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1,000 Dividends, 3 Lessons

Morningstar DividendInvestor editor Josh Peters explores some valuable lessons he’s learned collecting the first 1,000 dividends in his newsletter’s portfolios.

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As the founding editor of Morningstar DividendInvestor, I have to confess to a certain bit of annoyance when I hear the phrase "dividend trade." The idea of using high-quality, high-yielding stocks as vehicles in a short-term game of pops and drops isn't just insulting; it's bad logic. For one thing, these stocks tend to be less volatile than the market overall. If you're trying to trade, isn't more volatility what you want? For another, these dividends are so small relative to how much stock prices fluctuate from day to day. A 4% yield is very good these days, but even that takes a full year to earn, typically in quarterly increments of 1%. For all I know, a stock could go up or down 1% because some hedge fund trader spilled coffee on his keyboard.

Ah, but how very beautiful--and powerful--dividends become when we add the magic ingredients of time and inaction. That's not a misprint: Inaction is very important aspect of our strategy!

The two DividendInvestor model portfolios that I mange are backed by real-money accounts funded by Morningstar. In addition to making our recommendations crystal clear--buy means we're buying, sell means we're selling, and hold means we're holding--the account histories allow me to track our results in exacting detail. On the morning of June 10, I fed our most recent transactions into my spreadsheets and discovered--almost by accident--that we had just received our 1,000th dividend payment since inception. This honor comes by way of a dividend of $94.55 paid on the 310 shares we own of  Spectra Energy (SE) in our Dividend Builder Portfolio. 

Yet investing--even when focused on dividends--is never just about the dividends. Total return, which reflects both income and capital appreciation, is the bottom line for any investment strategy. As of June 10, our model portfolios earned a combined annualized return of 8.6% since inception, which compares with 6.1% from the S&P 500 and 5.5% on the Dow Jones U.S. Select Dividend Index of high-yielding stocks. This isn't the kind of performance that is likely to attract the get-rich-quick crowd. We haven't outperformed every year or under all circumstances. I can't predict the short-term future any better than anyone else, so I don't try. Yet these results show our strategy is working, and working quite well.

I've always been confident that this would be the case, though not because I'm a brilliant investor; it's the dividends themselves that are brilliant. But we've also learned some valuable lessons while collecting our first thousand dividends that will serve us well as we go on to earn our next thousand dividends and beyond.

Lesson 1: Quality, Quality, Quality!
It's possible to reduce the DividendInvestor strategy to a very simple premise: Make sure your dividends grow!

In the eight-plus years of managing the DividendInvestor model portfolios, we've owned 86 different stocks, 36 of which we continue to own today. (Our annual rate of portfolio turnover has been only 17%, but even that modest level adds up over time.) Of the 54 stocks that have raised their dividends without any reductions while we owned them, we earned positive total returns on 49, a success rate of 89%. We've also owned 15 stocks that merely held their dividends flat, though 5 of these are recent additions to the portfolios that I expect to raise their dividends by the time we've owned them for a full year. Even so, we've earned positive returns from 12 of these stocks, a success rate of 80%. The dividend cutters occupy a land of agony: We lost money on 13 of the 16 portfolio holdings that cut their dividends, and the 3 that have been profitable--  General Electric (GE),  U.S. Bancorp (USB), and  Wells Fargo (WFC) --only pulled into the black long after their dividends began to recover.

There is a paradox of sorts at the heart of a high-dividend strategy: Large dividends are more rewarding than small ones, but large dividends place a bigger financial burden on the companies that pay them--and that burden can be tough to shoulder at times. To get yields of 3%, 4%, 5%, and up, dividends often account for 50% or more of a company's annual earnings. If earnings fall, the dividend could be in trouble too. Of the 16 dividend cuts we've had--all of which took place during the calamities of 2008 and 2009--13 of them were financial services firms of various kinds, and a 14th (GE) got into trouble because of its huge financial services subsidiary, General Electric Capital Services.

This result underscores the need for quality, which is to dividend investing what location is to your real estate agent. There is no one statistic of financial strength that can guarantee the safety of a dividend; no dividend is ever guaranteed. Fortunately, it's not hard to identify factors that can contribute to a reliable and growing dividend. The first four that come to mind are: (1) economic moats--narrow or wide, as rated by Morningstar; (2) manageable debt loads and secure forms of borrowing, where Morningstar's proprietary corporate credit ratings come in handy; (3) the absence of potentially grave risks--I strongly prefer stocks with fair value uncertainty ratings of low or medium; and (4) a payout ratio that provides an adequate margin of safety given the variability and cyclical sensitivity of profits.

It is also absolutely essential to avoid reaching too far in pursuit of the highest yields. Over the course of eight years and 86 different stocks, I made plenty of mistakes, but the worst by far came from the very highest-yielding stocks I bought--Allied Capital, CapitalSource (CSE), and MuniMae (MMAB). Back in 2007, I thought of these stocks as the best properties in a bad neighborhood, but the real estate mantra "location, location, location" was the far more critical variable in subsequent performance. You can bet that I will never invest in any specialty lender, business development company, or mortgage real estate investment trust again.

Lesson 2: Dividend Investing Is Its Own Thing
This lesson might seem a bit like inside baseball, but it's still one of the most important conclusions I've drawn over the course of collecting our first 1,000 dividends. Investing for dividends is not really a subset of value investing, or what most people think of as value investing. Dividend investing doesn't fall into the growth or momentum styles, either, though growth of dividends is a critical part of our approach. Dividend investing is its own thing.

I've always believed dividends were the most important aspect of our investment strategy, but I've always been something of a cheapskate, too. I don't like paying full price for anything if I can help it. In the first year or two of DividendInvestor's run, I brought this impulse to my stock-picking, but I was often disappointed. In the banking industry, for example, I originally passed on top performers like  M&T (MTB) and gravitated toward statistically cheaper names like National City and First Horizon (FHN). I also dabbled in a few straightforward value plays that, at least in hindsight, really didn't have much to do with their dividends ( Sonic Automotive (SAH) and Tuesday Morning (TUES) come to mind). The results from these stocks were mediocre at best; worse, they kept me the sidelines as best-in-class issues like  General Mills (GIS) and  Southern Company (SO) kept raising their dividends.

It didn't take too long for me to recognize these mistakes. I managed to sell those four stocks before their dividends were cut, and our portfolios performed well overall. But it still took several years for me to take a key piece of Warren Buffett's advice to heart. Starting in the late 1970s, Buffett realized that it was better to pay a fair price for a great business rather than a great price for a fair business. The best-of-the-best dividend-paying stocks are rarely cheap, and when they are, it's usually because the whole market has been crushed and most other stocks are cheaper still.

At the same time, I can't endorse paying any price to buy a high-quality dividend-paying stock. You might say experience has turned my approach into DARP: dividends at a reasonable price. I still demand margins of safety, principally through economically defensive and competitively advantaged businesses, strong balance sheets, and manageable payout ratios. But if you start your search for dividend-paying stocks by looking for cheap valuation metrics rather than the best businesses, you're prone to make a mistake Ben Graham identified in his final (1973) edition of The Intelligent Investor:

The risk of paying too high a price for good-quality stocks--while a real one--is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions....These securities do not offer an adequate margin of safety in any admissible sense of the term.

Lesson 3: Let the Dividends Do the Work!
Most value strategies in stocks--like most growth strategies or momentum strategies--place the burden of earning returns on the investor rather than the investment. Buy low, sell high, repeat as necessary. It is possible to be successful within this framework, but it's not always the most practical approach. Often, the much-maligned buy-and-hold mentality works best, especially with large and growing dividends.

When I disaggregate the performance of DividendInvestor's model portfolios into income and capital appreciation components, the advantage of letting dividends do the work becomes clear. Cumulatively, there's very little difference between the capital gains we've earned since inception and those of the S&P 500. Our stocks go up when the market goes up, our stocks go down when the market goes down, and there's not much I've been able to do about it.

But there's a giant difference in terms of income: Thanks to our focus on high-yielding stocks, we've collected more than twice the dividend income that the S&P 500 has paid, and this premium represents our entire margin of outperformance. Better yet, our income--as opposed to the market value of our holdings--is a factor I can influence. By choosing to focus on high-yield stocks, I can manage the amount of income we're receiving. I can't make the market go up or stop going down. By holding our stocks through thick and thin, I've been able to collect all of the income they've paid. I couldn't hope to achieve that while darting in and out.

I do make trades in our portfolios from time to time. I can't expect to buy and hold a stock forever, and I also enjoy a steady inflow of dividends that I reinvest. But when I make a trade, it's only because I expect it to benefit our income, in terms of current yield, future dividend growth potential, or the quality of the business paying it. Capital appreciation is a hoped-for side effect that I think is reasonable to expect from a stock over a long time horizon, as long as its dividend is growing, and that's the kind of result we've gotten from our portfolios to date. But capital appreciation is still just an item in the cart; it's not the horse.

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Josh Peters, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.