How are you different from everyone else?
For investors with a dividend focus, this question is of paramount importance right now.
That’s because today’s low-interest-rate environment has greatly increased the popularity of dividend strategies – and as a result, capital flows into dividend stocks and ETFs have broadly inflated valuations, pushing down expected returns.
Many large-cap dividend payers with high earnings quality have become very expensive relative to the broader market. Indeed, more than a few Dividend Aristocrats fall into this category.
Worse yet, many have adopted the faulty – and reckless – view that dividend stocks can act as bond replacements.
Thus, we clearly need a unique approach. To be successful, we need some kind of competitive advantage…
The Power of Dividend Growth
In a world desperately reaching for yield and focusing on consecutive years of dividend increases, the magnitude of dividend growth remains an underutilized metric.
I’ve shown dividend growth back-tests, but real-world examples are often more compelling.
In February 2014, I brought the 133% dividend increase at FBL Financial (FFG) to everyone’s attention. This small-cap insurance company was flying under the radar, even after its monster dividend hike and stock buyback announcement.
Well, since my mention, FFG is up 59.7% on a total-return basis (dividends reinvested).
The other, well-known insurance stocks (with far lower dividend growth) have effectively gone nowhere. MetLife (MET) and Aflac (AFL) are up 2.5% and 3.3%, respectively. Prudential Financial (PRU) is actually down 2.7% over the past 14 months.
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The dramatic outperformance of FBL Financial, a seemingly boring life insurance company, illustrates the power of dividend growth.
Through a large dividend increase, a company’s management is signaling that it’s highly confident in the underlying business and ability to generate ample free cash flow (operating cash flow minus capital expenditures).
However, dividend growth alone is insufficient. Lots of companies are increasing their dividend payouts in this environment.
Notice that FFG was also cheap. The company wasn’t highly levered, and the stock had an attractive valuation. These are also big reasons why it has performed so well.
With respect to valuations, it’s helpful to understand that a stock and a business are two different things. Great businesses can have expensive stocks. Many dividend investors miss this important point in their myopic search for yield among blue-chip dividend growers.
This brings me to yet another advantage that you can capitalize upon: your small size.
As a retail investor, you can invest in small caps which may be too small for many institutional investors and hedge funds to even consider. And as FFG’s performance shows, small caps can be especially rewarding.
Bottom line: Differentiate yourself from the dividend investing herd. Seek out cheap dividend growers flying under the radar to set your returns apart from the crowd.
Safe (and high-yield) investing,
Alan Gula, CFA