Part Three in a series on Story Capital's favorite investment strategy.
In a previous blog, we asked the following question: Was Berkshire Hathaway’s experience with its Coke investment a coincidence, an outlier, or a freak of the markets? We believe the direct answer is no. Let’s peel back the onion on this question.
Story Capital believes that stocks exhibiting sustainable dividend growth consistently outperform their benchmark indexes with less risk. Further, we believe that a dividend increase is a signal of management’s confidence in future growth.
The quote above is an investment management value proposition statement. First, let’s analyze dividend growth’s relationship with risk:
- When choosing stocks based on dividend growth history, we can choose from more than just the big companies.
- Many people believe that only large companies pay meaningful dividends. Our clients are pleased to discover that there are ample numbers of dividend paying stocks in the micro, small, and mid-size company ranges (capitalizations) to build a diversified dividend growth portfolio across the entire company size spectrum. (See the chart below)
- But, what about the fact that volatility (or risk) is generally greater at smaller company sizes than in large-size company portfolios?
- Story believes that the greater share of volatility in a stock portfolio is produced by non-dividend paying companies. Please read that again… it’s a tip worth noting. *
- Since the percentage of dividend paying companies decreases as market capitalization decreases, one would expect greater volatility in the broad indexes as one moves into smaller size companies. Fortunately, due to the large number of eligible small cap dividend paying companies, managers can successfully select qualified dividend growth companies which carry the desired lower volatility.
Dividend Stocks >1% Yield
% Paying Dividends
Micro Cap Stocks
Small Cap Stocks
Mid Cap Stocks
Large Cap Stocks
S&P 500 Stocks
As we look at the numbers, and we’re pleased to share them with you, we observe:
Portfolios of dedicated dividend growth companies outperform their broad benchmarks with lower risk (volatility/standard deviation) than their benchmarks across all company size ranges. This allows Story Capital to advocate for the “potential” of higher returns and enhanced diversification by incorporating small and mid-size companies in our dividend growth portfolios WITHOUT adding the additional risk or volatility broadly associated with traditional diversified portfolios of smaller company stocks. The dividend growth strategy is an investment style which we believe demonstrates that active portfolio management consistently adds value or “alpha” over and above the benchmark index to the portfolio.
Since we have demonstrated that one can have a diversified portfolio of dividend growth stocks that have a history of outperforming their broad capitalization benchmarks, the following questions emerge:
1) Generally, what do dividend growth portfolio managers look for in stock selection?
- Competitive Advantage: Low cost structure, scale, market share, pricing power, solid brand, and consistent Earnings Per Share growth in excess of 10% per year.
- A management team making exquisite cash flow and capital allocation decisions: a company should consistently distribute dividends using 25-30% of free cash flow on continuously rising earnings, reinvest the balance of cash flow to promote growth, fend off competition, maintain pricing power, and keep debt below 40-50% of equity.
- Sustainability of continuous dividend growth: Rising earnings per share, continuous review of return on invested capital (ROIC), ample cash flow (to cover both the growing dividend allocation and solid prospects for continuing business growth), and management’s stated commitment to future dividend increases.
2) Generally, what do dividend-growth portfolio managers view as a red flag which might lead to elimination of a position from the portfolio?
- A suspension, cut, or failure to raise a dividend: Many dividend growth managers will immediately sell a portfolio position that cuts or fails to raise their annual dividend.
- A quantitative threat to raising future dividends: The best dividend growth managers continuously monitor “dividend quality” which broadly means monitoring a company’s cash flow, earnings and other quantitative factors to be assured the ongoing dividend paying ability remains unhampered.
- A threat to fundamentals: All dividend growth managers continuously monitor a company’s competitive advantage, regulatory environment, industry vitality, management team changes and capital allocation decisions. Any shift in fundamentals that might degrade dividend growth potential places a company at risk of being eliminated from the portfolio.
Both Story and the management teams of dividend growth companies believe that commitment to an increasing dividend is an indicator of confidence in the company’s current success and its prospects for continuing growth.
Story further believes that the greatest possible alignment of stakeholder interests (the board, professional management, and shareholders) occurs when a company continuously grows dividends. We believe that the market also concurs, as substantiated by the high correlation between the percentage growth rate of dividends per share, earnings per share, and price per share; just as we observed with Berkshire’s acquisition and long-term holding of Coke in our previous blog.
Dividend growth investing: What’s not to like?
*For a resource explaining why dividend-paying stocks are less volatile, read the following article from Investopedia: "Why Are Dividend-Paying Stocks Less Volatile?" published March 21, 2018
**Uncharted Investing: "Which Stocks Pay Dividends? Small Cap vs Large Cap for High Dividends" published July 26, 2019