The dividend is a symptom of a company’s free cash flow, and therefore not a driver behind an estimate of a company’s intrinsic value. Dividend-paying and dividend-growing stocks have done very well in the past, but it may be equally important to pay attention to the underlying valuations of ideas, too. You just can’t stop at analyzing the dividend payment. Don’t let the “yield” tail wag the “value” dog.
By Brian Nelson, CFA
There is a reason why we call ourselves Value-ntum. That’s because we put value first!
But there are instances where share prices can catch sustained favor in part due to a dividend payment. The growth component of the dividend may also offer investors an ever-rising income stream, particularly if they find a company that expects to continue to grow the payout for a long-time coming.
Even though we generally don’t like speculative-themed exchange traded funds (ETF)–as most ETFs are since they don’t consider a price-versus-value component–the idea of the SPDR Dividend ETF (SDY) as an investment consideration is effectively three-fold, in our opinion.
1. A Basket of Strong, Competitively-Advantaged Companies
For those that may not be familiar with this ETF, the SPDR Dividend ETF seeks “to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P High Yield Dividend Aristocrats Index:”
The S&P High Yield Dividend Aristocrats® index is designed to measure the performance of companies within the S&P Composite 1500® that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years.
We may never feel comfortable holding AT&T (T), IBM (IBM) or even Target (TGT) by themselves, but in a diversified dividend growth ETF, we’re more open to the concept, especially when some solid REITs such as Tanger Factor (SKT), Realty Income (O) and National Retail Properties (NNN) are also included in its top 10 holdings! The list of solid companies in this ETF is simply incredible (see more here xls).
2. The Companies It Holds Fit the Dividend Growth Theme to a T
The SPDR Dividend ETF includes a grouping of some fantastic companies that not only have the business models to support a growing dividend, but also have the executive teams to stay dedicated through both good and bad times! Think: capacity to grow the dividend, and willingness to grow the dividend. You can’t have one without the other and achieve dividend expansion! Though a company being on this list doesn’t mean the company will stay on it forever, the ETF does provide some nice diversified exposure to dividend growth, and this we like.
3. Dividends Themselves Offer Support and Compounding Dynamics
The dividend yield, if sustained, can offer some nice support to a dividend payer’s share price. Of course, one has to look at the Dividend Cushion ratio to determine just how strong a company’s dividend payment might be going forward, particularly as it relates to capital-market dependence, but nonetheless, in an environment of low, albeit rising, interest rates, the dividend yield can still act as a foundation for the price.
In an appreciating market over the long haul, dividend growth and dividend reinvestment may simply be another “Wonder of the World,” with an even greater compounding nature to returns than compound interest itself. Of course, it only works well when stocks are on the rise over the long haul, but it’s hard to bet against the strength of the global economy over a long-enough time horizon!
We wouldn’t be telling the whole story if we didn’t explain that readers should still watch out for the rising interest rate environment, however, as the potential tradeoff into higher-yielding fixed income instruments may pressure prices of dividend-paying equities through selling (portfolio re-allocation).
Don’t Just Consider the SPDR Dividend ETF and Stop There
Readers looking to add a sliver of dividend growth to their portfolios can do much worse than the SPDR Dividend ETF, but we think it is worth noting that this broad ETF alone may not be enough to be completely diversified against key risks. For example, the ETF doesn’t consider a price-to-value component, so it matters little whether such stocks trade at 20 or 30 or 50 times earnings. As long as they fit the index criteria, they’re included.
The lack of a valuation consideration could expose a holder to significant valuation risk, something only exacerbated as interest rates rise. That’s why we only view the SPDR Dividend ETF as one of many ideas in the simulated newsletter portfolios. Access the archived Dividend Growth Newsletter and simulated portfolio here >>
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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.