The following guest post on deep value dividend stocks was written by subscriber, Xavier Hill; Creative Commons photo by Pictures of Money. The thoughts and opinions expressed here are those of the author and may not reflect those of anybody else at Broken Leg Investing.
Which dividend stocks are best to fund your retirement: deep value dividend stocks or dividend growth stocks?
As you're about to see, the answer is clear-cut but the sort of dividend stocks you should focus on will probably come as a surprise.
The western world’s aging population receives endless commentary with all manner of demographic doomsday scenarios. I am not a demographer so won’t forecast the exact age profile of western countries in 30 years time. As a net net investor I came to terms with my limitations long ago.
Still the market thankfully does not often think like me. This supposed demographic cliff has gained great currency, inspiring the Dividend Growth Investing strategy which aims to buy growth stocks with strong dividend yields. It's a popular strategy and likely to become more popular as investors seek passive income in retirement. By buying growth stocks, investors assume, you are receiving a 2 for 1 deal: both a dividend stock and a stock with a great growth story.
Value investors have also gotten mixed up in the latest investing fad. Ask a typical value investor, the supposed contrarians of the investment world, which dividend stock they would like to invest in for income and they'll point to strong companies with good growing fundamentals. Strong firms like Coca-Cola, GE, Apple, or Home Depot often take a front seat in a value investor's portfolio.
Like all investment theses the Dividend Growth Investing strategy contains at least some kernel of truth, however this kernel is ultimately wrapped within the rotting flesh of speculation.
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Yes, Dividend Stocks Outperform Long Term
One of those kernels is the belief that dividend stocks produce superior returns. Back in the first half of the 1900s, investors sought out stocks that paid a dividend due to their perceived safety while punishing firms in the market that withheld cash distributions from investors. Today, dividends are't usually factored in to the investment merits of a stock.
That's a real shame. There are a plethora of studies showing that dividend stocks outperform the market long term. You can read Superinvestor Tweedy, Browne's in-depth study of dividend payers for a solid overview. To sum up their excellent work, dividend stocks beat non-dividend stocks long term and the stocks with the largest dividend yields produced the highest returns. The outperformance was shown to be fantastic.
In another much longer study presented in the book Triumph of the Optimists: 101 Years of Global Investment Returns Elroy Dimson, Paul Marsh, and Mike Stauton show that from 1900 to 2000, dividend stocks with dividends reinvested provided an 85 fold return over the general market. Take a look at the chart below:
UK And American Dividend Stocks Vs. Non-Dividend Stocks, 1900 to 2000
The returns to dividend stocks versus stocks of companies that didn't pay a dividend wasn't even close. Dividend stocks crushed the market and their non-dividend stock peers, producing a return of 10.1% in both the UK and US markets compared to a tiny 5.1% and 5.4% return for stingy companies.
Six time Graham and Dodd award winner and investing legend Rob Arnott came to an even more compelling conclusion. When he analysed the returns of all US stocks between between 1802 and 2002 he found an annualized return of 7.9%, with 5% of that return coming from dividends, 0.8% from growth in dividends in real terms, 1.4% from inflation, and 0.6% thanks to rising valuations.
Dividend Stocks and the Three Dwarfs: Growth of $100 invested in US Equities, 1802-2002
Dividend stocks are important, indeed crucial, to long-term investing success for most investors. They also provide our aging population with a passive income. In short, dividend stocks are critical to both maintaining a lifestyle AND beating the market.
Dividend Stocks That Destroy Wealth
While dividend stocks outperform, it is the “growth” part of the “Dividend Growth Investing” strategy where the strategy falls apart. Not only does growth investing badly trail value investing over the long run but it could also lead to massive losses going forward. Evan highlighted this in his warning to investors, "Are Dividend Growth Investors About To Lose Their Life Savings?"
Investors are paying a large premium for a stock based on projected future earnings, even when we know that the future is uncertain.
It sounds obvious, or redundant, but when demand for a growth company’s product or service changes, its valuation can take a dramatic turn. A recent example is Australian listed high-speed internet provider Vocus Telecommunications.
Through a series of acquisitions Vocus grew from a lowly telecommunications bit player to an ASX top 100 company by mid 2016. Vocus pays strong dividends and has a fantastic growth story backed by the business of providing high speed internet. By mid 2016 it was the perfect “Dividend Growth Investing” stock.
By August 2016 trouble emerged. Subscribers were not signing on as fast as anticipated, margins were being compressed, and there was tension at board level due to the merger between Vocus and M2 Communications. The share price crashed from $9.42 to $3.73 in a few months. Ouch!!!!
Backtesting highlights how this phenomenon plays out. Investment firm Fidelity compared a series of value and growth etf’s between 2000 and 2015. The study compared 3 value etfs. Small cap value stocks, mid cap value stocks and large cap value stocks against small, mid and large cap growth stocks. The results were shocking to most investors. Take a look how $100 invested with each strategy at the start of the year 2000 performed by 2015:
As the chart shows, value obliterates growth for long term returns. The best performing growth etf was midcap growth stocks that turned $100 into $187 at the end of the period. Compare this to the worst performing value strategy, large cap value stocks, which returned $224.
And the best performer? Small cap value stocks turned $100 into a market crushing $407 in 15 years. Despite this dramatic outperformance, small cap value stocks rarely receive a mention from the investment community. This under-appreciation turns up fantastic bargains which is why The Broken Leg Investment Letter mostly focuses on tiny companies.
Despite all the evidence, growth stocks have an allure, a dreadful siren song that few investors can resist. Their sound is beautiful compared to the disastrous businesses deep value investors buy. Deep value stocks are stocks that have been beaten down in price, have scant growth or deteriorating profitability, and are cheap based on classic value measures.
At first investors struggle to understand why anybody would want to buy a terrible company. On the surface a rapidly growing firm like Vocus seems like the obvious buy over a money-losing firm with terrible business problems. Still, the facts speak for themselves: value outperforms growth and small cap deep value outperforms them all.
So Why Doesn’t Everyone Own Small Cap Deep Value Stocks?
To buy deep value stocks you need to plug your nose and dive in. You have to base your buying decisions on real assessments of value, not expectations of future growth. You have to buy with a solid margin of safety, well below intrinsic value. Value stocks are unloved because they are not exciting - few people will brag about their deep value stocks at a cocktail party.
Small cap deep value stocks are ugly. They are often in terrible, dying businesses, sometimes hopelessly managed and few can see their redemptive qualities. This horribleness turns investors off and allows the value investor to buy a bargain.
The world’s greatest investor, Warren Buffett, actually based his entire fortune on these terrible deep value plays. But, as Buffett’s wealth grew, it became harder for him to buy small cap stocks. He simply had too much money to deploy. Compounding the problem was the rising valuations of the American markets which made executing a solid Cigar Butts strategy in the 1960s even tougher.
But, if you look hard enough and your capital is small enough ($US 1 million and under), you can still find high quality deep value stocks of tiny companies around the world. If you’re prepared to comb through international markets (or let Broken Leg Investing do the - ahum - legwork for you), you can find enough of Buffett’s original Cigar Butts to make a nice portfolio. Click here for insight into the highest performance deep value strategies.
It’s hard to overstate just how great of a portfolio you could craft with a diversified group of international deep value stocks. You see, net nets even outperform small cap value stocks – and by a significant margin.
But I want a stock that pays dividends so despite value’s outperformance, I will stick with growth stocks.
The idea that you have to choose between rapid portfolio growth and fat dividend yields is one of the biggest false dichotomies in the market today. You can have BOTH rapid growth and large dividends!
And, you can do this by following in the footsteps of Superinvestors such as early Warren Buffett, Ben Graham, or legendary investor Walter Schloss. Through copious research we have found a small niche within the market that provides large dividend yields, rapid portfolio growth, and safety of principle. Best of all, it's backed by one of the top deep value strategies ever created - Ben Graham's net nets.
Dividend Growth Investing Versus Pay Daddy Deep Value Dividend Stocks
We call these deep value dividend stocks Pay Daddy net nets.
Net net stocks are stocks of companies that are selling for less than the company's per share Net Current Asset Value. This is a highly conservative assessment of the company's liquidation value.
Pay Daddy net nets are deep value dividend stocks that have been filtered through our Pay Daddy Scorecard, the checklist we use to identify the most compelling buys. Part of the process means identifying net nets offing a larger than market average dividend yield and solid margin of safety. Other factors include a past price above NCAV, an adequate level of past profitability, and bonus factors such as insider buys.
Here's how a random sample of low price to Net Current Asset value dividend stocks performed in the US between 1999 and 2016:
US listed deep value dividend stocks (ie. a random sample of net nets paying a dividend that have not been put through our Pay Daddy Scorecard) returned an average 15.7% compounded yearly against the NASDAQ's 4.8% return. In other words, deep value dividend stocks CRUSHED the market by an extra 10.9% per year on average during the year between 2000 and 2016 – turning $100 into $1,200! Remember these deep value dividend stocks are just a random selection of dividend paying net nets - not a group of our more rigorously selected Pay Daddy net nets.
We selected this random sample of deep value dividend stocks to provide a fair comparison against the best Dividend Growth Investing indexes provided by Russell, shown below. By comparison, a dividend growth strategy tracked from 1996 to 2015 produced pretty good results, but returns fell well short of those earned by our deep value dividend stocks. Take a look:
The graph above shows the returns for 6 Russell indexes. The Russell 1000 is the large cap index while the Russell 2000 is the small cal index. The Russell 3000 is the all cap index.
At first the returns look pretty good. All Dividend Growth variants are up versus their non-Dividend Growth counterparts. The top index, the Russell 2000 Dividend Growth index produced a return of 875% over the19 year period, amounting to a CAGR of 12%.
Keep in mind though that this peak back at Dividend Growth Investing spans a longer time period than the low price to Net Current Asset Value dividend stocks above. The Russell graph starts in 1996 and ends in 2015, while the deep value dividend stocks starts in 1999 and ends in 2016. Despite having an extra 2 years to compound, the best Dividend Growth Investing index underperformed Pay Daddy net nets by -27%.
When you look at the start of the graph, however, you'll notice that those first 2 years saw a 75% jump. If we reduced the Russell 2000's total return by that initial growth, the index would likely have reached about 800%, trailing a random sample of deep value dividend stocks by 1/3rd. You can consider this 1/3rd loss as the price of buying good stocks at either reasonable or expensive valuations. Keep in mind that all of this took place during a period of dropping interest rates, pushing firms valued on earnings to new heights. What happens when interest rates revert?
Russell also discusses the expectations investors should have as far as long term returns to Dividend Growth Investing stocks. According to this Russell report:
"Based on an analysis of Russell U.S. index constituent data from 1987-2014, companies that regularly increased their dividend payments over a period of ten years or more returned a year-on-year average of 13.9%%, as opposed to the year-on-year average 10.1% returns of companies that paid dividends but did not increase them."
Over the same time period, the NASDAQ returned 10.2%… so Dividend Growth Investing stocks only beat the index by a scant 3.7% per year.
Deep value investors do not have to worry about scenario of rising interest rates nearly as much. With Pay Daddy deep value dividend stocks backed by a stock value well below the firm's liquidation value, which really helps protect your principle investment. Asset values are much more stable than the value the market places on earnings.
Stocks of Dividend Growth companies with fading growth are also hit hard by investors, the 1/3rd "tax" Dividend Growth Investors had to pay above. Pay Daddy deep value dividend stocks have already been hit hard, which is why they trade below liquidation value. You get in after the crisis hits and wait for the eventual recovery. Most of these stocks either hold their ground after purchase or significantly advance in price.
On the surface, these are hopeless businesses that are somehow managing to pay a dividend. No Financial Advisor is going to recommend a loss making distillery in Eastern Europe or a cement maker in Japan that's seen its stock tumble. Dividend Growth stocks are easy to sell - which is why they're always recommended. This is just the way we like it. It means more opportunity for smart investors.
These businesses very much remind me of the Durian fruit. Durian are found through much of Asia and they smell totally revolting. When you smell a Durian there is no way you want to eat it. But if you get over the smell and force yourself to commit to eating one, you’ll see the most magnificent sweet flesh covering a magnificent kernel.
So, if you can hold your nose to see the real value present, you can set yourself up for massive & sustainable market crushing returns.
Our Pay Daddy deep value dividend stocks strategy is the ultimate dividend investment strategy, but you need to scour the globe to find them. Here at Broken Leg Investing we focus on the the best Pay Daddy net nets available, those with a high probability of recovery and good capital gains.
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