desirable stocks to own.
Here are the steps:
1. I used the Dividend Champions [CCC] spreadsheet to define “dividend growth stock”: A US-traded company that has increased its dividend for 5 years or more in a row. Any stock failing this simple requirement is not on the CCC, and therefore it is not in the results here. As of the end of May, the CCC had 778 dividend growth stocks in its database.
2. I deleted more than half the CCC stocks before checking for smart-beta factors. Removed were:
• Stocks with yields < 2.0%. These are shown in red in the yield column of the CCC. This took the number of eligible stocks from 778 down to 537.
• Stocks with 5-year DGRs (dividend growth rates) < 4.0% per year (or designated as “n/a”). I did not remove such stocks if their yield was 4.0% or greater. This step took the eligible number down to 444.
• Stocks with a frozen or overdue dividend increase shown in red on the CCC. This reduced the survivors to 380.
3. I selected 10 ETFs to represent the factors.
For all of the ETFs, I used the top 25 holdings as shown on Morningstar for that ETF. Most ETFs have more stocks than that, but they are generally weighted – following smart-beta principles – to emphasize the smart beta factor(s) rather than sheer company cap size.
4. After hiding many CCC columns for clarity of presentation, I added 11 columns, one for each ETF in the table above plus a column for total score. Each stock gets a point for each smart-beta ETF that it appears in. Thus those stocks that display more smart-beta factors get more points.
5. I hid the rows with no X’s and sorted on total points.
Here Are the Results…
There are 60 stocks that made it through with at least 1 point. So of the 778 stocks to begin with, < 8% made it to the end of the grading process.
Here are the results, presented in 3 groups for visual clarity:
Observations and Comments
As you can see, 12 stocks garnered 4 or more points on this simple scoring system. Most of them would be in any Dividend Growth Hall of Fame: AT&T (T), Johnson & Johnson (JNJ), PepsiCo (PEP), ExxonMobil (XOM), Procter & Gamble (PG), and McDonald’s (MCD) are all in this group.
Other great dividend growth companies appear further down, including 3M (MMM), Coca-Cola (KO), United Technologies (UTX), Altria (MO), Lockheed Martin (LMT), and Southern (SO).
Please note that being a value-style stock in a smart-beta ETF is not the same as being well valued. Always check valuations as part of your due diligence process. You may find that many of the stocks in the table, while being great companies, have unfavorable valuations at their current prices.
Many of you have been following the valuation articles that I publish twice per month on Daily Trade Alert. I have already covered some of the smart-beta stocks in those articles, and going forward I evaluate a few more from the tables above.
Most dividend growth investors use smart beta factors when they are selecting stocks. They just do not think of them as smart beta factors. For example, many investors have methods to judge quality. Almost everyone checks valuation. A lot of us look for low volatility. And of course, we all look for dividend growth.
Smart-beta ETFs can be useful in identifying candidates for your portfolio. But finding candidates this way does not replace due diligence. Depending on your goals and needs, any index is going to contain bad apples that you would normally discard, not to mention good candidates that are badly valued at the moment.
So, as always, do your own work and make your own judgements.
— Dave Van Knapp[ad#wyatt-income]
Disclosure: I own T, JNJ, PEP, PG, IBM, MCD, MSFT, BA, KO, PM, SO, LMT, and KMB.