In this podcast I will answer the question: does investing in stocks that have increasing dividends provide a portfolio that outperforms the broad market?

I hardly ever comment on other blogs or podcasts, but recently I heard a popular internet marketer suggesting a ‘simple’ strategy to beat broad market investing by buying stocks that pay high dividends. He (Ryan Moran) was on a podcast I enjoy (Smart Passive Income with Pat Flynn) and I felt compelled to comment. He was nice enough to comment me back and we ended up have a pretty long exchange.

Ryan Moran dividend increasing stocks

I’ll summarize his strategy:

  1. Invest in companies that have a current dividend yield of over 4% and at least 10 years of rising dividend amounts/share. He recommends reinvesting all dividends back into the stock. He mentioned a website that have about 24 companies that meet his requirement (http://www.dividend.com/dividend-stocks/10-year-dividend-increasing-stocks.php).
  2. By investing in high dividend paying companies you reinvest when the share price is low and high (a form of dollar cost averaging – steadily buying in all markets). Dividends will continue to pay out (most likely continuing to increase) in all markets. If the stock is down, that’s fine, the dividends will buy more.
  3. This screening will only have stocks from a few sectors (mostly real estate investing and oil). There will be more volatility than a diversified portfolio but that volatility is welcome because it provides an opportunity to buy when stocks are lower.
  4. He recommends using dividends for 80% of the screening process but is not clear about the other factors.
  5. He also recommends reviewing the holdings when the dividend goes below 4% (to potentially sell).

He gave a few examples of his holdings: real estate investments (REITs), Chevron (CVX), and Target (TGT).

To be fair, Ryan had some good general recommendations about reducing debt, investing in your own business and investing in real estate. His investment strategy was the only portion I had issues with.

Summary of Concerns

Ryan’s claim is that by selecting stocks using his method (4% increasing dividend) your resulting portfolio will outperform the broader market.

My issues are:

  1. The performance is not better by using Ryan’s method. His strategy results in lower returns than the broader market. Even after seeing inferior returns, he was not convinced that his strategy and claims were flawed.
  2. Dividend payment are directly related to the profits of a company. They will go down if a company (or industry) becomes less profitable. It is more important to select quality companies than companies with growing dividends.
  3. This strategy limits the portfolio to a small number of industries and companies. Investment portfolios will not be well diversified. If there are downturns in the energy or housing sectors, portfolios using this strategy will be more impacted that a broader portfolio.
  4. This is not a simple strategy. While he bases most of his selection decision on dividend growth, he admits that there are other factors that he looks at. Timing his sale/hold decision on when a company cuts dividends absorbs much of the loss.

After determining that Ryan’s claim of superior performance is incorrect, we should be done. However, Ryan was not convinces that total return on investment was a good indicator of performance, so we continued our discussion. This evaluation does provide some information about stock investments.

Let’s examine his assumptions and strategy.

Dividends

Companies generally have three options to share their profits with their owners (shareholders):

  1. They can reinvest it in the company, to increase the value of the company (and increase the stock price). They can acquire another company, invest in research, expand, …
  2. They can buy-back outstanding shares in the company. All shareholders hold a larger portion of the company. This increases the share price.
  3. They can issue dividends, payments to the shareholders.

Of course, they can do a combination of these three. The decision depends on many factors including the nature of their business, opportunities, cash needs, …

By using dividends to buy shares, this strategy is just increasing your investment in that company. Dividends are the least effective of the three to do that because of double taxation (the company pays taxes on the dividends they issue and you pay income taxes on the dividends received). If the goal is to own more of a company – companies doing Options 1 and 2 are more efficient.

One issue that I have with his assumptions is that dividends to vary with a company’s performance. The dividend payout is one way to share profits, but if there are no profits there will be no dividends.

There are many companies that paid dividends that do not exist now (Blockbuster, Lehman Bros, Wash Mutual, Mervyns, Enron …). The reinvestments in these companies from the dividends they paid out did not turn out to be a good investment. If there is a carbon tax or governments limit the amount of fossil fuels that can be extracted, companies like Chevron could experience large losses (Carbon Bubble). Their dividends and share price will both go down.

Stock Picking

With this strategy, and any stock picking strategy, the best long term returns will be made by selecting the best companies. This strategy focuses on dividend growth (which is one good indicator) but there are many other indicators to look at to select quality companies. Here are a few other indicators:

  • Earnings compared to the price of the stock
  • Debt compared to equity
  • The growth in earnings per share
  • The value of assets that a company has
  • Cash on hand
  • Revenue per share
  • Amount held by insiders
  • Profit and operating margins
  • Company size / market location
  • The relative cost of the broader market (price / 10 year earnings)

There are many more. Focusing on any one, doesn’t give you complete picture.

Volatility

Ryan wants volatility in his holdings so that his dividends would buy when the market was low (assuming dividends continue to pay, unaffected by the share downturn). He was not concerned about having a more volatile portfolio even if it gave the same total return.

Volatility is an important consideration. If you can get the same return with less risk, that would be preferred. Having diversification in your portfolio protects you against unknown future bubbles in the market. Many people will need to access their investment (even if they didn’t plan on it) and may not be able to wait for the perfect time – stability in the value of your holdings can me very important.

Ryan states that if the stock is down and you want to get out, wait for it to rebound or go up before selling. This is easier said than done. Anyone with experience in stock investing knows that timing the market is not practical. Unless you have information that other investors do not, you cannot say that the current value of the stock is too high or too low. Stocks are priced based on the information that is publicly available.

Alternative

To compare with Ryan’s strategy – let me offer a general alternative (for a beginning investor who wants to invest on their own).

  1. Open an account (one with no fees or costs to open and trade in) at a discount brokerage house (Schwab, TD Ameritrade, Vanguard, eTrade, …).
  2. Come up with an investment policy (I put a very basic one below – it should be based on your risk tolerance and time horizon) and
  3. Select a low expense ratio ETF or mutual fund for each asset class (one with no transaction fee). The investments will change depending on where you hold your investments – look for no transaction fees. For example:

60% US stock (Vanguard total stock (VTSAX or VTI) or Schwab (SWTSX or SCHB))

20% foreign stock (Vanguard total intl (VTIAX or VXUS) or Schwab (SCHE/SCHF))

20% bonds (Vanguard total bond (VBTLX) or Schwab (SWLBX or SCHZ))

Of course, there are hundreds of variations on this, but this is the core approach. The idea is that you regularly (monthly for example) invest according to your plan (dollar cost averaging – buying at all market conditions). Once every 3-6 months you re-balance to this investment policy – so if stocks have done well, you sell some stocks and buy bonds – if stocks do poorly, you sell bonds and buy stock. (forcing you to buy low, sell high)

People famously under-perform a market (Dunbar study) – they sell when the market is down (and things look bad) and buy when the market is up (and things look great). The opposite of Warren Buffet’s advice (be scared when others are greedy and greedy when others are scared).

By having a simple automatic strategy – people don’t have to try to outguess the market, they spend very little time, no advisor fees, no research tools. You can invest in very small amounts.

Returns on Investment

This was an issue in our discussion. Ryan was not in agreement that the growth of the investment assets was a good way to evaluate performance. He was not clear about what alternative measure he would use. He valued the dividend payment over increased value, even though the dividends were being reinvested in the company. We never resolved this issue of coming up with a measure gaging his strategy versus the broader market.

Total returns are calculated assuming that dividends, interest, and any distribution is reinvested in the investment. This will allows you to determine how much money will be in your investment over a given period of time.

There are 24 stocks that meet Ryan’s criteria (SXL, GEL, DLR, EPD, OKE, WPC, O, PAA, HP, OXY, APU, BPL, HEP, HCP, T, DGAS, SO, CVX, ARLP, NWN, UBA, UVV, MCY, ORI). Of these 24: 10 are in the oil and gas industry, 5 are real estate investments (REITs), 4 utilities, 2 insurance companies, 1 coal company, 1 tobacco company, 1 telecom company.

Of these 24, 12 had out-performed the broader US market (VTI) over a 10 year period (12 had underperformed the market over 10 years). During the last year, 3 companies outperformed the US market, 21 underperforming. During a 3 year period, 5 outperformed and 19 underperformed. None of the options outperformed the US market for all three time periods (1,3,10 yrs). Hence, during a 10 year period (the best for this group of stocks), half over performed and half underperformed the market index. Random selection (throwing a dart at a list of stocks) would give equal results. The disadvantage of Ryan’s companies are that dividends are taxed at a higher rate than growth (capital gains). For the 1 and 3 year periods, the US market outperformed 83% of these stocks.

From 2009 through 2014, the US market outperformed this group of 24 stocks (that meet Ryan’s criteria) 54% of the time. Again the strategy is about a coin toss underperforming or over-performing the market.

Here are some returns (for comparison):
Stock/Fund(Ticker), Current Dividend Yield, 1, 3, 5, 10 yr annualized Total Return

Vanguard Total US Stock (VTI), 1.8% yield, 9, 17, 17, 8
Chevron (CVX), 5.0% yield, -29, -5, 6, 6
Target (TGT), 2.6% yield, 39, 10, 11, 5
Vanguard REIT (VGSIX), 3.7% yield, 9, 11, 14, 8
Vanguard Dividend Appreciation (VIG), 2.2% yield, 7, 13, 14, na
Vanguard High Dividend Yield (VYM), 3.0% yield, 6, 14, 16, na

So if you started with $100k 10 years ago, today you would have the following amount with each investment (with dividend reinvestment):

Vanguard Total US Stock (VTI), $180k
Chevron (CVX), $160k
Target (TGT), $150k
Vanguard REIT (VGSIX), $180k
(VIG and VYM have not been around for 10 yrs)

In addition, after tax returns favor low dividend investments (income vs capital gains rate). This information did not convince Ryan that his strategy was not outperforming the broader market.

Implementing the Strategy

Another issue with his strategy are his last two point. Selling (or holding) when dividends decrease and the additional factors to select a company.

The idea of selling your stock once the dividend goes down is not a productive strategy. When the share price goes down, the dividend yield (amount of dividend as a percentage of the share price) actually goes up. So when a dividend cut is actually announced and you see the dividend yield go down, the stock has already lost a significant amount of value. Your dividend reinvestments and initial purchase will all have lost value.

Ryan did say that if the dividend was cut, he would not automatically sell, he would evaluate the company and maybe hold or sell. This ties into my second concern, evaluating the stock. Ryan states that he would look at other factors besides just dividend growth and current dividend yield but he wasn’t clear about what he would look at. This makes it hard for someone to follow his strategy and get claimed performance.

Conclusion

I’m sure Ryan Moran is a very smart internet marketer and I do think that dividend growth is an indicator to consider if you are investing in individual stocks. However, his claim that he has an easy investment strategy that outperforms the broader market is unfounded.

I appreciate any feedback for our AIO Financial blog.  Please contact me if you have any comments, questions, and suggestions.  You can comment here or contact me through FacebookTwitter, email (bill@aiofinancial.com), or call 520-325-0769.

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