How to Score Compound Income↑ Stocks Part 5 - Dividend Growth

This is a slightly controversial metric to include as many believe and some studies have shown that buying growth stocks or focussing on historic growth is not necessarily a winning strategy. However, in income investing it can be appropriate if you are trying to secure a growing income which can protect both your income and capital in real terms. Other studies and as highlighted on this site show that compounding your income can also greatly increase your returns and speed the recovery from draw downs (declines).

So what is the evidence for looking at dividend growth? Well specifically in the UK in 2008 there was an interesting working paper titled Consistent Dividend Growth Investment Strategies by Gwilym, Clare, Seaton and Thomas from the Cass Buisness School. In the abstract from this they said:

"We investigate whether firms in the United Kingdom that have a long, uninterrupted history of dividend growth outperform the broader equity market. It is observed that firms with in excess of 10-years consistent growth have returned considerably more than the equity market as a whole, with the additional benefits of lower volatility and smaller draw downs. A size effect exists amongst these firms with lower market-capitalization firms demonstrating improved risk-adjusted returns."

They also highlighted some of the other research which suggests that looking at dividend growth history is a good idea as follows:

"There are a number of good reasons why investors should favour companies that have a consistent history of increasing dividends. 

• Firstly, one of the components in Gordon’s (1962) constant growth valuation model is the growth term. It takes a much greater leap of faith to assume a future growth rate when there has been no precedent set in recent years compared to a stock that has a long-term growth rate already demonstrated. 
  
• Secondly, Lintner (1956) observes that management only raise dividends when they believe that earnings have permanently increased. This implies that firms that continually increase their payments envisage a positive outlook for profitability. 
  
• Thirdly, Barth et al (1999) show that firms with a pattern of increasing earnings have been accorded higher price-earnings ratios after controlling for growth and risk. Given that in the long-run dividends and earnings are inexorably linked, this appears to bode well for the valuations of consistent dividend payers. 
• Finally, Arnott and Asness (2003) demonstrate that, in aggregate, higher dividend payouts are consistent with higher future earnings growth. Walker (2005) supports the case for investments in consistent payers. In the 10 years to April 2005, it is stated that a basket of US securities with at least 10-years of consistent dividend growth outperformed the S&P 500 by 3.28% per annum coupled with the advantage of two percentage points lower volatility."
  

Indeed S & P even produce what they call Dividend Aristocrat indices based on this concept and a number of ETF's have been launched based on these and other indices with a similar concept. See the link above for a useful site (buyupside) which details the US qualifiers and has lots of other useful free information for investors.

So it seems that there is some value in looking at dividend growth history although they found that it worked best in smaller and mid cap names, which again fits well if you are running a concentrated portfolio and not closet indexing. Indeed the authors of the above paper said: 

"The conclusion is rapidly drawn that for consistent dividend portfolios to be successful they should be formed on an equally weighted basis; otherwise there is no real advantage in diverting from the benchmark. The equal versus value-weighted issue might in itself explain some of the out performance of comparable US ETFs versus the market-capitalization approach of the S&P 500 described by Walker (2005)."

Thus dividend growth history is one of the factors I take into account when scoring Compound Income stocks. It could also be argued that this is another way of measuring or assessing quality as those companies with a long history of rising dividend presumably are well managed and have a business which can generate rising returns for shareholders over time. So in a way it follows on well from the operational quality measures I looked at in part 4. Similarly here a steadily rising profile is likely to indicate a better quality / managed business, whereas weaker or more cyclical ones are more likely to have pauses in their growth or even dividend cuts which obviously you would want to avoid.

With that in mind and with an eye to the future I also factor in the one year forecast dividend growth alongside the dividend history for a combined dividend growth score as I like to know that growth is still forecast and how it compares with the past. In the next part I'll look at another indicator which helps to back this up.

Finally, the other take away I had from this paper was the fact that they found that "a significant portion of the improvement in absolute return of the consistent dividend growth stocks can be attributed to the avoidance of non-paying firms."  So when compiling a list of Compound Income stocks to compare I make a point of generally excluding zero yielding stocks as I'm not interested in them and as the authors observed:

"The most immediate observation is the exceptionally poor performance of the zero-dividend firms, particularly those larger ones that were in the All-Share Index. Not only were returns comparatively low but also the volatility was much higher relative to the dividend paying firms. The maximum draw down was an eye-watering 85% for the All-Share constituents, with accompanying extreme Ulcer index levels." Ouch - buy zero yielding stocks if you like but I just say No !