Wednesday, May 18, 2011

Are dividend stocks a separate asset class?

Fellow dividend investor Dave Van Knapp posted an interesting article explaining why dividend growth stocks could be seen as a separate asset class.

An asset class is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (instruments). Some investors also classify real estate and commodities as a separate asset class.

I certainly disagree that dividend stocks are a separate asset class. To say that dividend stocks are a separate asset class is similar to saying that growth stocks are a separate asset class as well. As I explained in a previous article, dividend stocks are equities and not a separate asset class.

As a dividend investor, I benchmark my performance against S&P 500. I also benchmark my total return performance as well as the growth in my dividend income. I also expect that over the long run, my total returns would probably be close to the total returns of the S&P 500. The main difference is that my portfolio is structured in a way that it will generate dividend income which rises over time. As a result, I am generating a stable return on investment, which is not dependent on the irrational behavior of the stock market. I do not want to stress selling out 4% of my portfolio when the market is down, in order to afford my daily dose of peanut butter and jelly.

The reason why dividend stocks are equities is that they are correlated strongly with returns of S&P 500 or Wilshire 5000 (the market). During the financial crisis of 2007- 2009, most dividend stocks experienced declines in their share prices.

In addition, during the same financial crisis, many dividend stocks cut distributions. If you compare the dividend growth of S&P 500 to the dividend growth in a dividend growth portfolio, one would definitely see strong correlation. If you compare the results of the broad dividend achievers index over the past decade, to the results of the S&P 500 over the past decade, one would notice startling correlation:

The reason behind the correlation is that the top stocks by market weight that make the S&P 500 are actually dividend growth stocks. The table below shows the top ten stocks of the S&P 500 by market weight:

The the ten stocks of the Dividend Achievers Index, which have the highest weightings include:

That being said, do it yourselves investors should not focus exclusively on stickers such as large-cap, mid-cap, small-cap. Investors should instead focus on quality companies with strong competitive advantages, strong brand names and pricing power that stems from these quality characteristics. The quality characteristics of the products and services which the dividend paying stock sells should allow the company to pass price increases to consumers and maintain profitability over time. This should lead to rising earnings per share, which would fuel future dividend growth. Only companies which generate excess cashflows will be essentially able to pay and boost distributions on a consistent basis. I do not believe in diversification at any price, that ignores quality.

Investors who view dividend stocks as a separate asset class, would likely be very surprised when their diversified income portfolios end up generating a total return that strongly correlates with equities in general. In order to be properly diversified however, other asset classes such as fixed income would likely benefit investors as they are somewhat non-correlated with stocks.

Full Disclosure: Long XOM, CVX, PG, JNJ, WMT, KO, PEP

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