Month: January 2024

Almost every week now, we publish a study showing the underperformance of actively managed funds versus passively managed funds or indexes. We highlight one such study in our DGI News section this week. Rather than jump on the bandwagon of indexers (ETFs) or beat up the actively- managed crowd any further, we want to show you the reasons why our DGI strategy outperforms both.

Here are the reasons why we outperform:

Our income and portfolio returns are more predictable.

Owning investments that produce reliable income allows you to navigate market volatility confidently, as you patiently anticipate the growth of dividends to propel price appreciation. Our strategy doesn’t hinge on the expectation of another investor purchasing our stock; rather, we rely on the steady increase in dividends to generate capital gains. We actively pursue and successfully achieve both objectives.

“Certainly, prices still fluctuate. But ours do so around a stable and predictable CAGR dividend core.”

– Tom Connolly

Most managers of dividend funds and dividend ETFs skew toward income. Our strategy picks up both. 

Our portfolios are concentrated with only the best individual stocks in a sector.

Our portfolios focus on a select group of quality individual stocks within a specific sector. The freedom to personally select dividend growth companies based on our established criteria (DGI quality indicators) enables us to tailor our portfolios to meet our unique goals and objectives.

Exclusively holding the finest companies in our portfolios prevents our returns from being diluted by underperformers or entities in sectors currently out of favor. Why compromise the performance of robust dividend growers with mediocre opportunities?

Funds and ETFs own too many mediocre companies. 

We have diversification across industries but don’t over diversify. 

In their book ‘Investment Analysis and Portfolio Management’, Frank Reilly and Keith Brown reported that in one set of studies for randomly selected stocks, “…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.”

We don’t need to own hundreds of companies to mitigate risk. When you own quality companies, risk is in the price you pay for them, not in the number of companies you own.

Most funds and ETFs own far too many stocks to maximize diversification’s benefit. 

We can exploit mismatches in market pricing. Being able to “buy low and sell high” is what gives us an edge.

Many of the stocks we invest in have a ‘narrow valuation corridor’, meaning the stock price follows a path that rarely deviates from its historical trading range. Finding companies that follow this pattern allows us to enter positions on price weakness at higher yields and with higher potential price appreciation down the road. Winnowing or exiting positions when prices go beyond these ranges is a good way to generate better returns during periods of price strength. 

Actively managed funds and ETFs are typically fully invested. When the downdraft arrives, there’s no cash to buy quality companies. In addition, depending on the mandate of the fund or ETF they may also be forced to rebalance according to a predetermined schedule.

Dividend growth investors HOLD.

If our dividend growth companies continue to increase their dividends and nothing fundamentally changes with the underlying business, we hold.

Fund managers are constrained by the necessity to prioritize short-term thinking, focusing on quarterly statistics. Underperformance in quarterly results poses a potential risk to their careers, leading them to align their strategies with those of their peers and follow similar approaches. Essentially, they must herd…do roughly the same thing.

ETFs are mandated to trade frequently and miss out on the benefit of increasing cash flow.

In 2012, I switched to dividend growth investing and began telling all my friends about it. You should, too.

New retirees or novice investors often seek direct guidance regarding investment choices. To address this, we offer a model portfolio, complete with buy/sell alerts and valuation analysis supporting all transactions. Our process allows investors to get comfortable with our DGI strategy by building their portfolios passively over time alongside ours. For those who want to jump right in, we thought we would offer an alternative.

Today’s post applies to dividend growth investors with a lump sum to invest. Enter the ‘No-Look’ DGI Portfolio, inspired by the sports term, ‘no-look’ pass. Like athletes relying on instinct for the ‘no-look’ pass, success with this portfolio hinges only on picking the highest quality companies from the list of dividend growth companies we follow (The List). There is no overthinking, evaluating, or guessing which companies will outperform in today’s market.

The ‘No-Look’ Portfolio skips the valuation step in our process, relying solely on the quality rankings of Value Line and S&P ratings agencies. The Value Line ratings are based on the rating services’ proprietary ranking system, which evaluates stocks on various factors, including financial strength, earnings potential, and risk. S&P ratings assess the creditworthiness of entities such as corporations, governments, and other issuers of debt. The better the ratings, the higher the quality of the company.

Using our ten-year compound annual growth rate (CAGR) spreadsheet, we sort all twenty-eight companies on ‘The List’ by quality. We then take the top twenty companies and create our ‘No-Look’ Portfolio.

The shaded area displays three compound annual growth rates (CAGR) columns representing the annualized total return (TR), dividend growth (DG), and price growth (PG) over the past decade for companies on ‘The List.’ The overall list averages are presented at the bottom. If an equal amount of each company on ‘The List’ was purchased at the close of business on the first trading day of 2014, the returns shown in the ‘Averages’ row would have been generated by the close of business on the first trading day of 2024.

Here are two ways dividends and their growth can be used to predict returns:

Price growth tracks dividend growth. Dividend growth closely mirrors price growth, which is evident in the comparable averages of dividend growth (DG) and price growth (PG) at 9.5% and 9.1%, respectively. Company-stated or historically derived dividend growth rates, readily available, help us estimate future price growth.

Total return tracks starting yield + dividend growth over the decade.  For ‘The List,’ our annualized total return (11.2%) closely matches the sum of the initial starting yield in 2014 and the annualized dividend growth rate. The slight difference can be attributed to valuation at the time of purchase.

Accurately predicting stock price growth and total return by focusing on the dividend and its growth eliminates the need to be concerned about short-term market fluctuations. John Bogle’s view that “the stock market is a distraction to the business of investing” resonates with dividend growth investors.