Instead, I am suggesting that you do a couple of very simple things.
First and foremost, I suggest that you keep trading activity at a minimum. Although, as I previously mentioned, every index does have some activity where stocks enter and leave the index. However, this is usually the limit to transactions. Succinctly stated, if you want to perform as well or better than an index, keep your turnover low. Every time you make an investment decision you expose yourself to being wrong as much as you do to being right. Therefore, I believe you are better served by making a few well-researched good decisions than by making a lot of impetuous moves.
This leads me to my second simple thing, if you are endeavoring to be better than average, then limit your investments to above-average companies. In this regard, I am not talking about price performance. Instead, I’m talking about identifying companies that have produced operating results that are above the average of the S&P 500. And then, and I consider this the most important part, be careful to only invest in these above-average companies when their valuations make sound economic sense.
Although this seems simple, it is also extremely challenging for many to implement. It takes patience, and a certain amount of research and due diligence, coupled with constant monitoring. But once again, not price monitoring, but monitoring the fundamental strength and success of the businesses you have chosen.
The above strategy is one strategy that I believe is capable of outperforming the market over the long term, but it is certainly not the only way. Personally, there is a strategy that I am currently implementing that is almost certain to outperform the market in a very strategic manner. Generically it is commonly referred to as dividend growth investing. However, my personal approach has its own nuances as follows.
My personal objective is for maximum current income at reasonable levels of risk. Therefore, I am searching for fairly valued dividend growth stocks with above-market current yields. Importantly, finding blue-chip dividend growth stocks at sound valuations is challenging in today’s market. However, that is not to say it is impossible. Nevertheless, the rewards are very predictable, and to my way of thinking – very calming.
However, since this article is discussing beating the market, I believe this strategy beats the market in precisely the way that is most relevant to my objectives. Stated more simply, I look for companies that are producing dividend yields higher than the market with companies that have long histories of increasing their dividends over sustained periods of time. The simple strategy virtually assures me that I will generate more spendable income than the index is capable of providing. Consequently, I am position to currently, and in the future, outperform the S&P 500 on a total dividend income basis.
However, I have also experienced a very interesting side effect that often occurs over the long run. In the majority of cases, if I’m investing in above-average yielding stocks, and I am careful to buy them when valuation is sound, I might even beat the S&P 500 on a total return basis as well. Maybe not over the short run, and maybe not over every timeframe, but in the long run my total returns can be quite attractive.
So before I provide a few examples, let me summarize the benefits of investing in dividend growth stocks at sound valuations. Total return is calculated based on two components – growth and income. Since my strategy is to invest in above-average yielding companies, I am close to certain of beating the S&P 500 on a total income basis. But best of all, since current income is my primary objective, I have already won.
The growth or capital appreciation component will be a function of the growth of the business I invest in relative to the valuation I pay to buy it. If I have done this part even reasonably well, I’m almost certain to receive some amount of growth or capital appreciation over the long run. Therefore, I am also reasonably certain that my investment might also compete with the S&P 500 reasonably well on a total return basis as well.
Real-world Examples via F.A.S.T. Graphs™
In order to establish fair and relative comparisons, I will start out by utilizing the benchmark S&P 500. Additionally, I have chosen the timeframe 2003 to current because it represents a time when the S&P 500 was reasonably valued. It also represents a timeframe several years prior to the Great Recession and the subsequent time since. Note the average earnings growth rate of 7%. Here’s what the market looked like at the beginning of 2003:
There are critical elements of the performance results associated with the S&P 500 over this timeframe that I ask the reader to focus on with this example, as well as the additional examples that I will offer later. For starters, note that the yield on cost of the S&P 500 for 2003 was 1.9%. This will serve as our benchmark yield as compared to our other examples. Also note the total cumulative dividend income that the S&P 500 produced through the end of 2016. Finally, note the total annualized rate of return of 8.4% that the S&P 500 produced.
Kimberly-Clark Corporation (KMB)
Kimberly-Clark was also soundly valued at the beginning of 2003. However, its earnings growth rate over this timeframe of 4.4% was significantly lower than the 7% earnings growth achieved by the S&P 500. Therefore, relative to earnings growth, Kimberly-Clark investors were at a disadvantage.
On the other hand, the initial yield on cost of 2.9% for Kimberly-Clark was higher than the 1.9% we saw with the S&P 500 above. Consequently, advantage Kimberly-Clark on a starting yield basis. This is what I meant when I suggested investing in companies that offered a current yield higher than the market.
Interestingly, capital appreciation of 7.1% for Kimberly-Clark was only modestly below the 7.2% achieved by the S&P 500. However, it is only fair to point out that I consider Kimberly-Clark relatively more overvalued currently than I do the market.
But perhaps most importantly, look at the total cumulative dividend income advantage for Kimberly-Clark over the S&P 500. When you add the total cumulative dividends with the growth, you end up with a total return of 9% versus the S&P 500’s 8.4%. So here’s a clear example where above-average yield generated better returns than the market, even with the earnings growth disadvantage.
The Southern Company (SO)
With my second example, I chose the slow growth utility stock The Southern Company. Note that earnings growth of 3.7% was approximately half the 7% growth of the S&P 500. Advantage here goes to the S&P 500 for growth.
However, note the yield on cost advantage of 4.9%