In a previous article found here I postulated that the S&P 500 (INDEXSP:.INX) was currently fairly valued. In this article, I review a specific hand-selected list of Dividend Champions that I believe are reasonably priced and therefore capable of generating above-average returns at below-average risk. In today’s low interest rate environment, I believe that high-quality blue-chip dividend growth stocks represent an attractive asset class that can provide a retirement portfolio with a growing income stream.
Retiring Without Being Predestined to a Fixed Income
Once we reach retirement, investing becomes all about income and safety. Yet over the years one of the greatest laments of the retiree is the struggle associated with living on a fixed income. Retirees have been conditioned to the notion that once they reach retirement age they must become completely risk-averse regarding their investing practices. Therefore, they end up holding portfolios full of fixed income with little or no growth of either income or principal. However, it doesn’t have to be that way. I believe that retirees can have their cake and eat it too. If they adhere to sound principles of investing, they can have safety, growth, and an increasing income each year.
Perhaps the most important consideration regarding the appropriate investment practices of retirees relates to how you define risk. In my opinion, too much emphasis is being placed on short-term price volatility as a primary determinant of risk, and too little on maintaining an appropriate standard of living that can keep up with inflation. A portfolio that provides a fixed rate of return or income stream is continuously decimated by the ravages of inflation. In other words, no matter where it comes from, the loss of purchasing power is a major risk that retirees face. Therefore, I argue that retirees should place great emphasis on building a portfolio capable of producing an increasing income stream.
In order to accomplish that goal, it is imperative that a portion of the retiree’s retirement fund be allocated to equities in some form or another. Carefully selected equities can provide the growing income stream that fixed income investments cannot. Although price volatility is clearly an unavoidable attribute of equity, there are equity classes that do provide a consistent and ever-growing income stream. Therefore, I am suggesting that more emphasis be placed on the income component of the equity portion of the retiree’s portfolio, then on the price volatility of the underlying shares. Although price volatility can be unnerving, I plan to show evidence that in the longer run, price volatility is more often than not a paper tiger.
Selecting Stocks for Safety and Income
Ben Graham’s famous book, The Intelligent Investor, is considered by many to be the seminal work and authority on prudent investing. In Chapter 14 titled Stock Selection for the Defensive Investor, Ben Graham laid out seven quality and quantity criteria that he suggested for the selection of common stocks. These include:
- Adequate Size of the Enterprise
- A Sufficiently Strong Financial Condition
- Earnings Stability
- Dividend Record
- Earnings Growth
- Moderate Price / Earnings Ratio
- Moderate Ratio of Price to Assets
There is a category of dividend growth stocks where the majority of them possess all seven of Ben Graham’s quality and quantity criteria. This category is widely known as either Dividend Champions, as produced by David Fish and/or Dividend Aristocrats published and maintained by Standard & Poor’s. I have gone through these lists one company at a time utilizing the fundamentals analyzer software tool FAST Graphs™, and identified the Champions and Aristocrats that I believe most closely exemplified Ben Graham’s stock selection criteria.
Choose Companies with the Long Legacy of Paying Dividends
Although all seven of Ben Graham’s criteria listed above are important, the primary focus of what follows relates to number four – the Dividend Record. Ben Graham believed that the conservative investor should only consider companies that have paid a dividend every year for at least the last 20 consecutive years. He believed that dividends represented a strong proxy for profitability since they are paid from earnings, and he liked the idea that they offered investors a return even when the company’s stock price was not cooperating. This last point is a critical element of the thesis behind this article, and will be elaborated on more fully later.
However, Dividend Champions and/or Dividend Aristocrats go one step better than Mr. Graham’s stringent dividend criteria. Not only have they paid a dividend for 20 consecutive years, in order to make these elite lists, they have also had to have increased their dividend each year for at least 25 years consecutively. Moreover, almost by definition, in order to have accomplished these dividend achievements, they for the most part simultaneously and automatically meet the other six criteria as well. (Note: Later when I show sample FAST Graphs™ on a few individual examples, wherein all the attributes that Ben Graham coveted will be graphically revealed).
Dividend Champions in Value 2013
Ben Graham’s Criteria 6 – Moderate Price / Earnings Ratio, and 7 – Moderate Ratio of Price to Assets, primarily relate to valuation. Personally, I believe that valuation is a critically important component of a good common stock investment. No matter how much I like a company, I am never willing to pay more than I believe the stock is worth. I once read that when the venerable Warren Buffett, the most famous of all of Ben Graham’s students, was once asked if he was a value or growth investor, he responded, and I paraphrase as follows:
“I am both, I would never invest in a stock that I didn’t believe would grow, and I would never be willing to pay more for it than I thought it was worth.”
The Dividend Champions’ list currently has 105 names on it, and the Dividend Aristocrats currently has 51. All of the Dividend Aristocrats can be found in the Dividend Champions list. Therefore, I have hand screened the Dividend Champions one company at a time looking for those candidates that I believed best exemplified Ben Graham’s criteria, while simultaneously could be bought at fair value. It should be noted that my selection process was partially arbitrary where I excluded companies which did not possess the consistent records of earnings that I prefer.
Through this process I have identified 33 of the 105 Dividend Champions that met Ben Graham’s criteria and were simultaneously trading at fair value. Although I believe that each of these Dividend Champions is an extremely high-quality company, this list is offered as a precursor to a more comprehensive due diligence process. On the other hand, I strongly believe that each of the 33 companies on this list represent excellent long-term dividend growth investments. However, their relative attraction will be a function of the individual investor’s own goals, objectives and risk tolerances. In other words, although I think all of these candidates possess attractive total return potential, some will be more appealing for their yield, others for growth, and yet others for a combination of both.