Counting on dividends. Preventing risks.
The financial markets have recovered. However, the price gains are largely attributed to investor sentiment, rather than improved earnings prospects. How dividend strategies work and why such defensive investment strategies are particularly interesting now.
The "Dogs of the Dow" strategy is based on dividends
Following the stock market crash of 1987 and the start of the recession in 1991, stock market participants increasingly started seeking out simple ways of outperforming an index. In his book "Beating the Dow," published in 1991, Michael O’Higgins described an investment strategy based on dividends, called the "Dogs of the Dow" strategy. At the start of the year, the ten equities with the highest dividend yields are selected from the Dow Jones Industrial Average and held in the safekeeping account for 12 months with the same weighting.
With every new calendar year, the positions are checked again with regard to their dividend yields and are adjusted accordingly. So, for example, according to the dividend calendar, this year's "Dogs of the SMI" includes major insurance and telecommunications providers.
Dividend yields are not the only indicator of success
Dogs of the Dow strategies are aimed at the long term and are no guarantee of success. Although they have sometimes performed well historically, the underlying dividend yield is not suitable as a sole selection criterion. This is particularly the case when dividends paid are detrimental to business operations.
General Motors, a long-established member of the Dogs of the Dow, is an example of this weak point. Over the period 1997–2008, the automotive group reported strong dividend yields, which was attributable not to high dividends but to a declining share price. While this may have boosted dividend yields, it nonetheless sent out a clearly negative signal.
For many years, General Electric also belonged to the family of regular dividend payers, and at the end of 2017, it qualified for the Dogs of the Dow portfolio on the basis of its dividend yield of over 4 percent, even though earnings problems were reflected in a negative return on equity at the time. In 2018, the stock lost more than 35% of its value, and was removed from the Dow Jones after more than 100 years.
Other dividend strategies take continuity into account
Dividend yields only constitute a momentary snapshot, and are therefore not always an appropriate way of forecasting long-term stock market success. More importance is attached to the consistency of a company's distributions over many years – i.e. a dividend strategy where the focus lies on continuity and steady growth.
Whereas some investors had to do without a dividend altogether in the aftermath of the financial crisis some ten years ago, food manufacturing giant Nestlé stood out with a strategy that was geared around the long term. Nestlé therefore ranks among the so-called "dividend aristocrats," a term used to describe companies that have managed to increase their distribution of dividends each year for at least 20 years in succession.
The S&P High Yield Dividend Aristocrats Index replicates precisely this dividend strategy for the US stock market. A true champion among these aristocrats is consumer goods manufacturer Procter & Gamble, which has paid a dividend for an impressive 128 years without interruption – and this dividend has risen steadily each year ever since 1957.
Dividend strategies reduce investment risk
The price losses seen in the last quarter of 2018 have shown once again how rapidly equity markets can undergo a correction. Short-term risks, such as political tensions, the ongoing trade dispute, and a slowdown in the global economy, are increasingly leading investors to focus on more defensive strategies – such as the dividend strategy, for example.