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How dividend growth can help to unearth resilient growth stocks

In the hunt for growth stock ideas, it may pay to take more notice of a company's dividend track record
markets, investments
Some growth investing strategies see dividends as a negative

When it comes to investment strategies, ‘growth’ and ‘income’ investors tend to focus on very different things.

For growth investors, it’s often the case that sales and earnings are more important than dividend payouts.

But it’s worth remembering that dividend track records can tell you a lot about a company’s growth and outlook - and not just how much cash is finding its way back into shareholder pockets.

Jim Slater, the famous British growth investor, wrote in his 1992 book The Zulu Principle, that he preferred companies that pay a dividend.

Slater was a dyed-in-the-wool growth investor, but here he was stating the case for dividends.

He explained: “...the dividend payment and forecast (if any) to some extent corroborate the management's confidence in the future.

The ideal company will have a steadily increasing dividend growing broadly in line with earnings.”

What he was saying was that the dividend was a useful extra way of figuring out whether a company’s growth was likely to continue.

Yet some growth investing strategies actually see dividends as a negative.

Indeed, a traditional view of companies that pay cash back to investors is that they’ve simply run out of ideas.

They don’t know how to grow any further and may have gone ex-growth.

More generally, there’s an assumption by growth investors that dividend-paying stocks actually deliver lower portfolio returns.

They can’t deliver the capital growth that fast moving growth stocks are known for.

But none of this is necessarily true. Research shows that higher yielding stocks can actually deliver superior portfolio returns over time.

The power of dividends

In his book Behavioural Portfolio Management, the investor and academic Dr C. Thomas Howard makes the case for high yielding stocks not only outperforming but also producing lower portfolio volatility.

He argues that they do better, with fewer stomach-churning swings.

To understand what it is about dividends that makes them so useful, it’s worth considering the credibility of all the other ways that management teams signal their confidence to the market.

One of the most common of these, of course, is forecasts. Dr Howard notes that management forecasts and projections are often far too optimistic.

The second source of management confidence comes in financial results and routine earnings updates, but again, these are either externally audited or bound by strict market rules.

That means it can be hard to decipher whether management is truly confident or hiding something.

By contrast, dividends and dividend policy are almost entirely under the control of management.

Which means that a payout history can be a useful barometer of what the directors really think.

Dr Howard notes that companies tend to be careful about paying out too much but are keen to deliver progressive, sustainable payout growth.

So, he says, “by increasing dividend payments, management is actually signalling higher future cash flows, which in turn foretell higher stock returns.”

Unsurprisingly, long dividend growth streaks are well used by dividend investors looking for resilient payouts that are unlikely to be cut.

These streaks are what underpin the well known Dividend Achievers index.

But there certainly a case that dividend growth isn’t just a measure for dividend hunters.

It’s a particularly interesting gauge of management sentiment, which means that growth investors should take note too.

At Stockopedia, we track a screen modelled on the classic Dividend Achievers approach.

It looks for dividend growth streaks of more than four years in companies with earnings that have grown at an average annual compound rate of more than 10% over five years.

Debt has to be under control and there should be reasonable liquidity in the shares.

Before dividends, this regularly rebalanced portfolio has had a pretty good run over the past six years, although it has been flat over the past 12 months.

Here is a list of the companies currently passing those Dividend Achievers rules:

Name

Dividend Growth Streak

DPS Growth %

EPS 5y CAGR %

Debt To Assets %

10d Avg Vol

4imprint

8

97.6

30.0

-

21,088

Somero Enterprises

5

92.5

81.4

-

62,125

Redrow

5

64.7

41.7

1.12

974,179

Robert Walters

5

48.6

43.5

7.92

19,709

Miton

6

40.0

32.4

-

737,597

Howden Joinery

6

38.3

16.4

-

1,932,581

MJ Gleeson

5

33.3

43.5

-

40,353

AFH Financial

5

33.3

54.3

4.28

56,021

ECO Animal Health

8

29.6

22.8

-

22,342

Cranswick

9

21.8

12.3

-

50,881

One of the interesting things about this screen is that looks for firms with double-digit earnings growth rates, so it naturally gravitates towards smaller, more growth-oriented stocks.

That means this kind of strategy would tend to appeal to growth investors.

Dividend growth streaks vary between five and nine years and the dividend growth over the past year has ranged from around 30% to nearly 100%.

The yields won’t always be as high as many ‘high yield’ investors would usually want, but the point here is more about dividend growth than high yield.

One feature of this ‘dividends + growth’ approach is that it tends to pick up profitable, higher quality smaller companies, and these may well be on relatively expensive valuations.

A number of these companies have high StockRanks. 

However, in the search for growth, a robust dividend track record paired with strong earnings growth has been shown to be a sound basis for portfolio construction.

Smaller companies are not immune from having to make dividend cuts - and careful research is always important - but in the hunt for growth stock ideas it may pay to take more notice of the dividend track record.

 

 

 

Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.

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