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8 Quantitative Rules For Better Dividend Investing

The 8 Rules of Dividend Investing are the quantitative stock screening system developed by Sure Dividend and used in our newsletter to help investors build high quality dividend growth portfolios for the long run.

Note: From now through January 21st only we are offering a special discount to ValueWalk readers on the Sure Dividend Newsletter. Scroll down to the end of this article for more.

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Alex Roepers

The system contains 8 rules that are supported by:

  1. Academic research
  2. Common-sense investing principles from investing greats

The 8 Rules contains 5 buy rules, 2 sell rules, and 1 portfolio management rule.

Keep reading this article if you are interested in finding quantitative factors that have historically either increased returns or reduced risk. Each rule is described in detail below.

Rule #1: The Quality Rule

The quality rule is based on the common-sense notion that high-quality businesses have greater wealth compounding abilities than low-quality businesses. The problem is how to define a “high-quality business.”

In our view, one of the key characteristics of a high-quality business is a long history of steadily increasing dividend payments.

A company must have a strong and defensible competitive advantage to increase its dividend payments for years on end.

Another trait exhibited by high-quality businesses is a long corporate history. Companies that were founded in the 1800s and are still wildly profitable today are likely to continue growing and rewarding shareholders in the decades to come.

To capture these two observations, the Quality Rule rank stocks by their dividend history and their corporate history (the longer the better).

Evidence shows that this rule will boost performance. The Dividend Aristocrats – S&P 500 stocks with 25+ years of consecutive dividend increases – have outperformed the S&P 500 by more than 3 percentage points per annum over the last decade according to S&P.

Rule #2: The Bargain Rule

The bargain rule is based on the idea that buying cheap items is better than buying expensive items, all else being equal. This is true as a consumer and even moreso as an investor.

The following quote from Warren Buffett illustrates this concept nicely:

“Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

When stock prices are cheap, dividend yields are higher.

Accordingly, the bargain rule ranks stocks by their dividend yields (the higher the better). This provides the two-pronged advantage of generating more portfolio income and also helping to identify stocks with low valuation metrics (such as the price-to-earnings ratio, the price-to-book ratio, or the price-to-free-cash-flow ratio).

Evidence shows the Bargain Rule should also help to boost portfolio total returns, as the highest-yielding quintile of stocks outperformed the lowest-yielding quintile of stocks by 1.76% per annum through the 85-year period from 1928 to 2013.

Rule #3: The Safety Rule

Just as the Bargain Rule looks to invest in undervalued stocks, the Safety Rule looks to avoid overvalued stocks.

A great way to do this is by looking for companies that are actively repurchasing their own stock. This indicates that corporate management – the people who know the most about the business – believe that the stock is undervalued.

With that in mind, the Safety Rule ranks stocks by their share repurchase yield. The evidence shows that this should boost performance over time, as the S&P 500 Buyback Index has outperformed the S&P 500 by 2.54% per annum over the last decade.

Rule #4: The Growth Rule

It seems very logical that we seek to invest in fast-growing businesses where possible.

Indeed, business growth will eventually translate to a higher share price if investors can ignore the short-term vicissitudes of the stock market.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
– Benjamin Graham

With this in mind, the Growth Rule recommends ranking stocks by their earnings-per-share growth estimates. This benefits investors through both share price appreciation and higher dividend payments, as there will be more corporate profits to be distributed to shareholders.

The evidence shows stocks with rising dividend payments have outperformed stocks with unchanging dividends b7 2.4 percentage points a year on average from 1972 to 2013.

Rule #5: The Peace of Mind Rule

Psychology is an important factor to be successful in the stock market. With that in mind, the Peace of Mind Rule helps identify stocks that are easy to hold through all economic environments.

The most straightforward way to do this is by ranking stocks by their long-term volatility and beta.

Volatility and beta measure how ‘bouncy’ a stocks return has been. Lower volatility implies less risk because stock price fluctuations tend to come from changes in business prospects. Lower volatility businesses are more stable, and therefore safer, on average.

Interestingly low volatility has the unintended consequence of improving returns – the S&P 500 Low Volatility Index outperformed the S&P 500 by 2.00% per annum during the 20-year time period ending September 30th, 2011.

Rule #6: The Overpriced Rule

The first 5 rules of the 8 Rules of Dividend Investing help investors know what stocks to buy, and when.

The next two rules that we’ll discuss tell you when to sell.

The first sell rule is the Overpriced Rule. This rule is based on common sense. If you are offered $500,000 for a $250,000 house, you take the money.

It’s the same in the stock market. If you can sell a stock for far more than it is worth, you should do it and reinvest the proceeds elsewhere.

Quantitatively, this implies selling a stock when its normalized price-to-earnings ratio (which uses adjusted earnings-per-share instead of GAAP earnings-per-share) exceeds 40.

This high bar means you will only sell when a stock is very overvalued. The idea is to limit selling to foster long-term investing, while still taking advantage of situations where valuation multiples are excessive.

Selling stocks after such a large valuation expansion may be difficult, but it is certainly the right portfolio management decision. When stratified by price-to-earnings ratios, the lowest decile of stocks outperformed the highest decile of stocks by 9.02% per year during the 35-year time period from 1975 to 2010.

Rule #7 – The Survival of the Fittest Rule

If a company cuts its dividend, there are two potential causes:

  1. Management is financially unable to make the dividend payment
  2. Management is unwilling to continue paying dividends

Both of these reasons for cutting a dividend are very worrisome for investors. If you buy a stock to generate rising passive income over time, a dividend cut is the exact opposite of your goal.

Accordingly, the Survival of the Fittest Rule requires investors to sell a stock that has cut its dividend payment.

The evidence for this rule is very powerful: stocks that reduced or eliminated their dividends had a 0% return from 1972 through 2013.

Rule #8: The Hedge Your Bets Rule

Diversification is one of the fundamental principles of successful portfolio management is diversification. Investors need to own many stocks to smartly reduce the impact that any one holding will have on their long-term performance.

With this in mind, the Hedge Your Bets Rule recommends that you buy the highest-ranked stock that you own the least of according to The 8 Rules of Dividend Investing and never selling unless one of the two sell rules is triggered.

Over time, you may wish to sell holdings if your portfolio becomes too diversified. There is a wide body of academic evidence that shows that the majority (as much as 90%!) of the benefits of diversification come from owning as little as 12 to 18 stocks.

Final Thoughts

The 8 Rules of Dividend Investing is a proven quantitative strategy used by thousands of self-directed investors to build rising passive income over time.

The 8 Rules system is implemented in the Sure Dividend Newsletter to take the guess-work and long time commitments out of building your high quality dividend growth portfolio.

If you’re interested in implementing this powerful investing system, the Sure Dividend Newsletter provides the Top 10 stocks along with detailed fundamental analysis each month.

From now through this Sunday only we are offering a special 25% off forever discount on the Sure Dividend Newsletter and a risk-free 7 day trial for ValueWalk readers.

There’s no risk to trying the Sure Dividend Newsletter thanks to the risk-free 7 day trial. There is, however, serious upside to investing in high quality dividend growth stocks for the long run. Click here to start your 7 day free trial today. Be sure to enter coupon code VALUEWALK when you join to get your 25% off discount.