Dividend Growth Investors Face Unique Risks in 2014 by Brian Nelson, CFA
With 2013 now in the rear-view mirror, we can happily say that the Dividend Growth portfolio significantly exceeded its goals of an annualized return in the mid- to- high-single digits for the year. We know that you’ve been a part of this journey in 2013, and we wanted to congratulate you as well. In fact, the successful year would not have been so without you, and we wanted to extend a big thank you for that. If you haven’t been a member for that long yet, we’re expecting an exciting 2014, too!
For one, dividend growth investors are enjoying a time like no other in the history of the equity markets. The attractiveness of dividend growth investing as a style has prompted companies to reevaluate their entire capital allocation decisions, and some firms’ boards have even decided to implement material step-ups in dividend payouts. For the most part, earnings expansion has supported the pace of dividend growth in 2013, and just like business owners that enjoy increased operating cash flow, dividend growth investors are enjoying increased dividend payments. It’s been a great experience for the dividend growth crowd.
Still, dividend growth investors will face some unique risks in 2014. The markets are ushering in the year with an aggregate price-to-earnings ratio of roughly 15 on S&P 500 constituents, a level above both the 5-year and 10-year averages. The 10-year Treasury has just recently hit the highest level since July 2011, a sign that a) yields on new bond issuances will act as heightened competition for income and b) discount rates applied to equities will increase, pressuring fair value estimates. Investors should not be surprised if overvalued dividend growth entities face pricing pressure in 2014, especially if yields begin to rise and certainly if price-to-earnings ratios contract toward 5- and 10-year averages.
In this environment, it will be very important for dividend growth investors to continue to focus on the underlying cash-flow dynamics of the businesses they’ve invested in and their respective Valuentum Dividend Cushion scores—a cash-flow coverage measure of the health of the dividend. After all, dividends are paid in cash, and earnings are but a component of cash flow.
Second, assessing valuations and applying an appropriate margin of safety will remain paramount. In overvalued stocks (ones with price-to-fair value ratios above 1), we do not expect to allocate any new capital in the Dividend Growth portfolio to them this year, even if the markets continue to race higher. We would find that to be an irrational move, not supported by underlying cash-flow fundamentals.
Though the markets are making the hunt more difficult, we will continue to look to undervalued, dividend growth gems for the portfolio—companies like Microsoft (MSFT) and Apple (AAPL). These two tech giants, for example, have mountains of net cash on their balance sheets and generate gobs of free cash flow (operating cash flow less capex), making them fantastic dividend growth ideas over the long haul.
Happy New Year! Thank you! And let’s keep the outperformance of the Dividend Growth portfolio going into 2014 and beyond!
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INSIDE THIS ISSUE
1 Dividend Growth Investors Face Unique Risks in 2014
2 Financial Analysis 101: Understanding Stock Splits
4 McDonald’s US Comparable Sales Fall (ticker: MCD)
5 Our Dividend Growth Portfolio
6 Kinder Morgan Energy Partners’ 2014 Outlook Reveals Distribution Growth (ticker: KMP)
6 Share Buybacks in Vogue for Portfolio Holdings (ticker: UNP, PSX)
7 Valuentum Members Are Reminded of the mREITs (see article for tickers)
9 Cisco’s Investor Update Reveals Challenges (ticker: CSCO)
10 Stocks with High VBI Ratings and Strong Dividend Growth Prospects (see article for tickers)
11 Our Dividend Growth Watch List
12 Yields to Avoid
13 Industrial Conglomerates Dominate News (tickers: GE, HON, UTX)
15 Oracle Steals the Headlines (ticker: ORCL)
16 Nike’s Earnings Expansion Will Continue to Be Challenged (ticker: NKE)
19 About Our Dividend Cushion™
22 Featured Reports: GE, MSFT, BA, MDT
26 Our Valuentum Buying Index
29 Valuentum Definitions