Portfolios: Dividend Growth Versus Best Ideas
publication date: Apr 8, 2018
author/source: Brian Nelson, CFA
Let’s talk about the difference between the Dividend Growth Newsletter portfolio and the Best Ideas Newsletter portfolio.
I wanted to post a short note because it’s important that we continue to explain the difference between the two newsletter portfolios that we provide as part of the individual membership. We publish a Dividend Growth Newsletter and a Best Ideas Newsletter, the former delivered on the 1st of the month and the latter delivered on the 15th of the month. We also cover and provide reports on over 1,000 stocks and dividends on our website, as well as provide quarterly publications like the Dividend100 publication, for example. We cover the bases. We also provide the monthly Nelson Exclusive publication, which by the way has an awesome success rate for new ideas, and we also publish a High Yield Dividend Newsletter.
In this note, I wanted to clarify a few things as it’s not easy to keep everything in order, especially when we start talking about the Valuentum Buying Index and Dividend Cushion ratio, and it’s even more difficult to get all of our team’s thoughts on paper when we’re considering ideas for portfolio construction, both to add and to remove (considerations beyond individual equity analysis, instead related to portfolio diversification). It’s perfectly understandable there are always a lot of questions. To get things started in this note, I think the heart of the matter is that you must understand that the dividend is a component of total return (dividend yield + capital appreciation % = total return). The dividend is not incremental to total return, but instead the dividend is a part of total return that otherwise would have likely been capital appreciation if the company had never paid a dividend.
As the dividend is increased, the capital appreciation is reduced, while total return is held constant, generally speaking (all else equal). This concept has been misconstrued by even the most respected investors to some of the most-read bloggers that it seems like efforts to provide correct information to investors may be fruitless. I’ve written an open letter to the board rooms of America on this topic, I’ve helped explain it through the eyes of indexers, I’ve written about it time and again, and I even did a video on the topic. I’ve been screaming about this from the mountaintop for years! More recently, I came across another great video from my alma mater, the University of Chicago, that may help further explain, “The Free Dividend Fallacy.” You have to understand that the dividend is a part of total return that otherwise would have been capital appreciation if the company had never paid a dividend.
Just because this is the case doesn’t mean the dividend is not important, however. The dividend can be used by financial advisers to set up dividend growth or income portfolios. It can be used by dividend growth or income investors to build income over time, and the dividend helps to keep management in check so the executive suite doesn’t build too high of a cash pile where it could be wasted on foolish acquisitions. The dividend is vitally important in many respects, and the idea of reinvesting growing dividends over time into strong-performing dividend growth stocks may be better than compound interest itself, what Albert Einstein once called: “the eighth wonder of the world. He who understands it, earns it…He who doesn’t…pays it.” Reinvesting dividends in appreciating dividend-growth companies offers an even greater compounding dynamic. However – it doesn’t change the idea that the dividend is a part of total return that otherwise would have been capital appreciation if the company had never paid a dividend.
That said, when we speak of dividend growth, that’s what we’re focused on when we include ideas in the Dividend Growth Newsletter portfolio. For example, when we look at the most recent addition, Digital Realty Trust (DLR), the REIT has an adjusted Dividend Cushion ratio of 1.8, excellent dividend growth potential and a nice dividend yield to boot. Though its valuation may not be the greatest, not many companies in today’s still-frothy market are, so sometimes we have to relax some considerations to achieve the goals of the Dividend Growth Newsletter portfolio, in providing an awesome dividend growth idea, in our view. Similarly, Oracle (ORCL) boasts a Dividend Cushion ratio of 3.9 (this is incredible coverage), has excellent dividend growth potential, and while its yield is a little light, we’re expecting huge increases in the dividend in coming years, and the company is a rare bargain in today’s market (its stock price is trading meaningfully below our fair value estimate).
Notice how we said very little about the Valuentum Buying Index or momentum. Why? Because these two ideas were added to the Dividend Growth Newsletter portfolio. The Dividend Growth Newsletter portfolio is focused on companies that we think will achieve future dividend growth. We pay attention to business models, of course, and we’re looking to scoop up the best dividend growth companies at the best price, but dividend growth stocks are not immune to market forces either. We’ve been in a 9-year bull market and the pullback that started in early February has created a situation where there are fewer and fewer highly-rated stocks on the Valuentum Buying Index. This is a good thing. Can you imagine if we had hundreds of 9- and 10-rated stocks on the Valuentum Buying Index heading into February for the market’s recent swoon? We didn’t have one 9 or 10, and that’s a testament to the methodology--not our dividend growth methodology, but the Valuentum Buying Index methodology that we use primarily in the Best Ideas Newsletter portfolio.
Unlike the Dividend Cushion ratio (a core part of our dividend growth methodology), which focuses on evaluating the health of a dividend, which itself is independent to the valuation of a company (the dividend is a symptom not a driver of value), the Valuentum Buying Index puts discounted cash-flow valuation first and adds a relative value overlay (think price-to-earnings ratio) and a technical/momentum overlay to help sort out which stocks that are already undervalued may be more or less timely than others. Within the Best Ideas Newsletter portfolio, we focus on strong business models and good companies, of course, but we’re also looking for stocks that are undervalued and ones that have good Valuentum Buying Index ratings. In this frothy market, the number of undervalued stocks and those with good momentum (or those having high Valuentum Buying Index ratings) are few and far between. Our latest 9 or 10 on the Valuentum Buying Index was a huge winner, even though we didn’t capitalize on it in the Best Ideas Newsletter portfolio as much as we would have liked.
The key takeaway is that the Dividend Growth Newsletter portfolio mostly focuses on dividend growth and the Best Ideas Newsletter portfolio mostly focuses on valuation mis-pricings and long-term capital appreciation. We would generally expect ideas in the Best Ideas Newsletter portfolio to have a greater price return than those in the Dividend Growth Newsletter portfolio. The reason? Because when a company’s dividend is paid, the exchange reduces the price by the amount of the dividend. Over time, this weighs on the price of dividend paying stocks. But now you get the point – if dividend paying stocks didn’t pay a dividend, then their capital appreciation would likely be much better. The cash that was paid out as a dividend over time would have been stored up as cash on the balance sheet. That cash has intrinsic value, and intrinsic values generally act as magnets to stock prices.
Because the dividend is very important to how investors structure income, we pay very close attention to the health of a company’s dividend in the Dividend Growth Newsletter portfolios – that’s our primary consideration. In fact, we removed Kinder Morgan (KMI) and General Electric (GE) well in advance of their respective dividend cuts, saving those that followed the Dividend Growth Newsletter portfolio considerable income deterioration but also meaningful capital losses in these two companies. Probably said more plainly, capital appreciation, itself, is not the primary goal in the Dividend Growth Newsletter portfolio. We’re after dividend growth. Capital appreciation is probably more appropriate to look for with respect to ideas in the Best Ideas Newsletter portfolio such as Visa (V) or PayPal (PYPL), for example.
Why are we spending so much time writing this? Well, readers should not expect an undervalued stock that has good momentum--but doesn’t pay a dividend--to be added to the Dividend Growth Newsletter portfolio. That idea may be a better fit for the Best Ideas Newsletter portfolio, but only if our team signs off on it with respect to portfolio construction. Likewise, you shouldn’t expect a high yield stock to find its way into the Best Ideas Newsletter portfolio. That stock may have tremendous risk to the dividend (and therefore risk to the price as income investors may exert tremendous selling pressure in the event of a cut), and its share price will be weighed down with each and every dividend payment. You may find a stock that pays a strong and growing dividend in the Best Ideas Newsletter portfolio, but that stock would have been added to the Best Ideas Newsletter portfolio on the basis of its capital appreciation prospects. Remember, the dividend is independent to valuation, and valuation tends to act as a magnet to prices.
We want to continue to emphasize that the Dividend Growth Newsletter portfolio and the Best Ideas Newsletter portfolio are two different portfolios with two different goals that focus on finding two different kinds of stocks, though there could be overlap at times. Furthermore, the team in constructing the portfolios may have to relax certain criteria to gain diversified exposure. For starters, in today’s market, there aren’t many stocks that are underpriced and have good momentum, though we are watching Facebook (FB) closely for a turnaround in its equity price momentum. Furthermore, we generally target newsletter portfolios containing 20 companies. More conservative investors, however, might pursue a portfolio with 30-60 stocks, where 85% of portfolio dispersion or available diversification (including not only standard deviation, but also tracking error and r-squared) can be achieved. That’s why we publish the companion quarterly financial adviser level publications, the Ideas100 (a grouping of our 100 favorite ideas with the strongest business models) and the Dividend 100 (a grouping of our 100 favorite dividend growth ideas).
This article is a lot to digest for sure, but we want to be as transparent about our processes as possible. Our team is looking to run the newsletter portfolios to meet their respective goals, and it is easy for members to get the portfolios and the many methodologies mixed up at times. The quick rule of thumb, however, is that the Dividend Growth Newsletter portfolio targets dividend growth potential, while the Best Ideas Newsletter portfolio targets capital appreciation potential. Dividend growth and capital appreciation are two distinct concepts and ideas, even though there could be overlap at times. The dividend is a component of total return that otherwise would have likely been capital appreciation if the company had never paid a dividend. Perhaps more directly, we may include a stock in the Dividend Growth Newsletter portfolio because we like its dividend, but we won’t include a stock in the Best Ideas Newsletter portfolio only because we like its dividend.
It’s difficult to keep track of everything going on. What’s more, we cover 1,000 stocks and ETFs, and we also have unique methodologies such as the Valuentum Buying Index and Dividend Cushion ratio, but we do so because we want to make sure that we’re delivering the most value we possibly can to you. We’re not throwing darts at the stock pages of the newspaper. We’re digging into the company’s fundamentals and offering extensive analysis with respect to each idea across our newsletter publication suite. The core of our product will always be the content behind the ideas. We’re not your financial adviser, so we can never tell you what to buy or sell. That’s not the business we’re in. All we can do is deliver the best information we possibly can and be as transparent as possible. We think we do this better than anyone else out there, and we hope you do, too. Please let us know if we can elaborate further.
Brian Nelson, CFA
Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.
Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.