There’s a famous interview question that stumped some graduates applying for a high-profile job. The interviews asked the candidate to tell them the color of the wall behind them. This was a ridiculously simple question, but it had one important catch – the candidates had to tell the interviewer the color of the wall without turning back.
Rarely would a nervous candidate notice the wall directly behind while seated for an interview. But the question wasn’t designed to test attention to detail. Rather it was meant to test common sense and the candidate’s application of mosaic theory. There was simply no way to know the color of the wall without looking at it, so the candidates were expected to guess the color based on the wall that’s in front of them. In other words, answering the question required the candidate to realize that the chances of all four walls being the same color were exceptionally high.
This attempt at estimating an unknown is really useful while investing in dividend stocks. Dividends are promised to investors who hold onto stocks for the long term. Most companies end up declaring a dividend a few weeks in advance. Investors can expect to receive the dividend either monthly, quarterly, or annually. But dividends are intrinsically linked to profits, and there’s simply no way to predict how much profit the company will make next year. What happens over the next twelve months is anyone’s guess.
While picking dividend paying stocks, you are required to make this guess. You must estimate how profitable the firm is likely to be, for how long, whether or not the dividend payout policy will be maintained, and if there’s a risk the dividends will be cut in the near future. All these factors will ultimately determine the intrinsic value of the company you’re looking to buy.
So, to predict future dividends financial analysts turn to the most traditional sources of data – history. Analysts tend to look back over a number of years and see how the company has performed. If they can figure out a pattern in the dividend payments over the past few years, they can make a reasonable estimate for future payments. That’s where the Dividend Aristocrats Index comes in.
The Dividend Aristocrats Index is an index published by the Standard & Poor’s global financial services firm (the same people who maintain the S&P 500 index). The index was designed to find dividend stocks that had a higher probability for dividend growth in the future. The methodology is based on a simple pattern of incremental growth. Basically, the Dividend Aristocrats Index is a list of stocks that have managed to grow the dividends they pay every year for twenty-five consecutive years.
The index is based on the theory that massive, stable companies that have demonstrated an ability to keep paying growing dividends in the past will be more likely to pay growing dividends in the future. Here is the methodology for how the index is constructed:
- Stocks are picked from the S&P 500 index.
- Only stocks that have increased dividends every year for the past 25 years are included.
- Stocks must also meet certain liquidity and market cap requirements to be considered.
If the stock meets all three criteria, it is considered for the index. The index is equal-weighted, which means it is equally divided between each constituent to give a fair representation of small and mid-cap stocks alongside the larger ones. In other words, if the index had 50 stocks and you invested $100 in it, each stock on the list would get $2 regardless of size.
There is also a minimum number of stocks that must be on the list. The Dividend Aristocrats Index needs a minimum of 40 constituents. So, if there are not enough of stocks to fill this quota and meet the three requirements, the rules are slightly relaxed. Instead of looking back over a 25 year history, the index could include stocks that have managed to grow dividends for only 20 consecutive years.
If the minimum quote is till not met, the remaining S&P 500 stocks are added on the basis of dividend yield in descending order.
As of now, the Dividend Aristocrats Index has 50 constituents, which means there are more than enough of stocks that meet the three main criteria. The average market capitalization of all these 50 stocks combined is $67.5 billion. The largest company on the list is worth $347 billion, while the smallest is worth only $6.4 billion.
Once every quarter the index is re-balanced so that each stock gets an equal weight. If a certain stock fails to meet the three main criteria stated above, they are deleted from the index.
Is it effective?
Perhaps the most reasonable question on any investor’s mind is – does the index work? Comparing an index to a benchmark is the only way to know if the index is worth paying attention to. Since its inception in 2005, the Dividend Aristocrats Index has outperformed the S&P 500 index. Over the course of its history the index has managed to return 9.73% on average every year, while the S&P 500 index has only managed 7.13% annually over the same period.
How is it used?
There’s a few different ways this index could be used. Investors looking for high-quality, blue chip companies could find them in this index. Income seekers can add high-quality stocks with a long history of stability. The index basically narrows down the list of S&P 500 stocks to the best dividend payers. That’s useful information for someone building a dividend portfolio from scratch.
On the other hand, some investors could invest in an ETF that directly tracks the index. SPDR S&P Dividend (SPY) and ProShares S&P 500® Dividend Aristocrats ETF (NOBL) are two indexes that track the Dividend Aristocrats Index.
Hedge funds, mutual funds, insurance companies, and Warren Buffett regularly take their favorite dividend picks from this list. Johnson and Johnson, for example, was one of the most popular Dividend Aristocrats. It’s part of the Berkshire Hathaway portfolio and is part of a considerable number of hedge fund portfolios. Archer Daniels Midland Company (NYSE:ADM), Chevron Corporation (NYSE:CVX), Abbott Laboratories (NYSE:ABT), AT&T Inc. (NYSE:T), and Wal-Mart Stores, Inc. (NYSE:WMT) are nearly as popular.
The Dividend Aristocrats Index is a invaluable tool for dividend investors. When you’re looking for high-value, blue chip companies, this index is usually the best place to start.
The 50-odd companies that are on the index right now have proven they can sustain and grow dividends. They have managed to grow for over a quarter of a century. The chances that they will keep boosting dividends are pretty high. We’ll be coming back to this index frequently to look for some investment gems later in this series.