When you focus on the long term and place part of your capital in dividend-yielding stocks, you should be sure to target companies with the highest potential.
How do you define that potential among thousands and thousands of companies?
By investing in those stocks with the most stable dividends. In fact, the ideal is to invest in companies whose dividends increase every year to protect us from inflation and take advantage of the magic of compound interest by reinvesting our earnings.
Here you may wonder if such companies exist, as the economy tends to have a lot of ups and downs.
In fact, yes, such companies do exist, and the best of them are grouped into a very select club.
This is the “S&P 500 Dividend Aristocrats Index” or “S&P 500 Dividend Aristocrats Index”, which groups companies that have been able to increase their dividends in each of the last 25 years at least.
The first condition for a company to be considered a Dividend Aristocrat is that it is included in the S&P 500 Index(SPX), which already implies meeting several selectivity criteria.
These criteria include market capitalization (at least $3 billion), but also other aspects such as the level of liquidity, the company’s location, its sector of activity, its age on the stock exchange and its financial base, among others.
It is worth noting that when a company in the S&P 500 manages to accumulate 25 years with such a record, it is included in the Dividend Aristocrats index, while when it fails to increase its annual dividends or leaves the S&P 500 Index, it is excluded.
The Dividend Aristocrats Index was launched in 2005 as a new product of the S&P Global Inc. index (SPGI), however, we will not focus on the index but on its components, as we are interested in a variety of companies whose stocks are attractive to invest in.
Of course, we must remember that investing in the stock market implies the risk of losing our capital, totally or partially, so it is necessary to educate ourselves to reduce this risk.
In this article you will learn who are the Dividend Aristocrats in the U.S. and what would be the keys to identify the best companies within this select group.
Reasons to invest in Dividend Aristocrats stocks
“Companies that pay dividends and are able to increase them for years or decades tend to be more financially sound and stable.”
Companies whose stocks pay dividends and are also able to increase them steadily for years or decades tend to be more financially sound and stable in their fundamentals than those that pay high dividends, but are unable to sustain them or are very erratic.
Therefore, we must begin by making a distinction within the dividend stocks that make up the Dividend Aristocrats, identifying the 2 most attractive types:
Rising Dividend Stocks
These are those that increase the dividend base annually, beyond the yield of those dividends on the share price. That is, they may reflect a low, medium or high dividend yield, but are capable of sustaining it for a long time.
High dividend stocks
These are stocks that pay high dividends on the share price (high dividend yield), regardless of whether they are able to maintain or increase them over time. In this case the trajectory of the dividend may be irregular and even decrease.
It should be noted that high dividends are not necessarily an indication of strength.
There have been cases, especially in new or at-risk companies, that have gone into debt to pay higher dividends and attract investors.
According to a 2020 study by Tianyin Chen (Strategy Indices Senior Director) and Izzy Wang (Strategist Indices Analyst) for S&P Global Inc. on the “Arguments in Favor of Growth Strategies”:
“As a result, stocks that pay high dividends and have higher financial leverage, lower yields and lower earnings growth are more likely to cut their dividends in a volatile, low-growth market.”
Therefore, when analyzing dividend-paying companies we should pay special attention to 3 metrics:
- The Debt/Equity ratio.
- The return on shareholders’ equity (ROE).
- Earnings per share growth rate.
As far as dividends are concerned it is more important their track record and not so much their level or yield, although it is desirable that they are high.
This is particularly important at times like the present, with great risk for the U.S. economy and with a geopolitical situation that is already impacting via commodity prices.
If the situation worsens you do not want to be positioned in stocks that are not able to withstand a market downturn or recession. In other words, you will want to have Dividend Aristocrats in your portfolio.
Income stocks that pay growing dividends and have good fundamentals can offer better protection from volatility and down markets than stocks with high dividends, but which are not sustainable.
However, if you are going to invest in income stocks with growing dividends it is always advisable to diversify across different sectors.
The same study mentioned above argues that, as a hypothetical exercise, stocks with growing dividends could generate higher income over time than stocks with high dividends, since the latter grow at lower rates.
So all of the companies that are part of the “S&P 500 Dividend Aristocrats” index are growing dividend stocks.
4 characteristics of the best dividend stocks
In short, the ideal dividend stocks have the following 4 characteristics:
- A low volatility measured by its Beta the volatility of a stock, to consider stocks whose profitability tends to fluctuate less than the market’s profitability. However, this depends on the degree of diversification of the investment portfolio.
- A record of sustainable dividend increases in order to offset inflation.
- A dividend yield higher than the yield of a “10-Year U.S. Treasury Note.” (10-year U.S. Treasury note), to compare the stock to a low-risk asset.
- A reasonable level of earnings growth, to consider stocks with good prospects for expansion over time.
Who are the Dividend Aristocrats and how to select them?
Currently the group of Dividend Aristocrats who meet the above criteria are 65 companies including those who joined the club in 2022.
In the link above you can access the list with the name, share ticker and sector of activity.
To give you a preview of some of the names you are probably familiar with, we have 3M (MMM), IBM (IBM), Coca Cola (KO), Pepsi (PEP), Colgate-Palmolive (CL), Procter & Gamble (PG), Johnson & Johnson (JNJ) and Walmart (WMT), among others.
However, most of them are probably unknown to you, although what is important is the ability to have generated growing dividends for at least 25 years.
In fact , some of these companies have done so for more than 60 consecutive years.
These companies are already part of a select club, but that doesn’t mean they can’t have bad years or face difficulties.
What we do know is that in the crucial area of dividends they are more consistent than the rest of the companies in the market.
But then, what would be the characteristics to take into account if we wanted to select the companies with the greatest potential?
Dividend Aristocrats Value Map
To answer the above question we have created a “value map” to prioritize some of the characteristics we should consider when selecting the companies with the greatest potential to invest in the Dividend Aristocrats club.
Although the past is no predictor of the future, the track record of these companies suggests that they tend to have better and more stable fundamentals than the rest.
That is, if they have been consistent companies in the past, they are likely to continue to work to remain so in the future.
In fact, some researchers who have tracked the performance of companies that have been excluded from the club have found that after that, in some cases, their metrics tend to improve.
From the information available at Investing.com we have extracted the current values (as of March 11, 2022) of 16 very important metrics for the 65 companies.
In other words, we have created a “Data Dashboard” to be able to compare the 65 companies and rank the companies according to any of these 16 variables or combinations of them.
You have at your disposal the above data panel as a Google Spreadsheets document, so you can observe the analysis done and apply filters to the Dividend Aristocrats according to your own criteria: https://docs.google.com/spreadsheets/d/1sIr6….
Instead of using several time series to analyze a single company, we have considered several single values to analyze 65 companies at a certain point in time which is now.
It’s like taking a photograph of 65 different people and comparing their different traits, rather than taking a photo album of a single person to get to know them in depth.
You can even do statistical regressions with data like this, but today we will just combine different filters to rank the strongest companies in a simple spreadsheet.
The 16 variables that make up this value map are:
P/E Ratio – Company
It is a fundamental ratio to know how high or how low the company is trading based on its earnings per share.
P/E Ratio – Industry
It collects the same information but for the industry where the company operates. Most importantly, it allows us to compare the company’s P/E ratio with its industry and estimate a relative valuation.
(Undervaluation) Absolute Overvaluation
It is simply the difference of the two previous variables. When this difference is negative (positive) it tells us that the stock tends to be undervalued (overvalued) with respect to the average of its sector. This indicator is a proxy for the intrinsic valuation of the stock, since this aspect requires other more complex calculations.
(Undervaluation) Relative Overvaluation (%)
This is the previous variable expressed as a percentage. This allows a better appreciation of the approximate degree of under or overvaluation with respect to the sector average.
It should be noted that a high degree of undervaluation (overvaluation) does not necessarily mean that a stock should go up (down) as a result.
A company may even remain years out of line with its intrinsic value if its fundamentals are very strong (weak), as this may lead investors to want to pay higher (lower) premiums to buy the stock over a prolonged period of time.
What is true, as the tenets of value investing state, is that over the long term investors tend to be more rational and this leads to prices converging towards their intrinsic value.
Last Annual EPS ($)
The last earnings per share in dollars generated by the company on an annual basis.
Last Annual Dividend ($)
The last dividends per share in dollars paid by the company on an annual basis.
Last Annual Dividend Yield (%)
This is the yield of the last annual dividend per share. In other words, how much the dividend paid represents over the share price.
Beta
A measure of a stock’s volatility relative to the market (S&P 500 for example). It measures the degree to which the return tends to fluctuate relative to the market return and therefore reflects systematic and non-diversifiable risk.
A beta equal to 1 implies a volatility equal to the market, while below 1 (above 1) implies a volatility lower (higher) than the market.
Beta is particularly useful for balancing the risk of a portfolio that includes several stocks.
Sales Growth (5YA %)
This is the average sales growth rate over the last 5 years.
Net Profit Margin (5YA %)
The average net profit margin over the last 5 years.
EPS Growth (5YA %)
The average earnings per share growth rate over the last 5 years.
ROE (5YA %)
The average return on shareholders ‘ equity for the last 5 years.
Dividend Yield (5YA %)
The average annual dividend yield per share for the last 5 years.
1-Year Change in Price (%)
This is the percentage change in the share price for the last year.
Total Debt to Equity (MRQ %)
The Total Debt to Equity ratio for the last available quarter. It measures the relative weight of debt to equity and is a very important measure of a company’s degree of indebtedness.
Payout Ratio (TTM %)
This is the Dividends Paid / Net Income ratio and tells us how much of its profits a company pays as dividends to its shareholders. It is estimated that a healthy ratio is around 50%, although each industry is different.
Therefore, a ratio that is too low is a sign of poor distribution of value to shareholders, and may occur when the company is reinvesting a large proportion of its profits in operations and expansion.
A ratio that is too high is a warning sign that requires a review of other aspects. It can be an unsustainable practice over time, since if the company distributes all its profits it can affect its cash flow. Some companies even go into debt to do so..
Therefore, the level the payout ratio reaches defines the sustainability of a company’s dividend payout program.
“These 16 metrics above are arbitrary, but they would serve to profile the most attractive companies in the S&P 500 Dividend Aristocrats club.”
These 16 metrics above are arbitrary, but would serve to profile the most attractive companies in the S&P 500 Dividend Aristocrats club.
Remember that investing in the stock market involves the risk of losing our capital, in whole or in part, so we need to educate ourselves to reduce that risk.
So when deciding to invest in any company we must know it thoroughly first.
This exercise is not an investment recommendation, we are only going to select some of the best dividend aristocrats based on certain combined criteria.
If you were going to select income stocks (which generate a passive flow from dividends) for potential purchases with a long-term investment horizon, which ones would you choose?
Well, those with the best track records in sales, earnings per share, dividend yield, ROE, low debt, among other desired characteristics.
We may also be interested in selecting companies with a certain tendency to undervalue.
One of the principles of value investing is to buy shares of companies with growth potential that are below their intrinsic value and have a good margin of safety in their price.
So what are the best companies for Dividend Aristocrats?
With these selection criteria in place, do you want to know what the outcome of this exercise is and find out which are the best companies in the Dividend Aristocrats club?
To find out, you will have to continue reading the article Which are the best dividend paying stocks in the S&P 500, where we reveal the result of our analysis
