CEF’s Relative Premiums & Discounts

In truth, all discounts and premiums are relative to another number. Absolute discounts/premiums are relative to the net asset value (NAV). Relative discounts/premiums are relative to the average discount of the particular CEF being considered.

Because absolute discounts and absolute premiums tend to persist, relative discounts and relative premiums matter.

Academic studies have shown that current discounts/premiums converge to their average discounts/premiums much more regularly than they converge to their NAVs.

Measuring Relative Discounts/Premiums

• To measure relative discounts, we use a z-score:
  z = (current discount – average discount) / standard deviation of the discount
• A negative z-score indicates that the current discount is lower than its average.
• A positive z-score indicates that the current premium is higher than average.

In our opinion, a z-score of less than -2 signals that a fund is relatively inexpensive, and a z-score greater than +2 signals that a fund is relatively expensive.

Example 1

• Current discount = -8%
• Average 1-year discount = -15%
• 1-year standard deviation of discount/premium = 2
• z-score = (-8 - -15) ÷2 = (-8 + 15) ÷ 2 = 7 ÷2 = 3.5

With a z-score of 3.5, this fund would be considered relatively expensive. But this doesn't necessarily mean that the CEF is overvalued.

Example 2

• Current discount = -15%
• Average 1-year discount = -10%
• 1-year standard deviation of discount/premium = 2
• z-score = (-15 - -10) ÷2 = (-15 + 10) ÷ 2 = -5 ÷2 = -2.5

With a z-score of –2.5, this fund would be considered relatively inexpensive. But this doesn't necessarily mean that the CEF is undervalued.

Why Are Relative Discounts Helpful?

For one, they can help you avoid value traps.

Let's look at the mythical CEF trading at a 15% discount. According to the oft-cited "CEF wisdom," this would be a good trade because the market is offering investors $1.00 of assets at the bargain price of $0.85. (Forget the fact that the $1.00 worth of assets may fall in value to $0.85!)

Consider this:

• 3-year average absolute discount = -25%.
• Current absolute discount = -15%
• Standard deviation over the certain time period = 2
• z-score = (-15 - -25) ÷ 2 = (-15 + 25) ÷ 2 = 10 ÷ 2 = +5.

A z-score of +5 indicates that, far from being relatively inexpensive--as CEF wisdom would have it--this CEF is relatively expensive. It could represent a classic value trap.

Z-score can also help investors uncover potentially truly undervalued and overvalued CEFs. If the z-score is greater than +2 or less than -2, more research would be warranted.

Using relative discounts/premiums is a bit of an art. The time period analyzed is a large factor in the z-score.

The same CEF may look relatively expensive on a 6-week basis and relatively cheap on a 3-year basis.

Even though the CEF may look relatively expensive or relatively cheap, it may not be truly overvalued or undervalued.

Consider a CEF that is going to liquidate in one month. Liquidation is a method of making a CEF's share price converge with its NAV. All assets are sold and the remaining capital is distributed to shareholders. At the point of liquidation, the discount will be 0.

• Current discount = -2% (in anticipation of the pending liquidation)
• 1-year average discount = -12%
• 1-year standard deviation = 1.5
• z-score = (-2 - -12) ÷ 1.5 = (-2 + 12) ÷ 1.5 = 10 ÷ 1.5 = +6.7
• This CEF is relatively expensive, but with very good reason: A corporate action has narrowed the discount. If an investor attempted a short sale of this CEF in the market, the likely outcome would be a capital loss.

There could be a fundamental reason behind a high or low z-score. Do not buy or sell a CEF simply because of its z-score. Further analysis as to why the current discount has deviated so far from its historic average is warranted.

Key Takeaways

• Buy-and-hold investors can use z-scores to determine whether the absolute discount/premium is truly signaling that the CEF is under- or overvalued or whether the absolute discount/premium could be a value trap.
• Trading-oriented investors can z-scores to find candidates for buying or selling short. (In practice, this is the most common use of relative discounts/premiums.)

• Regardless of how they are used, they are no guarantee of future investment gains. All that matters once a CEF is purchased is the subsequent total return. Just as absolute discounts/premiums can converge to NAV with no gain for the shareholder, so too can relative discounts/premiums.
• It is important to understand why a CEF is trading at a current discount/premium that is widely divergent from its historic average. There could be a very good reason, aside from market sentiment.

CEF Discounts and Premiums

(information from Morningstar.com’s CEF section)

CEFs have an underlying portfolio of securities. From this portfolio, a net asset value (NAV) can be derived.

NAV = (assets – liabilities) / shares outstanding

the investment portfolio primarily, if not solely, comprises the assets. For leveraged CEFs, the leverage itself is the bulk of the liabilities.

CEFs trade on an exchange. This means that they have a share price, which is set by the market. These two prices, the NAV and the share price, are rarely the same, and when they are, it's only by coincidence.

The differences between the share price and the NAV create discounts and premiums. Shares are said to trade at a "discount" when the share price is lower than the NAV.  The discount is commonly denoted with a minus ("-") sign. Shares are said to trade at a "premium" when the share price is higher than the NAV. The premium is commonly denoted with a plus ("+") sign. The calculation is (Share price ÷ NAV) – 1. Examples:

Share price = $19.00

NAV = $20.00

Discount = ($19.00 ÷ $20.00) – 1 = 0.95 – 1 = -0.05 = -5.0%

Share price = $12.00

NAV = $10.00

Premium = ($12.00 ÷ $10.00) – 1 = 1.20 – 1 = +0.20 = +20.0%

What gives rise to discounts and premiums? Why is the market seemingly inefficient?

Efficient market hypothesists have tried to explain discounts and premiums for years with myriad explanations. Most commonly, the reason a CEF trades at any given discount or premium is related to the fund's distribution rate, regardless of the source of the distribution. (Some fund families seemingly abuse the knowledge that this occurs to justify--in their minds, not ours--the use of destructive return of capital.)

Other typical reasons for premiums and discounts include:

• Overall market volatility
• Recent NAV and share price performance
• Brand recognition of fund family
• Name recognition (or lack thereof) of the fund manager
• Recent changes in distribution policy
• An asset class or investment strategy falling out of market favor
• An asset class or investment strategy rising in the market's esteem

Whatever the reason for a CEF's discount or premium pricing, it is crucial that CEF investors realize that discounts and premiums exist.

At Morningstar, when comparing a share price with a NAV, we often refer to discounts and premiums as "Absolute Discounts" and "Absolute Premiums."

We do this because, as discussed in another Solution Center presentation, there are other ways to look at discounts and premiums. For instance, if we compare a CEF's discount to its average historic discount, this is what we refer to as a "Relative Discount."

Most long-term investors just look at Absolute Discounts and Absolute Premiums. But when considering valuation, it's important to look at Relative Discounts and Relative Premiums.

There are three things to consider regarding discounts and premiums:

1. Regardless of the discount or premium, what matters to an investor is the share price at the time of purchase and the subsequent total return of the CEF.
2. A CEF's discount or premium tends to persist. If the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate actions from the board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe's average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount.
3. Over a complete market cycle, most CEF share prices will trade below, at, and above their corresponding NAVs.

Absolute Discounts

The standard thinking for CEFs is to focus on funds trading at discounts and to avoid funds trading at premiums. We think this maxim is simplistic and could lead to unrealistic expectations for investors.

All that matters for a CEF investor is the share price at which the CEF was purchased and the subsequent total return. Discounts and premiums wax and wane over time. For instance, if a CEF is trading at a 15% discount, people often tout this as an opportunity to buy $1.00 of assets for $0.85. The unstated premise is that eventually the price will reach $1.00.

This is problematic. Nothing mandates that a share price, even discounted at 15% to NAV, must converge to its NAV over time. Furthermore, the NAV could decline to $0.85 (or lower).

We recommend not purchasing CEFs at absolute discounts in the hope that the share price will converge to a higher NAV. The primary benefit of purchasing a CEF at an absolute discount is for income-seeking investors to enhance their yield.

"Yield Enhancement" and Absolute Discounts

Putting aside sources of distribution, let's assume that a fund's underlying portfolio at NAV yields 10%.

Distribution = $1.00 per share

Net Asset Value = $10.00 per share

Distribution Rate at Net Asset Value = $1.00 / $10.00 = 10%.

Let's further assume that the shares trade at a 10% absolute discount.

Net Asset Value = $10.00 per share

Share Price = $9.00 per share

Absolute Discount = (share price – NAV)/NAV = ($9 - $10) / $10 = -10%

Because they are buying at a discount, investors purchasing these shares will get a higher yield:

Distribution = $1.00 per share

Share Price = $9.00 per share

Distribution Rate at Share Price = $1.00 / $9.00 = 11.1%

So, "Yield Enhancement" = Dist Rate (Share Price) / Dist Rate (NAV) = 11.1% / 10% = 1.1%

Buying $1.00 of assets for $0.85 isn't necessarily a bargain.

The table below sets forth the nine scenarios that can play out when purchasing shares at an absolute discount.

How the Absolute Discount Can Narrow

1. NAV falls faster than the share price: This is the worst possible scenario. The underlying portfolio is losing value and your shares are worth less.
2. NAV falls and share price remains steady: This is the second-worst scenario, in that the underlying portfolio is losing value. At least your shares haven't declined in value.
3. NAV falls and share price rises: The investment portfolio is heading south but at least you are making some money. Be careful, though, because ultimately the discount or premium will rely, at least in part, on the portfolio's performance.
4. NAV is steady and share price rises: This is the scenario implied by investors who say they buy $1.00 for $0.85.
5. NAV rises and share price rises even faster: This is the best of all possible scenarios. Of the nine scenarios, this occurs in only half of one (because the NAV could rise faster than an increasing share price, meaning the discount would widen).

Also note the several scenarios where the share price declines or the absolute discount widens. Using absolute discounts as the sole method of finding undervalued CEFs is akin to investing in a value trap.

On the flip side, there is no reason to avoid all CEFs trading at an absolute premium.

If you are purchasing shares at an absolute premium, you are taking on risk. Your capital could decline, even if the underlying portfolio performs well.

This isn't to say you should never invest at a premium. Most CEF investors have no qualms investing at slight premiums to NAV. But absolute premiums above 10% should really give you pause.

The table below shows the nine scenarios that can play out when purchasing shares at an absolute premium.

If you find yourself in a situation where the share price is rising and the NAV is declining, you are likely in what Warren Buffett might call a "greater fool" scenario. You may want to consider taking your profits and finding a more suitable investment.

Note that only one half of one scenario leads to a rising share price and a narrowing premium.

Unwittingly purchasing shares at an absolute premium, only to see the share price decline as the premium narrows, is the number one reason people have a poor experience with CEF investing.

Key Takeaways

• Every CEF has a discount or a premium. It is rare, and short-lived, for a share price to equal the net asset value.
• Absolute discounts are an inappropriate method of finding undervalued CEFs. When searching for undervalued CEFs, use relative discounts
• Absolute discounts can and should be sought for "yield enhancement." Make sure to see our Solution Center presentation on distributions.
• Absolute premiums should not preclude investment, but they do represent additional investment risk. Extreme premiums above 10% should really give investors pause. Unless the NAV rises to meet your purchase price, even in the long run you will likely lose money on your investment.
• While there is nothing that mandates a CEF share price equal its net asset value, history shows that funds normally trade at both an absolute discount and an absolute premium over the course of a full market cycle. In other words, the share price does tend to revert toward, and then through, the NAV.
• Again, when investing in CEFs, discounts and premiums don't ultimately matter. What matters is your cost basis and the subsequent total return.

Understanding Leverage in a CEF

What Is Leverage?

Leverage simply means that an investment portfolio is larger than its net asset base. The fund raises additional capital through a debt issuance, a preferred share issuance, or by using sophisticated financial products to increase the value of its underlying portfolio.

Say, for example, a fund has net assets of $500 million, raised in an initial public offering of 50 million common shares.

• It then issues $250 million of preferred shares.
• Total capital is then $750 million.
• Common shares outstanding are 50 million.
• Total capital per share is $15.00
• Net asset value per share = (Total Capital - Liabilities (preferred shares)) ÷ Shares Outstanding = ($750 million - $250 million) ÷ 50 million = $500 million ÷ 50 million = $10.00

This CEF has a leverage ratio of 50%, computed as capital from preferred shares divided by net asset value: $5 from preferred shares ÷ $10 in net asset value = 50%

Leverage magnifies returns, both positively and negatively. In other words, a leveraged fund exhibits more volatility than would an unleveraged fund investing in the same securities.

Why Can CEFs Use Leverage?

Because of their closed-end structure, CEFs are allowed by law to use leverage. Specifically, according to the Investment Company Act of 1940--which provides the framework for CEFs, mutual funds, and ETFs--CEFs are allowed to issue:

• Debt in an amount up to 50% of net assets
• Preferred shares in an amount up to 100% of net assets

In practice, the average leveraged CEF carries 33% total leverage. For every $1.00 of net assets, they have another $0.33 in leveraged capital.

Non-'40 Act Leverage

Leverage achieved through debt and preferred shares is commonly referred to as "'40 Act Leverage," after the Investment Company Act of 1940. There are other methods by which a fund can leverage its net assets. This is referred to as "Non-'40 Act Leverage."

Whereas the provisions for leverage within the '40 Act were meant to safeguard the integrity of a fund's capital structure, non-'40 Act leverage is unrelated to the capital structure. It arises, instead, from the fund's portfolio of investments. Examples of non-'40 Act leverage include:

• Tender option bonds
• Reverse repurchase agreements
• Securities lending obligations

Transparency

Leverage is leverage. Regardless of the source of the leverage, it has the same effects on a portfolio as outlined earlier in this presentation. This is why transparency of a fund's true leverage is so important.

Only '40 Act leverage is required by law to be reported. All leverage is actually reported on the financial statements, but only '40 Act leverage needs to be reported as "leverage."

Fund families have wide discretion in how they choose to actively report non-'40 Act leverage. Their websites may say a fund is unleveraged, when it actually has a lot of non-'40 Act leverage.

One simple way for investors to check leverage ratios is the following:

Total Leverage = Total Assets / Net Assets

The closer the value is to 1, the lower the leverage.

Morningstar.com shows a CEF's '40 Act leverage, non-'40 Act leverage, and total leverage ratios to help investors see what's really going on.

Key Takeaways

• Adding leverage to a CEF's portfolio will increase volatility of NAV returns.
• Adding leverage can also enhance a CEF's distribution rate.
• There are costs to adding leverage to a portfolio.
• While the Investment Company Act of 1940 allows CEFs to issue debt and preferred shares (with certain limitations), CEFs can also use non-'40 Act leverage.
• Regardless of the source of the leverage, the effects will be the same.
• In times of extreme market distress, a leveraged fund may be forced to liquidate holdings to meet leverage coverage ratios. In such rare cases, the benefits of the closed-end structure eviscerate, and the capital is permanently impaired. In 2008 and 2009, this happened to a few leveraged high-yield ("junk bond") CEFs.
• While many investors are rightfully cautious about leverage, it's important to understand that the average leveraged CEF is only 33% leveraged.

I will be adding a rule to my CEF watch list to exclude CEF’s that are 30% or more leveraged.

A Look at Closed End Funds (CEF’s)

(information obtained from cefconnect.com)

Currently my portfolio is out of balance due to selling some positions in profit during a high level of the S&P and expecting a pull back soon.  So my dividend portion of my portfolio is out of balance.  I am looking to have cash available to enter new positions during the next pullback.  I am reviewing my study of closed end funds because I want to enter a few positions in my income allocation to increase the yield without adding undue risk.

What is a Closed-End Fund?

A closed-end fund is a publicly traded investment company that invests in a variety of securities, such as stocks and bonds. According to the fund's investment objectives, the fund raises capital primarily through an initial public offering (IPO). "Closed" refers to the fact that, once the capital is raised, there are typically no more shares available from the fund sponsor and the issuance of new shares is closed to investors.

After the IPO, most closed-end funds are listed on a national exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. There the fund's shares are purchased and sold in transactions with other investors, not with the sponsor company itself.

The typical closed-end fund strategy represents an actively managed selection of holdings. These investments in securities collectively add up to a value, known as its Net Asset Value (NAV), that may be different from the fund's market price. The market price is determined by market demand and supply, not the fund's net asset value.

Since most closed-end funds offer regular monthly or quarterly distributions, demand is often related to both the distribution amount and the NAV performance of a fund.

Although the outstanding shares of a closed-end fund remain relatively constant, additional shares can be created through secondary offerings, rights offerings or the issuance of shares for dividend reinvestment.

Key Considerations for Closed-End Funds

Closed-end funds are investments designed for income-conscious investors seeking to meet a wide range of investment goals, including:

• The potential to meet current obligations with monthly or quarterly cash flow;
• The potential to achieve attractive, long-term total returns;
• The opportunity to realize greater income portfolio diversification.

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Closed-end fund shares also carry risks investors should understand:

• Closed-end funds trade on exchanges at prices that may be more or less than their NAVs.
• There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price.
• Closed-end funds often use leverage, which increases a fund's risk or volatility.

There are several characteristics of closed-end funds that can help investors meet their investment goals:

Portfolio Management - The asset base for closed-end funds is relatively stable. Without the pressure of constantly investing or redeeming securities based on investor demands, closed-end funds may be able to take better advantage of a wide variety of investment strategies, including longer-term and less liquid securities or markets.

Distributions - Closed-end funds are generally designed for regular cash flow. Distributions are paid according to a prescribed schedule -- typically monthly or quarterly -- which allows investors to plan the timing of this income. Of course, the actual amount of the distributions may vary with fund performance and market conditions.

Leverage - Closed-end funds often borrow capital or issue preferred shares in order to leverage their portfolios. The goal is to use the additional capital to invest for a return that exceeds the cost of the leverage. Any excess return, or loss, is added to the return on capital raised through common shares. Thus, leverage multiplies both potential return and the volatility of the fund's portfolio. .

Market Pricing - Investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of closed-end funds.

Trading Liquidity and Flexibility - A stock market listing means that closed-end fund shares may be bought or sold at any time during the trading day, and the price is updated throughout the trading day, not just at the close. Like other investments, share prices will fluctuate with the market, and may be worth more or less at the time of sale than the original purchase price.

Expenses - Closed-end funds typically do not impose annual 12b-1 fees. However, investors must still pay a brokerage commission to purchase and sell shares for all closed-end funds. For those investors who trade frequently, this can significantly increase the cost of investing in closed-end funds. This means closed-end funds may have lower expenses internally, but an investor's total costs may not be lower.

I intend to add a series of posts as I review what I am looking at to analyze the funds and make selections.

Why Starting Young with Long Term Strategy Pays Off

Stocks That Raise Their Dividends Greatly Outperform

Academic and industry studies confirm that quality dividend payouts lead to strong future returns. That’s a mouthful to be sure, but what it distills down to is that as an investor, dividends allow you to have your cake and eat it too! Dividends provide you with a valuable income stream, plus they can play an important role in helping you focus in on stocks that have the ability to produce staggering share price growth.

In order to appreciate the predictive power of dividends, consider a recent study conducted by Ned Davis Research and Oppenheimer Funds (see Figure 1 below).

The study looked at the average annualized returns for S&P 500 stocks from 1972 to 2014. As you can see, during this impressive 42-year study, stocks with Rising Dividends greatly outpaced the stocks that cut their dividends or simply did not offer a dividend in the first place. Further, if you focused on investing in Rising Dividend Stocks over fixed dividend stocks, you would have received 32% more return each and every year of the 42-year study.

(above is from AAII)

Dividend Investing With a 10/10 Rule - Dividend Earner

I was watching the interview of Tom Cameron on Business News Network this past week where he highlighted the 10/10 rule utilized by his investment firms. It is very pertinent to dividend investors since it’s all about the dividend growth. In fact, 10/10 stands for a company that increases dividends for 10 consecutive years with an average of 10% or more growth in dividends per year.

10/10 Strategy

It’s a simple screening test really. You can follow this process of elimination.

1. Identify companies that have paid dividends for the past 10 years.
2. Identify the companies that have increased their dividends by an average of 10% per year for 10 years.

Rather than focusing on the yield, it focuses on the dividend growth to accelerate compound growth. A consistent growing dividend under a DRIP could double your holdings in a good time frame. Patience is quite important here as the growth in yield over many years is what you bank on to increase your holdings. What is interesting is that a dividend aristocrat may not pass the criteria here even if they increase dividends for 25 consecutive years. The combination of both should provide a really solid investment though.

Top Holdings

Although historical data are available to filter stocks, it’s not always easy to filter on it without putting the data together yourself. Especially when you need to look at historical data. The fund highlights their performance and top holdings on their site but I thought I’d share the holdings here with some extra information. It does in fact keep up with the S&P 500 index, my fellow blogger Andrew Hallam might be impressed Ticker  Co                           Stk Pr    DivYld 10yr Gr  Con Div Inc NVO  Novo-Nordisk A/S $124.42 1.52%    23.5%     14 TEVA TEVA Pharm         $50.00   1.64%    29.7%     10 ADM ArcherDanielsMid  $31.11   2.06%    12.6%     36 IBM  Int’l Bus Machines $166.56  1.80%   17.8%      15 WAG Walgreen                $43.32   1.62%    16.1%      35 NSRGY Nestlé SA           $63.59       -            14%       14 CAH Cardinal Health       $44.51   1.93%    27.6%      14 MCD McDonald’s Corp  $80.98    3.01%    28.3%      34 NVS Novartis                   $63.48    3.72%    10.6%     16 PX Praxair, Inc.              $103.39     1.93%    19.6%    18

 

Thoughts

I went back and looked at the stocks I reviewed in the past months and only one matches the 10/10 criteria: Enbridge (ENB). Power Corp (POW), Power Financial (PWF) and Great-West LifeCo (GWO) each had 8 years of consecutive double digit growth and then lower growth for the last couple of years with no increase in dividends for 2010. A similar faith for the banks. The lack of dividend increase in 2010 basically fails the criteria and takes the companies out of the selection for another 10 years. I still consider them solid companies as you would see from my stock analysis and a reason that following a rigid rule may not always be best but it can sure simplify the process and eliminate emotions. Readers: What do you think of the filtering criteria? Disclaimer: Long ENB.
Dividend Investing With a 10/10 Rule - Dividend Earner

The 8 Rules of Dividend Investing Sure Dividend

 

The 8 Rules of Dividend Investing

The 8 Rules of Dividend Investing quantify the best dividend growth stocks for long-term investors so  you know exactly what stocks to buy and sell.

At their core, The 8 Rules of Dividend Investing identify high quality dividend growth stocks.  These stocks have a mix of a low price-to-earnings ratio, high dividend yield, low stock-price-volatility, and high growth rate.  The Sure Dividend newsletter uses The 8 Rules of Dividend Investing to simplify the process of identifying and investing in high quality dividend growth stocks.

Rules 1 to 5:  What to Buy

Rule # 1 – The Quality Rule

“The single greatest edge an investor can have is a long term orientation”

– Seth Klarman

Common Sense Idea: Invest in high quality businesses that have a proven long-term record of stability, growth, and profitability.  There is no reason to own a mediocre business when you can own a high quality business.

Financial Rule:  Invest only in stocks with 25 or more years of dividend payments without a reduction.

Evidence:  The Dividend Aristocrats (stocks with 25+ years of rising dividends) have outperformed the S&P500 over the last 10 years by 2.88% per year.

Source: S&P 500 Dividend Aristocrats Factsheet, February 28 2014, page 2

Rule # 2 – The Bargain Rule

“Price is what you pay, value is what you get”

– Warren Buffett

Common Sense Idea:  Invest in businesses that pay you the most dividends so you can increase dividend income stream

Financial Rule: Rank stocks by dividend yield.

Evidence:  The highest yielding quintile of stocks outperformed the lowest yielding quintile of stocks by 1.76% per year from 1928 through 2013.

Source:  Dividends:  A Review of Historical Returns by Heartland Funds, page 2

Rule # 3 – The Safety Rule

“The secret of sound investment in 3 words; margin of safety”

– Benjamin Graham

Common Sense Idea:  If a business is paying out all its income as dividends, it has no margin of safety.  When a business downturn occurs, the dividend must be reduced.  Invest in businesses that have higher income than dividends to help ensure dividends won’t be cut during business downturns.

Financial Rule:  Rank stocks by their payout ratios.

Evidence:  High yield low payout ratio stocks outperformed high yield high payout ratio stocks by 8.2% per year from 1990 to 2006.

Source:  High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Rule # 4 – The Growth Rule

“All you need for a lifetime of successful investing is a few big winners”

– Peter Lynch

Common Sense Idea:  Invest in businesses that have a history of solid growth.  If a business has maintained a high growth rate for several years, they are likely to continue to do so.  The more a business grows, the more profitable your investment will become.

Financial Rule:  Rank stocks by long-term revenue growth.

Evidence:  Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4% per year from 1972 to 2013.

Source:  Rising Dividends Fund, Oppenheimer, page 4

Rule # 5 – The Peace of Mind Rule

“Psychology is probably the most important factor in the market – and one that is least understood”

- David Dreman

Common Sense Idea:  Look for businesses that people invest in during recessions and times of panic.  These businesses will have a relatively stable stock price that will make them easier to hold for the long run.

Financial Rule:  Rank stocks by their long-term volatility.

Evidence:  The S&P Low Volatility index outperformed the S&P500 by 2.00% per year for the 20 year period ending September 30^th, 2011.

Source:  S&P 500 Low Volatility Index: Low & Slow Could Win the Race, page 3

Rules 6 & 7:  When to Sell

Rule # 6 – The Overpriced Rule

“Pigs get fat, hogs get slaughtered”

– Unknown

Common Sense Idea: If you are offered $500,000 for a $250,000 house, you take the money.  It is the same with a stock.  If you can sell a stock for much more than it is worth , you should.  Take the money and reinvest it into businesses that pay higher dividends.

Financial Rule:  Sell when the normalized P/E ratio is over 40.

Evidence:  The lowest decile of P/E stocks outperformed the highest decile by 9.02% per year from 1975 to 2010.

Source:  The Case for Value by Brandes Investment Partners, Page 2

Rule # 7 – The Survival of the Fittest Rule

“When the facts change, I change my mind.  What do you do, sir?”

– John Maynard Keynes

Common Sense Idea: If a stock you own reduces its dividend, it is paying you less over time instead of more.  This is the opposite of what should happen.  You must admit the business has lost its competitive advantage and reinvest the proceeds of the sale into a more stable business.

Financial Rule:  Sell when the dividend payment is reduced or eliminated.

Evidence:  Stocks that reduced or eliminated their dividends had a 0% return from 1972 through 2013.

Source:  Rising Dividends Fund, Oppenheimer, page 4

Rule 8:  Portfolio Management

Rule # 8 – The Hedge Your Bets Rule

“The only investors who shouldn’t diversify are those who are right 100% of the time”

– John Templeton

Common Sense Idea:  No one is right all the time.  Spreading your investments over multiple stocks reduces the impact of being wrong on any one stock.

Financial Rule:  Build a diversified portfolio over time.  Use The 8 Rules of Dividend Investing to rank high quality dividend growth stocks.  Buy the highest ranked stock of which you own the least each month to build your diversified portfolio over time.

Evidence:  90% of the benefits of diversification come from owning just 12 to 18 stocks.

Source:  Frank Reilly and Keith Brown, Investment Analysis and Portfolio Management, page 213

Real Life Examples

I have selected 5 of the top 10 high quality dividend growth stocks using The 8 Rules of Dividend Investing so you have an idea of what businesses fit the 8 Rules:

The majority of 8 Rules stocks are well known businesses with a long history of profitability.  They are familiar household names.  This is because they have been so successful for so long.  I personally feel a sense of relief knowing I am invested in tried and true businesses that have withstood the test of time.  I hope you do as well.

The 8 Rules of Dividend Investing Sure Dividend

Dividend Aristocrats from Sure Dividend

Credit goes to suredividend.com for this material…

Sure Dividend

High quality dividend stocks, long-term plan

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March 2015 List of Dividend Aristocrats

The Dividend Aristocrats Index is comprised of 53 stocks that have paid dividends for 25+ consecutive years.  In addition to the exclusive dividend history requirement, Dividend Aristocrats must also be members of the S&P 500 Index and meet certain size and liquidity requirements.  The Dividend Aristocrats Index has outperformed the market by a wide margin over the last decade, is the image below shows.
Source:  S&P Dividend Aristocrats Fact Sheet

List of All 53 Dividend Aristocrats

The spreadsheet (or picture) below lists all 53 Dividend Aristocrats for March of 2015.  You can sort by dividend yield, standard deviation, growth rate, or payout ratio.
March 2015 Dividend Aristocrats List – Excel Download
March 2015 Dividend Aristocrats List – Picture Download

Explanation of Financial Metrics

The four financial metrics included in the spreadsheets are the same metrics used in the buy rules from The 8 Rules of Dividend Investing, and in the Sure Dividend Newsletter.  A brief explanation of each metric is below.  All data is from the market close 2-27-15.
Dividend Yield Dividend yield is calculated as 4 x most recent dividend / current price.  This is the standard calculation for dividend yield and shows what percentage of dividend income you can expect on your investment in the first year (assuming no dividend increases or reductions).
Standard Deviation Standard deviation in the spreadsheet above is calculated over a stock’s 10 year price history (when available).  Long-term price histories are used to reduce the effects of unusually high or low volatility in the recent past.  Interestingly, stocks with low price standard deviations have historically outperformed the market.  Better price returns have (obviously) come with lower ‘risk’ as defined by academics due to lower stock price standard deviation.  I don’t believe standard deviation to be a true measure of risk, but it is a good proxy for measuring real risk.  It has worked to improve returns historically; the historical record should not be ignored.
Growth Rate The growth rate used in the spreadsheet above uses 10 years of data (when available).  Growth rate is calculated as the lower of 10 year revenue per share growth or 10 year dividend per share growth.  For financial sector stocks, 10 year book value per share growth is often used in place of revenue per share growth.  Using long-term growth paints a clearer picture of a company’s real underlying business growth as it removes the random noise that comes with year-over-year growth rates.  Taking the lower of revenue or dividend growth prevents companies that have unsustainable increased their dividend faster than underlying business growth or that have grown revenue without increasing dividends substantially to show a high growth growth rate that is unwarranted.
Payout Ratio The payout ratio is calculated as last dividend payment x 4 / trailing-twelve-month earnings per share.  Adjusted earnings per share are used when applicable instead of GAAP earnings per share to minimize the effects of short-term or one-time events on the payout ratio.

Final Thoughts

The March 2015 Dividend Aristocrats list is a quick and easy way to generate investment ideas for dividend growth investors.  The Dividend Aristocrats Index is comprised of high quality businesses with long histories of rewarding shareholders with rising dividends.  Many of the stocks in the Dividend Aristocrats Index are ‘household names'; companies or stocks that are known by many people.  Some examples of these well-known blue chip Dividend Aristocrats include:

• Coca-Cola (KO)
• Wal-Mart (WMT)
• PepsiCo (PEP)
• Johnson & Johnson (JNJ)
• 3M (MMM)
• Target (TGT)
• Clorox (CLX)
• AT&T (T)
• McDonald’s (MCD).