Dividends are the surest, safest building block of a comfortable retirement. And you needn’t just “settle” for retiring on dividends. You can even pick dividend stocks that’ll double your money or better, too.
All you need is a little quality.
What’s is “Quality”?
Quality isn’t some nebulous idea. It’s a “factor,” and it’s defined by a set of attributes or characteristics that the Wall Street “quants” are increasingly affectionate for.
Factor-based investing has become quite the rage in recent years. It’s a way to slice and dice the stock market by numbers. Yield, value, momentum, and other metrics are the ingredients. Money managers mix ‘em together with the goal of a market-beating meal.
The definition of quality can change from provider to provider, but to get an idea, here’s how S&P Dow Jones Indices—which is responsible for the S&P 500 and numerous other indices—determines quality:
- Return on equity (ROE): Indicator of a company’s profitability. ROE is computed as (trailing 12-month earnings per share/book value).
- Accruals ratio: Indicator of a company’s operating performance. It is computed as (change of net operating asset over past 1-year/average of net operating assets over past two-year period).
- Financial leverage ratio: Indicator of a company’s capability in meeting its financing obligations. It is computed as (total debt/book value).
A focus on quality alone can make a stock portfolio more durable over time and improve returns. Meshing quality and dividends, however, can really add a jolt to performance. These are two factors that play very well together.
These Numbers Don’t Lie
As Wall Street intensifies its focus on factor investing, the research community keeps finding increasingly more data revealing the strength of a quality-dividends tag team.
Consider this analysis from S&P Dow Jones Indices, which compares quality and high dividends against numerous indexes, including the S&P 500 and Dividend Aristocrats:
The major takeaways? For one, every dividend-oriented strategy outperformed the S&P 500 in overall and risk-adjusted returns. But leading the way was quality + dividends, which outperformed the S&P 500 by more than 5 percentage points annually.
Better still: “The quality and dividend strategy held up relatively well in all market environments, with an average monthly excess return of 0.28%, which was the highest among all the strategies.”
Yield + Quality > Yield + The Rest
Factor Research produced a report in 2018 studying six different factors—dividend yield, value, momentum, quality, growth and dividend growth—from 2001 through 2017. This study tinkered a bit by studying long-short portfolios and comparing a combination of each factor plus dividend yield versus just dividend yield.
Here’s a look at the best chart of the bunch:
For what it’s worth, every combination produced better risk-return ratios than dividend yield alone. But high yielders with strong ROE and low debt-to-equity (quality) were both the most consistent and rewarding:
WisdomTree (WETF), which has made a name on its international funds, dug into a slightly different dividend theme—dividend growth—paired with equity, across both U.S. and international stocks.
“A key to lighting a fire under dividend growth—future dividend growth, not past growth—is high return on equity (ROE),” WisdomTree’s research claims.
The evidence it finds when examining its quality international dividend growth index is somewhat compelling. The implied dividend growth and payout ratio aren’t breathtaking, but it also has a massive yield advantage. “The MSCI USA Index, yielding barely 2%, would need to grow rapidly for years on end to catch up.”
The case for applying quality to dividend yield internationally, however, is crystal clear:
Yes, WisdomTree is selling its own product here. These indices are attached to three of its funds: the WisdomTree U.S. Quality Dividend Growth Fund (DGRW), the WisdomTree International Quality Dividend Growth Fund (IQDG) and the WisdomTree Dynamic Currency Hedged International Quality Dividend Growth Fund (DHDG).
But it finds what so many other researchers are discovering: that the quality factor boosts every strategy it’s applied to, including dividends.
The Cream Rises to the Top
What kinds of stocks make the grade, fulfilling the dividend-and-quality mandate?
- T. Rowe Price (TROW, 2.3%): The investment manager has more than $1.2 trillion in assets under its umbrella, and a bulletproof balance sheet to boot. It currently boasts $2.2 billion in cash against a mere $146 million in debt.
- Lockheed Martin (LMT, 2.3%): The defense contractor is responsible for military weapons such as F-35 Lightning fighter jets, Sikorsky Black Hawk helicopter and Trident ballistic missiles. Its return on equity is frequently in the triple digits, and currently sits at 242.4%.
- Cisco Systems (CSCO, 2.9%): Cisco has long been a leader in networking and telecommunications equipment, though it’s trying to modernize by adding arms such as cybersecurity. It has plenty of ammunition, with $8.4 billion more in cash than it has in debt.
These three high quality dividend stocks have all beaten the broader market in recent years.
Brett Owens is chief investment strategist for Contrarian Outlook. For more great income ideas, click here for his latest report How To Live Off $500,000 Forever: 9 Diversified Plays For 7%+ Income.