Chapter 11: Embrace Dividend Value Investing
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 11 of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real-time.
Chapter 11 uncovers an alternative yield methodology for outperforming Treasury rates without the limitations of the dividend growth strategy—such as overweighting dividend history—or the inherent risks of forward high-yield dividend investing.
Chapter 11
Embrace Dividend Value Investing
The pursuit of alpha equates to a portfolio of predominantly dividend-paying common stocks of quality companies outperforming the corresponding benchmark in total return over time.
Dividend investing is buying securities that pay dividends to receive a regular income from our investments. The dividend income is in addition to any capital gains in our portfolios where the constituent common stocks, exchange-traded funds, or other holdings increase or decrease in value.
Dividend growth investing is a popular strategy with retail investors. It entails buying shares in companies with a record of paying regular and increasing dividends, commonly referred to as kings and aristocrats in the financial media. An added component is using the payouts to reinvest in the company’s shares—or shares of other companies with similar dividend track records.
Dividend value investing focuses more on the company’s quality and the stock’s value than its dividend growth history. Any dividends are a bonus payment in the short term while waiting for capital gains to compound over the long term.
This chapter uncovers an alternative yield methodology for outperforming Treasury rates without the limitations of the dividend growth strategy—such as overweighting dividend history—or the inherent risks of forward high-yield dividend investing.
Here’s why I advocate dividend value investing toward preserving invested capital in contrast to dividend growth and high-yield investing.
Principles of Dividend Value Investing
The quality value investing model of owning the common shares of world-class enterprises purchased at reasonable prices builds winning portfolios over time from the compounding total return of capital gains and dividends, our two best financial friends.
Any ongoing dividend yields are the stock market equivalent of receiving interest payments on the outstanding principal of a loan or of the initial capital investment to purchase the shares of the stock.
The pursuit of alpha equates to a portfolio of predominantly dividend-paying common stocks of quality companies outperforming the corresponding benchmark over time, plus exceeding any other expectations of rational, disciplined, and patient investors.
Owning major exchange-traded common shares representing companies paying reasonable dividends far outweighs the risks of perceived fast money opportunities from non-dividend momentum growth stocks or forward high-yield dividend payers. Consider keeping major exchange-traded, quality, non-dividend-paying growth stock allocation to a minimum. Quality dividend value stocks compensate us now with regular payouts and reward us later with compounding capital gains.
Target companies with a forward dividend yield or the annual dividend rate divided by the current stock price exceeding 2 percent and below 6 percent. However, consider buying the dividend-paying stock of a quality company trading at an attractive price if the historical yield is below 2 percent. Trailing dividend yield indicates how much a company paid out in dividends for the previous twelve months relative to the share price. The dividend rate is the dollar sum of dividends paid by the company over the prior fiscal year.
Most high-yield and some dividend growth investors gravitate to forward dividend yields far exceeding the Ten-Year Treasury rate. On the contrary, quality-driven investors are cautious with dividends susceptible to erratic stock price fluctuations, unexpected rate decreases, or unsustainable payout ratios.
The dividend payout from an expensive stock equates to a dividend purchased or held at a high cost. Value and price prevail in every area of investing. Thus, practice the more balanced approach of value-driven buy-and-hold total-return investing.
With 43 of the 46 companies currently paying a dividend, the Quality Value Investing Real-Time Stock Picks, on the whole, seek long-term compounding growth of both principal and income. Achieving a sufficient current income from regular dividends is paramount to the total return objective. Therefore, with occasional exceptions, a company should pay a standard premium for the common shares to be eligible for coverage or investment.
Chasing Yield is a Recipe for Junk Equity
Chasing dividend yields and non-dividend momentum growth from equities are recipes for junk. Instead, achieve portfolio alpha with total-return investing—capital gains plus income—and, in retirement, pursue bucket list items instead of desperately seeking higher dividend payouts.
Quality-driven value investing focuses on forward dividend yields below 6 percent, a range where we find superior companies paying far lower than 100 percent of earnings in dividends, also referred to as the payout ratio, addressed further in this chapter. Many companies behind 6 to 10 percent and higher-yielding shares must grow dividend rates, or the stocks need to fall in price, or a combination thereof, for the dividend yields to remain high or increase. Those are recipes for destroying invested capital.
High-yield dividend stocks were top-of-mind for investors starving for higher payouts in the low-interest-rate environment of the post-Great Recession bull market. As a result, many top subscription offerings and financial media pieces focused on the high-yield paradigm. Unfortunately, history tells us the crowd is almost always wrong regarding fads and favorites. High-yield dividend stocks are no exception, so rational-thinking investors should maintain a skeptical view of the practice.
Along with elevated income returns, loom risky headwinds and questionable underlying fundamentals. Just ask the victims of the high-yield junk bond bubble in the 1980s. History reminds us of how that bubble burst during the 1987 stock market crash. The junk bond craze returned to the recent bull market through forward high-yield dividend stocks. This time, instead of leveraging mergers and acquisitions at the corporate level when available capital was insufficient, high-yield equities influenced daring risk/reward plays as retail investors and their advisors sought outsized returns to leverage underfunded retirement account balances.
An inevitable cyclical downturn in the overall stock market preempts the principal capital invested by millions of retail investors concentrated in risky, high-yield dividend equities such as business development companies (BDCs), master limited partnerships (MLPs), closed-end mutual funds (CEFs), real estate investment trusts (REITs), as well as energy transfer partnerships and preferred stocks.
Disciplined investors never buy stocks based on market euphoria or the forward dividend yield alone. However, some well-crafted story headlines and marketing pitches cast a positive spin on the paradox of a safe, high-yielder.
These pundits remind us of what we missed, disregarded, and tripped over in our retail-level analysis, challenging our assumptions and conclusions. Although the professional debate is encouraged and welcomed, the thesis remains that investors are chasing the dividend more than enterprise quality with forward high-yield stocks. Nonetheless, if a conscientious trading strategy puts income ahead of capital gains, so be it with cautionary best wishes.
Remember, dividend rates adjust monthly, quarterly, or annually from board-directed payouts, as the corresponding yields go up and down each market day as a prisoner of the stock price. The concept of dividend payouts involves a simple paradigm in the fundamental economics of the price/yield relationship, whether bonds or equities. The yield goes up when the price goes down, and vice versa.
The enticement of high-yielding stocks seems to overshadow the necessary due diligence to determine if the representative company is stable enough to justify the yield with capital allocations and shareholder returns from a well-managed operation. For example, do we prefer to own a quality 4 percent yielder with compounding average capital gains of 6 percent a year or a high-risk stock yielding 10 percent, although averaging a minus 5 percent annualized capital loss?
In the former example, quality value investors average a plus 10 percent annual total gain. In contrast, high-yield fans settled for a meager plus 5 percent average annual total return, hovering above the yields of short-duration government bonds.
Of course, some retirees have had the opposite experience by investing in forward high-yielders that have produced double-digit total returns in recent years.
An Alternative High-Yield Dividend Model
As an alternative method, measure a stock holding’s yield-on-cost instead of chasing current dividend payouts.
The return on cost represents the current annualized dividend rate relative to the cost basis of the common shares. For example, as of the writing of this chapter, the yields-on-cost of five dividend-paying QVI Stock Picks are far superior to the current forward yields.
Table Key
Ticker = Union Pacific UNP 0.00%↑ — Microsoft MSFT 0.00%↑ — DICK’S Sporting Goods DKS 0.00%↑ — Williams-Sonoma WSM 0.00%↑ — Coca-Cola KO 0.00%↑
Price = Closing Price — Closing share price on October 16, 2024
Rate = Dividend Rate — Trailing one-year annualized dividend payout
Basis = Cost Basis — Original cost of each common share of stock adjusted for splits and dividends
Yield = Forward Yield — Dividend rate divided by closing share price
Y-O-C = Yield-On-Cost — Dividend rate divided by cost basis per share
Yield-on-cost is the ideal alternative investment strategy to conventional forward high-yield dividend investing.
The All-Encompassing Payout Ratio
The payout ratio is the proportion of earnings paid out as dividends to shareholders, expressed as a percentage.
A lower payout ratio is preferable to a higher one, and a rate higher than 100 percent suggests that the company pays out more in dividends than it earns in net income.
Financial laws and regulations require many inflated payout players, such as REITs and BDCs, to distribute at least 90 percent of taxable income to shareholders. Yet, when screening high-yield dividend stocks, more than 50 percent of the companies listed often have payout ratios higher than 100 percent. Where is the cash flow to support this generosity?
The concern is whether the excess payout is coming from somewhere on the balance sheet or cash flow statement detrimental to the financial stability of the operation. So, instead of chasing risky, high-yield dividends, calculate the yield-on-cost of current holdings with low payout ratios.
Avoid initiating a position in stocks with payout ratios exceeding 60 percent. For example, the five holdings of the QVI Stocks Picks showcased in the yield on-cost table above had current payout ratios of Williams-Sonoma—24.60%, Microsoft—25.29%, DICK’S Sporting Goods—30.42%, Union Pacific—48.88%, and Coca-Cola—76.59%, albeit Coca-Cola was below 60 percent at its initial QVI coverage in 2010.
Again, own slices of companies paying sustainable and predictable dividends as those payments will compensate shareholders in the short term. At the same time, wait patiently for the capital appreciation of the stock price over the long term. Own shares of quality companies with sensible payout ratios and let the dividend yields flourish.
Despite the popularity of forward high yields, I advocate for the ownership of quality companies represented by dividend-paying common stocks listed on major exchanges and available at value prices. In retirement, the dividend becomes income in itself.
When measured by the yield-on-cost, a low payout ratio dividend rate might earn a high yield worthy of generational ownership.
How Value Investors Allocate Dividends
Most investors prefer reinvesting dividends, whether choosing automatic programs at their broker or using company-sponsored dividend reinvestment plans (DRIP). Some investors prefer dollar-cost averaging (DCA) or buying fixed dollar amounts of individual securities regularly. Each method has its benefits.
The hands-free automatic reinvestment plans are appealing and the best path for passive investors. A traditional advantage of automatic systems at online brokers or using DRIP programs directly from companies was paying zero trade commissions. On the contrary, using dividend cash payments as dry powder entailed potential commissions on future transactions. Nonetheless, the involuntary approach can be more expensive than direct reinvestment.
Disciplined, value-driven investors are often suspicious of automatic programs, whether working on Wall Street or living on Main Street. Buying securities at preferred price points and ignoring the whims of the market is the profitable alternative.
Buy shares at low prices based on the perception of intrinsic value instead of the market’s offering of the stock price at the moment of the automatic DCA or DRIP purchase. In addition, although the recent trend of online brokers becoming commission-free is good news, investors should continue to build up enough cash, accepting any commission or fees as an insignificant percentage of the gross amount on the trade. Either way, there is no excuse to overpay when reinvesting in the common shares of companies held in our portfolios.
Instead, follow the approach from the value investor playbook of buying equities on our terms instead of allowing the crowd to determine the entry price, for better or worse. First, have our online broker deposit dividend payments to an insured or government-protected cash account. Then, tap into this accumulation of protected dry powder to purchase new or add to existing investments at bargain prices according to sound valuation analysis.
Ultimately, the choice lies with investors based on comfort zones, as DRIP and DCA programs also provide a disciplined—albeit rigid—approach to personal investing. Of course, retirees often take dividends as cash to provide supplemental income.
Total Return with Dividend Value Investing
High-yield dividend stocks and dividend growth investing were all the rage in the post-Great Recession bull market. However, rational, disciplined, and patient investors are steadfast in dividend value investing or total return from capital gains and dividend income.
A profitable alternative to forward high-yield investing is calculating the yield-on-cost of quality companies with low payout ratios already residing in our portfolios. Instead of chasing yield, buy reasonably-priced quality and hold for as long as possible, perhaps forever. Any dividend payouts are a bonus.
Despite the noise, remain patient and monitor the enterprise’s prospects while collecting dividends as a short-term reward for perseverance in awaiting capital appreciation in the long term.
Although safer than forward high-yield dividend or non-dividend growth investing, dividend value investing still carries the risks of investing in the stock market. For example, all dividend stocks face unexpected rate reductions or suspensions by the company’s board of directors. Nevertheless, the dividend-paying common shares of quality companies tend to be less vulnerable to ticker price volatility and market liquidity than high-yield dividend or non-dividend growth stocks.
Rational, patient, and disciplined value-driven investors allow dividends and capital gains distributions to settle as cash and reinvest those funds only when prices are attractive. Arguably, the automatic reinvestment of dividends is convenient, if never the best approach to allocation. Therefore, quality-driven investors should consider the benefits of having their broker pay dividends to cash.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing, and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, MSN Money, TalkMarkets, ValueWalk, Yahoo Finance, QAV—Australia’s #1 Value Investing Podcast, Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
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