Tuesday, June 11, 2013

Are performance comparisons to S&P 500 necessary for dividend growth investors?

One of the questions I received recently from several readers of my site across platforms concerned my total returns performance and my benchmarks. As a long-term dividend investor, I doubt that sharing performance adds much in value.

My benchmark is S&P 500. I benchmark both my total returns and dividend income relative to this index. However, benchmarking my dividend income is more important to me than looking at my total returns relative to the market. I look at this information probably once an year, if not less often. I believe that focusing too much on comparative total return performance does not add much value to long-term dividend investors.

The stock market can value shares as it pleases, but I cannot control the price it would place on a stock or relative performance versus a basket of other stocks. I try to do the best using factors that are within my control. This includes identifying companies with strong competitive advantages and pricing power, which are able to grow earnings and pay higher dividends over time. I would then try to purchase shares in those companies at what I believe to be attractive valuations. Because my investment thesis relies on long-term momentum in earnings and dividends, I simply hold on to that security for as long as possible. One of the few factors that would make me sell include dividend cuts or an situation of extreme overvaluation relative to the underlying security’s growth prospects.

While I do not care about performance versus S&P 500, I have found that my methods for stock selections have delivered decent results since I started investing in 2008:

As a result, you can see that focusing on items such as benchmarking against S&P 500 for example, are simply items you can put on a checklist, but nothing that is purely actionable. Overall, I expect my portfolios to at least match the total returns of indices such as S&P 500. However, that would mean that I would underperform some portion of the time, and then outperform another portion of the time. I usually outperform during flat or declining markets, as well as situation where stocks as a group are up slightly. During strong up moves when growth stocks are bid up in a frenzy, dividend stocks would likely underperform.

Because I am investing for the long-term, I focus on items that could translate into more profits in one or two decades down the road. Thus, the data points I look at are usually annual fundamental results such as earnings per share, revenues, dividends, returns on equity etc. While the stock price of a company changes every nano-second, the underlying fundamentals are not materially affected that often. As a result, I only look at annual data points, although in rare situations I could look into quarterly sets of fundamental performance. This is why I refer to a period of about one or two years as simply noise. Nothing intelligent could ever come from noise, and most income investors who buy a stock today with the intention of flipping it in five months to an year are mostly kidding themselves.

One thing that intelligent investors should consider is that investment gains come unexpectedly. While it is commonly accepted that stocks have delivered a 10% annual return over the past 80 years or so, it is not commonly known that these returns are not straightforward. You don’t get 10% every year but are signing up for volatility in annual returns. You can as easily lose 50% in one year, and then recover and make 50% more. As a n investor, you need patience and if you do not have it, this could indicate that you didn't do enough due diligence or blindly followed stock tips. Of course, if there was a material change like a dividend cut, or major headwinds that’s ok. For example, neither Procter & Gamble (PG) nor Johnson & Johnson (JNJ) stock moved much between 2010 and 2012. Investors who simply held on to the stock didn’t see much in capital gains during this period. Over the past year and a half however, these companies have delivered very strong total returns. Investors who lost patience in the stock missed out on very good gains and the rising stream of dividend payments.

The other reason why I do not see much value in comparing my total returns relative to S&P 500 is because I find the index to be flawed. First of all, the components of S&P 500 index are subjectively selected by a committee, which considers certain factors such as liquidity, float and market capitalization in their inclusion decisions. If I had the requirements to only include stocks that trade at least 500,000 shares a day and have a market capitalization of $5 billion, I would have missed out on purchasing Hingham Insitutions for Savings (HIFS) at $34.90 in 2010. However, besides these factors, I do not know why they include certain companies, and exclude others. The flaws are evident if you study the history of some components in the index. For example, S&P 500 included a lot of technology companies in the late 1990s, just when they were selling at stratospheric valuations. Herd behavior such as this is destructive to long-term shareholder returns.

Another example as to why S&P 500 might not be the perfect black box to compare your results to is the fact that they didn’t include Berkshire Hathaway (BRK.B) until 2010. Berkshire had been one of the largest US companies for at least 20 years prior to that, which shows you the futility of this index. In addition, did you know that the original members of S&P 500 and their descendant companies selected in 1957 have actually outperformed the “actively managed” S&P 500 over the past 56 years? This means that truly passive buy and hold investing of the major companies without any rebalancing works better than S&P 500 itself.

If I consistently underperform over a period of 4 - 5 years, I would not worry too much, as long as I followed my common sense guidelines to constructing my portfolios. Focusing too much on comparative performance versus the S&P 500 could lead to chasing performance, which is not very smart. After all, a group of sound enterprises that are humming along will likely get ignored by the market at least several times over the next 30 – 40 years in favor of hot growth stocks. This has happened in the late 1960s with the go-go tronics boom, early 1970s with the Nifty-Fifty, early 1980s with technology stocks and the late 1990s with tech media and telecom stocks. An investor who underperformed a benchmark that included hot new issues, would face the psychological pressure that they are missing out. If they sell their portfolio to buy that index, they are essentially shooting themselves in the foot because none of the booms described above turned out well for the frenzied investors. They would have been better off sticking to tried and true dividend growth stocks like Procter & Gamble (PG) for example.

After a hot growth stock frenzy, sooner or later there will be reversion to the mean, which would translate into losses. In other words, one should stick to their strategy, know why they are following that strategy and ignore chasing performance. Chasing performance is counterproductive to your wealth. While you will underperform over short periods of time, over the long term, your dividend investment strategy would pay dividends.

One reason why mutual fund managers underperform is because they have the constant pressure to show results all the time. As a dividend investor, I do not have that pressure and I can afford to sit out periods where dividend stocks are out of style. I actually feel much more comfortable buying quality dividend stocks when no one believes in them than when everyone starts bidding up these fine companies. For example, back in November 2012 I was able to pick up some shares in McDonald’s (MCD) at $85 when there was short-term weakness in the stock.

The main reason why I purchase dividend stocks is to generate a rising stream of distributions that grows above the level of inflation and pays for my expenses. I do quite a lot of work in terms of stock selection, valuation at purchase price, portfolio monitoring in order to ensure that I can achieve this goal. This is why underperforming the S&P 500 over a short period of time does not bother me. This is because there will be fluctuations in performance depending on which sector is hot in the markets. However, the appeal of dividend investing is that your dividend return is always positive and it is more stable, which makes it ideal for someone who wants to live off their nest egg.

Relevant Articles:

The ultimate passive investment strategy
Does entry price matter to dividend investors?
Hingham Institution for Savings (HIFS) Dividend Stock Analysis
Benchmarking Dividend income
Dividend investing timeframes- what's your holding period?

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