Is dividend growth investing setting up a generation of investors for devastating losses by ignoring this major macro risk? What you don't know could hurt. This article was written by Evan Bleker, private investor and founder of Broken Leg Investing & Net Net Hunter.
Have you been sucked into the dividend growth investing trap?
When everybody is thinking the same thoughts and doing the same things, its time to get concerned. Today there's a mania over dividends and the fantastic passive income stream they're supposed to offer.
The current strategy of choice is known as "Dividend Growth Investing". Dividend paying stocks are commonly thought to be a safe way to invest and dividend growth year over year is assumed to be a solid bonus which will significantly grow passive income over time. The problem is investors haven't recognized two major risks that will disrupt returns, one of which will put their entire portfolio in jeopardy.
How Dividend Growth Investing Is Supposed to Work
Dividend Growth investing has gained a serious head of steam in the last 10 years. Its strategy is simple: you buy stocks that are paying dividends and have been growing those dividends for a significant number of years in the past. Other factors such as payout ratio, dividend coverage ratio, dividend yield, and the actual rate of growth are less important but still significant factors in selecting dividend growth stocks.
The preference for seemingly solid firms that are growing their yearly dividend payments is totally understandable. Interest rates are at all time lows, so it's difficult to find decent yield if you're looking for investment income. Dividend growth investing is all about paying up today for an income stream that will keep growing well into the future. Combine that with Buffett's influence, which has pushed investors to seek "great businesses at decent prices," plus the natural revulsion investors have for troubled firms and the result is potentially lethal.
Investors can quickly and easily find a bizillion dividend screening websites on the Internet, and filter to their heart's content. The whole project sounds perfect - another red flag.
Are Dividend Growth Investors at Risk of Losing their Life Savings?
Maybe not, but investors could easily see a substantial chunk of their life savings wiped out.
The issue isn't with the dividend payments themselves, or buying growing firms. Actually, the largest risk to the investment strategy is a major macro event that's totally out of of an investor's control: interest rates.
Here's the crux of the problem: Warren Buffett calls interest rates "financial gravity." Essentially, all financial assets that pay some sort of income stream (earnings, dividends, interest income) are priced relative to government interest rates.
Dividend yields today are razor thin, and stock PEs near nose-bleed levels, compared to historic standards. This is mostly because the US Federal Reserve has pushed down the yield on US government bonds to ridiculously low levels. Short term US government bonds are thought to represent the "risk free" interest rate that investors can earn on their money so all other assets are priced relative to these government bonds. If US government bond yields drop, investors shift some money into higher yielding stocks or bonds pushing those prices up and their yields down to fall in line with government bonds.
This has been a boon to investors over the 20 years. As interest rates have steadily fallen, the price of stocks and bonds have risen, keeping the stock and bond markets buoyant and even providing nice capital gains. Today, we're sitting at the lowest interest rates not just of the last two decades or last century, we're at the lowest rates of the last 5000 years. This situation can't last.
The problem comes when interest rates begin to rise - as they inevitably will. While the very long term trend has been towards lower yields, interest rates are still cyclical. They still move up and down to keep inflation in check and help spur the economy along. With interest rates at the lowest point in 5000 years, which way do you think they'll likely move?
Let's walk through an example using a hypothetical US government 30 year bond, yielding 2%, and a hypothetical company called Divomatic with a $100 stock. Let's also assume that, just like government bonds, Divomatic's earnings aren't growing. On the other hand, the company's financial position and business is pretty solid so investors have priced its stock to yield 4%.
As an investor, you are faced with a tradeoff. If you were looking for higher yield you would buy Divomatic but if you were looking for a rock solid stream of interest payments you would buy US bonds. So what would happen if US bond yields rose to 4%? In that case, both Divomatic and US 30 year bonds would be yielding the same amount, so which would you rather put your money into?
Given the same growth rate and the weaker safety of Divomatic's earnings, you'd place your money into government bonds. In this case there is no real advantage to owning Divomatic stock, but there is substantial downside risk.
Other investors tend to agree, so when government rates rise investors pay less for stocks or non-government bonds. Prices fall to reflect the proper relative valuation. In the case above, Divomatic's dividend yield would have to double to regain its correct relative valuation versus US government bonds. As a result, its stock price would be cut in half from $100 to $50. Investors who bought Divomatic stock would have lost half of their principle investment. And, it wouldn't be a short term loss, either. That money would be gone forever.
Today, 30 year US government bonds yield. 2.35%, and dividend growth stocks aren't yielding much more. When US government rates eventually rise, investors who invested in stocks priced on yield or earnings will lose a lot of money.
Another Major Problem With Dividend Growth Investing
Growth is a beautiful thing. Is there anybody who doesn't want to earn a solid growing stock?
Not that I know of. And that's one of the major problems with the dividend growth investing. Many of the most promising dividend growth companies have been spotted and bid up in price as investors anticipate a long string of growing dividend payments. But what if the company doesn't deliver?
Companies slip up all the time. Consider Best Buy, which was a growth investor's darling for more than a decade. Looking back at the company it was easy to see a fantastic record of earnings and growth. The firm had a solid Balance Sheet and was buying back stock. That stock was bid up to reflect the firm's past record but in 2006 there was a sign that the firm's great performance wouldn't last. It's growth began to slow down and the firm's solid performance slipped into losses. The stock sunk from $58 in 2006 to just $12 by the end of 2012. Investors lost 80% of their investment... and the stock has yet to recover its former highs 10 years later.
Is this a one-off?
Firm's suffer major declines in performance all the time. Yale lecturer Richard Foster found that the average lifespan of an S&P 500 company dropped from 67 years in the 1920s to just 15 years as of 2015. One of the major reasons firms are removed from the index is due to financial distress.
In 2015 a total 44 of the S&P companies paid out over 100% of EPS, the highest number in over 10 years. Consensus thinking is that dividend growth over the coming year will slow by about 45%. This is an early sign of financial stress.
In addition, there are lots of corporations no longer investing in revenue generating assets. The trend is to use cash flow to shrink shareholder equity. This pumps up reported earnings but eventually even this game has its limits. The stock price history of companies cutting dividends is not pretty. Just ask the victims.
Unfortunately, dividend growth investing precludes strong margins of safety that would help protect against declining performance. The main focus of the strategy is on growth, not protection of principle which requires a strong margin of safety. Trees do not grow to the sky. By paying up for assumed growth, investors are putting their capital at serious risk in the hopes of an increasing passive income.
Growth Stocks Underperform Long Term
"I'll just buy the good ones. There are plenty that I can find on screeners, or on ____ website."
Let's face the facts: if you want to own a nice stream of growing dividends then you have to select firms with durable competitive advantages, or moats, just like Warren Buffett does. Failing this, your firm's performance is likely to revert to a more typical level of profitability and growth and your stock's value is likely to crater as a response.
This phenomenon is known as reversion to the mean and is so common that it's essentially a basic natural law, like the law of gravity. Even Buffett's moats will see their performance erode over time (...many, such as the Washington Post, have...). Moats don't protect a castle forever. Eventually new technology is developed and the castle's walls are breached.
But let's suppose you do try to focus on finding firms with moats. Warren Buffett makes this sound like a great way to spend your time and fairly easy. Of course, everybody can spot the easy moats - Coke, Harley Davidson, Google - but the easy moats are always the more expensive companies to buy. What if you're wrong? And most investors under-estimate the skill and experience you need to actually do what Warren Buffett does, a phenomenon I call The Warren Buffett Trap.
The dividend growth stocks that you now see on stock screens and your favourite dividend growth investing website are the survivors. They're the firms that have lucked out and stood the test of time while their peers, all seemingly decent investments, fell by the wayside. The survival of a growing, dividend paying, firm over a large number of years either comes down to chance or a moat... and the firm's past results play no role in the company's current business. What does a company's 1988 payout ratio have to do with where the firm is heading today?
How to Earn a Growing Investment Income Stream While Protecting Your Downside
Want fantastic market-beating returns?
Want a good and growing income stream while protecting your downside?
Dividend growth investing is not the way to do it. An ever-increasing mountain of studies show that growth stocks dramatically underperform value stocks over a long time horizon. While the two styles may cycle back and forth based on investor sentiment, the sure money is on value investing long term.
When it comes to dividend paying stocks, there's a lot of ways that investors can reach for yield. But, unfortunately for investors with weak emotional temperaments, they all involve buying into firms going through major problems or that have questionable futures. This is the essence of deep value investing. Click here for insight into the highest performing dividend strategies.
Despite what it looks like on the surface, classic value investing is both safer and more profitable than growth investing - including dividend growth investing. This is because classic value investing exploits systematic errors in investor behaviour. The key is to find a proven strategy and then hold a widely diversified portfolio of stocks that fit the strategy.
High dividend yielding stocks is one way to take advantage of investor overreaction. A number of years ago legendary value investing firm Tweedy, Browne came out with a white paper titled "The High Dividend Yield Return Advantage". In the paper, high dividend yielding stocks performed very well versus the market and dividend stocks in general.
Tweedy found that over a 33 year period, high dividend yield stocks outperformed low yielding stocks by wide margins. The lowest yielding stocks provided a 33 year return of 81x but the highest dividend yielding stock came in at a whopping 403x return.
They also cited work done on high yielding stocks in the US by Jeremy Siegel in his book, The Future For Investors. After splitting the S&P 500 into high and low yielding stocks, he found that the high dividend yielding group returned over 6x more than the low yielding group over a 50 year period, and 3x the market return.
High dividend yields are fantastic for portfolios over the long run, but there's an even better investment strategy. That strategy is our own Pay Daddy net net stock strategy, a strategy that focuses on buying net net stocks that pay above market yields.
Net nets are essentially Low Price to Book Value firms that exclude "Long Term Assets" from the "Book Value" calculation. Doing this allows for a much more conservative assessment of a firm's liquidation value.
Net net stocks in general are associated with fantastic returns. In academic studies, white papers, and use in practice, the strategy has proven to be the highest returning strategy available to small investors...
But there are different ways to exploit the strategy, and one of those ways is to focus on net nets that pay a dividend. The advantage here should be obvious. These stocks are priced based on liquidation value, not dividend yield, so will remain buoyant when interest rates rise. They also pay above market yields and have a habit of popping back up to liquidation value, providing large capital gains. While high dividend yield stocks can return roughly 13 to 16% per year, Pay Daddy stocks return 20% a year, including dividends.
Pay Daddy stocks are only available for small investors, given liquidity constraints. For larger investors, we favour our Simple Way 2.0 strategy. This strategy combines high dividend yield with a low Price to Earnings Ratio and a 1.5x cap on Price to Book Value to help ensure not only good returns but also safety in the event of rising interest rates. Click here for our free investment guide.
The high dividend yield and low PE ratio should buffer investors from the effect of rising rates. These stocks have been hit by significant investor pessimism and are already priced for terrible times ahead. But, on average, investors overreact on the downside which provides value investors with significant outperformance. Buying one of these stocks means buying below the stock's fair value, providing a meaty margin of safety to protect against permanent loss of capital due to rising rates. Investors should expect a 20 to 25% CAGR using the strategy, including dividends.
You Can Do It... But Not With Dividend Growth Investing
Funding a retirement or just building a solid passive income stream is possible but it will take a major shift in thinking away from dividend growth investing. It's human nature to aim for hot stocks, or firms that have a nice record of growth behind them. Behavioural studies have highlighted our tendency to extrapolate trends, such as growing dividends, well into the future - a major investor error.
It's not easy to bust these biases, but as an investor you do have a lot of money riding on your ability to invest well. I suggest starting by diving into the works of Ben Graham in order to ensure safety of principle and the promise of an adequate return.
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