[Dec market outlook] Dividend champions are attractive

Summary

·       As top-down investors, we monitor the broader sectors to identify the most promising areas.

·       This month, we see the dividend champions as a whole group are becoming attractive.

·       We also performed a screening using the Magic Formula (MF) investing method to pick some of the best combinations of value and quality.

·       Many excellent dividend stocks such as RLI, TROW, CVX, and XOM showed up on our radar.

·       Dividend growth investors can take this opportunity to strengthen their holdings with this elite group of stocks in terms of geographical diversification and sector diversification.

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Front matters

As communicated in an earlier article, we closely track the dividend yield of the dividend champions for good reasons:

·       First, these champs as excellent stocks themselves and we’ve had great success with them.

·       Second, the dividends champs are companies who have been consistently increasing their calendar year dividend payout for at least 25 years consecutively. Thus, I view their dividends as the most reliable indicator of their owners' earnings and their dividend yield as the most reliable valuation indicator for the overall market.

And as you can see from the following chart, the average yield of this group has become quite attractive recently compared to its historical mean as of this writing.To wit, the mean yield for this group of stocks is about 2.62% since 2018 and it is about 2.58% since 2011. As of today (Dec 7), this group of stocks was yielding 2.56%. Therefore, the current yield is essentially on par with the historical mean (~0.6% above the mean in relative terms). Note that recent market volatility has brought the group to a discount to be as large as 10% at the end of September. And such a discount is very like to reoccur again the way the market volatility behaves. A 10% discount for this group is a quite large discount if you consider that this group of stocks are so consistent that their maximum premium/discount had been within about 10% over the past few years (as you can see from the two red lines).

Premium/Discount of Div Champs in Dec 2022

Dec 2022 Top 10 Picks

Given this background, we looked at the champs more closely and screened 10 top picks as shown in the table below. As usual, we will get to the point as quickly as possible. And plz make sure, especially for new members, that you reach out to us and ask follow-up questions.

The Magic Formula and its performance

We performed the screening by the so-called Magic Formula (“MF”) method. Readers familiar with this method can skip this entire session and directly to the next section to see our comments on this list.

The MF investing method was developed by Joel Greenblatt, a legendary investor and hedge fund manager. The method has been detailed in his book, entitled “The Little Book That Still Beats the Market”. The essence of the method is to use a set of simple rules to pick stocks that are an optimal combination of value and quality, in a methodical and unemotional process. The rules are simple:

1.  To compute the valuation of a stock (e.g., by the PE or EV/EBIT multiples). This number tells us how much we are paying to get a claim on one dollar of earnings in that stock. Obviously, the lower this number, the better the deal (or bargain) we are getting in terms of the price we pay. We used PE in our screening.
2.  To compute the quality of the stock (e.g., by some profitability metric, such as the return on capital, return on equity, or return on asset, ROA). This number tells us for every dollar we invest in the company (by buying its stock), how much of it can be turned into a profit. Obviously, the higher this number, the better (or more profitable) the business. And we used ROA in this screening.
3. To rank all the stocks we are interested in both the valuation and the ROA (the last two columns in the above list.
4. Then finally add these two rankings to generate a combined rank and order the stocks by this combined rank. The stocks at the top of this final list represent the optimal combination of valuation and quality.
5. The MF method has been thoroughly backtested and showed superior returns compared to the broader market. For example, from 1988 to 2004, the MF method returned an annualized 33%, compared to 14% for the S&P500. During this period of time, following the MF for any 3-year period in a row, the MF beat the market averages 95% of the time.

Furthermore, it is a relative method that works under any overall market condition. A very important feature for a market that is overall significantly overvalued, such that absolute methods (e.g., limiting PE to be below a threshold) would either lead to too few stocks or stocks with low quality.

MF past performance

Source: The Little Book That Still Beats the Market

The Top 10 Picks for this Month

Supported by the above previous work and our own experiences, we applied the MF+DG method to a total of 144 dividend champions with their current information and the top 10 candidates are again:

MF top 10 picks for Dec 2022

Not all picks are suitable for all accounts considering that some of them are small caps and/or in special niche areas (such as UHT and NC). However, we feel several of them could be of interest to conservative accounts such as our SWP (survival/withdrawal portfolio) given their very reasonable valuation, strong financials, and also relatively high dividend yield. In particular,

1.     CVX and XOM, you probably also know that we are in general bullish about energy stocks. And the fact that both CVX and XOM made it to the top 10 list of this screening adds another piece of data point to their attractiveness.

2.     NUE looks to be an interesting candidate in the metal/mining space. Although we are already exposed to this space with RIO. We opened a position in the $60 level earlier in the year, and it has been a successful exampleof the MF method (bear in mind it also paid more than $7 of dividends this year).

3.     RLI is an interesting candidate in the insurance industry too. But again, we are already exposed to this space with AFL, which has been another successful pick from the MF method too. We opened a position in the $55 level earlier in the year.

4.     Finally, in case you are not aware, MMM is entangled in a lawsuit now regarding the health effects of its earplugs. It is more of a high-risk/high-return choice here, and our overall philosophy is NOT to buy into lawsuits.

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