Category: MP Market Reviews

Step three in our process involves monitoring our quality dividend growers regularily, which can become quite challenging depending on the number of companies we track. Fortunately, we rely on ‘The List’ instead of the vast array of stocks in the index, which streamlines our task. Nevertheless, we continually seek methods to enhance our efficiency. Through dividend yield theory, we’ve discovered an approach that has proven remarkably effective over the years in aiding us with our efforts.

Dividend yield theory is a simple and intuitive approach to valuing dividend growth stocks. It suggests that the dividend yield of quality dividend growth stocks tends to revert to the mean over time, assuming that the underlying business model remains stable. In practical terms, if a stock pays a dividend yield above its ten-year average annual yield, its price will likely increase to return the yield to its historical average. Knowing that price and yield go in opposite directions, this theory helps us find stocks that are poised for a positive price correction.

We have already pre-screened our candidates using the criteria we laid out in building ‘The List’ initially. This helps us considerably narrow the universe of investable stocks.

1. Dividend growth streak: 10 years or more.
2. Market cap: Minimum one billion dollars.
3. Diversification: Limit of five companies per sector, preferably two per industry.
4. Cyclicality: Exclude REITs and pure-play energy companies due to high cyclicality.

We then sort ‘The List’ by how far they are from the undervalue price (Low Price) using dividend yield theory. The stocks above the line are the ones that are at or below our undervalue price. These companies make up this month’s‘ Timely Ten’.

One of the significant challenges I’ve faced while introducing subscribers to dividend growth investing (DGI) is steering them away from the fixation on short-term results to focus on long-term wealth creation.

During the weekend, I distributed the quarterly review of our Magic Pants Wealth-Builder Model Portfolio (CDN) to our paid subscribers. This portfolio aligns with the business plan we introduced to these subscribers in May 2022, outlining our approach to creating and managing a dividend growth portfolio.

Below are a couple of charts and excerpts from the review demonstrating the success of our process and how wealth-building works.

Have you ever tried sitting on a beach ball in your backyard pool? It is only a matter of time before you lose your balance, and it shoots several feet in the air! Much to the delight of your kids I might add.

This week’s post is about trying to hold a stock underwater when the fundamentals make it almost impossible to do so.

To identify stocks that may be ready to explode like our beachball, we first look for companies whose dividend growth has traditionally aligned closely with their price growth over the long term but for some reason are now disconnected.

One such company on ‘The List’ was CCL Industries Inc. When we ran a ten-year dividend growth vs price growth chart from YCHARTS for this quality dividend grower, we noticed something a bit odd. Up until 2020 the growth of the dividend and the price growth were closely aligned. COVID hit and the gap widened but returned to its historical alignment pattern shortly after. The divergence that caught our eye began in 2022 and continued for all of 2023. Up until last week, the gap between dividend growth and price growth was the largest it had been in ten years.

One of the magical things about a dividend growth investing (DGI) strategy is the predictability of both the dividend and the growth of that dividend. Because we are not predicting stock market returns, which can change from year to year or trend downward just as we are about to retire, it becomes much easier to plan our retirement if we focus more on the dividend.

In the context of retirement planning, let us start by outlining our objectives. We aim to retire in fifteen years and sustain our lifestyle through dividends. After conducting some research, we believe that $100,000 annually would provide us with a comfortable standard of living at that time. The pivotal question becomes: What amount do we need to invest today to reach this goal? Let us now work backwards to answer our question.

Employing our DGI strategy, which prioritizes a secure dividend and consistent dividend growth based on company fundamentals rather than market speculation, we introduce our All Canadian ‘No-Look’ DGI Portfolio. The portfolio is a condensed version of ‘The List’ we follow, which contains a diversified list of the top twenty Canadian stocks rated by third-party rating agencies as of January 2024.

We will distribute equal investments across all twenty companies, basing our current yield on the average of last Friday’s closing yields (3.6%). The estimated average annual forward dividend growth rate will mirror the five-year average growth rate of the stocks in the portfolio (9%). Our investment horizon spans fifteen years, aligning with our retirement goal.

Crestmont Research has introduced the ‘Reconciliation Principle’ as a tool for forecasting future stock market returns and evaluating the accuracy of past predictions made by analysts and pundits.

According to Crestmont, conventional wisdom suggests that stock market returns are essentially random and cannot be reliably forecasted in the short term (spanning days, weeks, months, or even a few years). However, they argue that short-term fluctuations can deviate temporarily from long-term principles that hold true over extended periods. Interestingly, stock market returns exhibit a high degree of predictability on either side of a decade.

We’ve observed a similar pattern with our Dividend Growth Investing (DGI) strategy and our ten-year compound annual growth rate charts, utilizing the stocks we monitor on ‘The List’. Initially, we were uncertain about the reasons behind this predictability until we came across an article by Ed Easterling at Crestmont Research. This predictability arises from the underlying components that drive stock market returns.

Data is starting to pour in about the underperformance of actively managed funds over longer time horizons with one research report from S&P Global showing that close to 95% of Canadian fund managers did not even beat the TSX Composite Index over the ten years to June 30, 2023. This is bad news for the wealth management industry in general but also a bit disappointing when you look at where financial journalists and wealth managers are transitioning their clients.

In response to this, there’s a growing interest in passively managed products in the United States, and it seems that Canada is poised to follow suit in the near future. The financial landscape reflects a shift toward the mentality of “if you can’t beat them, join them.” The distinction between actively managed and passively managed products is becoming increasingly blurred. To illustrate this shift, we’ll examine a top-performing dividend fund alongside a popular dividend ETF.

Here are the ten-year cumulative returns of the index, a top actively managed dividend fund and a passively managed dividend ETF:

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.