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What a 118-Foot Superyacht Can Teach Us About Investing

With an interior that resembles a New York-style loft apartment, 360-degree views from the dining area and a teak wood deck, the WallyPower 118 is one of the most luxurious yachts in the world.

And with a top speed of 70 mph, it offers speed and comfort – all in the same package.

Such a combination reminds us that we don’t have to compromise.

Now, what if we could apply this same principle to our own portfolios?

Investments with high potential returns typically have higher volatility, or risk. This is the risk-return tradeoff.

But what if we could get better performance and lower volatility at the same time?

The power of dividends makes it all possible…

Alpha From Dividend Growers

We always want to invest in healthy companies that are generating ample free cash flow. One of the best ways to identify these companies is by taking a look at management’s dividend policy.

As it turns out, companies that have increased their dividends – or started paying dividends – have not only outperformed, but have outperformed with less risk over the long term.

This makes sense. If corporate executives are confident enough in their business to increase the dividend payout, then investors should increasingly want to own the stock.

After all, who knows how well an underlying business is doing better than the company’s executives?

Granted, this is just a backtest. To see how a simple dividend growth strategy can perform in the real world, just take a look at the next chart…

The Vanguard Dividend Appreciation ETF (VIG), which holds stocks that boast at least 10 years of increasing annual dividend payments, clearly outperformed the broader market. This ETF may follow a very basic approach, but I wouldn’t be surprised to see VIG gain even more ground over the S&P 500 during the next bear market (yes, there will be bear markets in the future).

You might be saying to yourself, “That outperformance doesn’t seem like a big deal.”

Think again!

According to Vanguard, the majority of equity mutual funds – in each and every style category – underperformed their benchmarks from 2002-2012 (after adjusting for survivorship bias). And the Bloomberg Hedge Funds Aggregate Index is still down 1.8% from its July 2007 peak.

The chart above also shows why we don’t want to simply buy the highest-yielding stocks. The iShares Select Dividend ETF (DVY), which doesn’t focus on dividend growers, has underperformed with higher risk.

We want dividend growers, not yield traps.

But if dividends are good, buybacks must be great, right?

Dividends vs. Buybacks

It’s often argued that buybacks are more desirable than dividend raises as a way for companies to distribute excess cash. That’s because stock repurchases are more tax efficient for shareholders.

Don’t miss the bigger picture. Companies, or rather the highly-paid management teams that run them, are generally atrocious at timing buybacks.

For example, General Electric (GE) repurchased $13.9 billion of common stock in 2007 – including a whopping $5.5 billion (at an average price of $38.83) during the fourth quarter. Well, the company ended up selling shares at much lower prices to raise capital during the financial crisis. And the stock hit a closing low of $7.06 on March 6, 2009.

Making matters worse, companies that are conducting buybacks aren’t necessarily reducing their share counts. At the same time they’re buying stock, they could be issuing it back to employees through restricted stock or stock options packages.

We also want to be wary of companies that are issuing debt and repurchasing shares at the same time. These companies are levering up, and this rarely occurs at the right time.

Imagine a management team that sits on a huge pile of cash and restructures its business while the economy is booming. Then it repurchases stock and buys cheap assets when the world is seemingly coming to an end. Few managers are able to pull this off.

Implementing a shareholder-friendly dividend policy is a lot easier. And unlike ill-timed buybacks, dividends don’t destroy shareholder value.

Keeping Our Eyes on the Prize

A dividend cut is embarrassing for a company’s management team, so if the dividend is being raised, it’s likely that a lot of thought went into the payout’s sustainability.

Invest in these companies for higher return and lower risk.

By focusing on dividends growers and initiators in our core portfolios, we’ll be one step closer to outperforming that billionaire hedge fund manager with the WallyPower 118 superyacht. We’ll have the edge we need to reach our retirement goals as early as possible, but still be able to sleep at night because we are comfortable with our risks.

Speed and comfort.

Don’t forget to follow us on Twitter as we continue our quest to find you max yields in a zero interest rate world.

Safe (and high-yield) investing,

Alan Gula, CFA