9 secrets of dividend investing, from a couple of stock pros who beat the market

Many income-focused investors dwell on dividend yield and buy largely on that basis. More income is better, right? 

Not so, say the two dividend-minded mutual-fund managers who run the outperforming Guinness Atkinson Dividend Builder Fund GAINX, -0.52% . Matthew Page and Ian Mortimer use a much more nuanced approach to get high-achieving results. Over the past three years, they have beaten both their Morningstar World Large-Stock category and the MSCI ACWI Index by 1.9 and 1.4 percentage points, respectively, on an annualized basis. 

That’s a solid record given that most stock-fund managers lag their categories. So it’s worth learning how Page and Mortimer operate to help you improve your own income-investing strategy.

Their system starts by identifying companies with the characteristics that exemplify long-term outperformance. Then they fish in this pond, since these businesses are likely to continue doing well. “It stacks the odds in our favor,” says Page. Here are the qualities they favor, and other tips on how to succeed in dividend investing:

1. Go with dividend growers: Dividend stocks outperform, as a group, but companies with a history of increasing dividends do better, whereas companies with flat dividends tend to be more average. You want to own shares in companies that are likely to continue hiking dividends. To find those, look for these next four qualities.

2. Favor companies with a high return on capital: Companies with a long history of investing smartly in their business will probably continue to spend wisely. This means they’ll have more sustainable cash flow, so they’re more likely to keep hiking dividends. A good long-term investment record is key. Studies show companies with a great investment track record over 10 years have a 95% chance of repeating their success over one year, and an 80% chance of doing so over four years. 

There are many ways to measure corporate investment prowess, but Page and Mortimer use a gauge called cash-flow return on investment . They favor companies with a cash-flow return on investment greater than 10% for 10 consecutive years.

3. Go with moderate dividend yields: This sounds counterintuitive, but it makes sense if you think it through. First, having a moderate dividend makes it easier for a company to hike its dividend, simply because there is more room to grow. “It’s the law of large numbers,” Mortimer says.  Meanwhile, a high dividend is not always attractive. It means a company is less likely to hike payouts.

Moreover, excessively high dividend yield due to a steep stock decline can be a sign of trouble. To identify promising companies in selloffs, the fund managers analyze the issue that’s distressing investors, and favor companies with great investment track records. “If a stock falls but it has high return on capital, you can make the argument there is a short-term issue,” Page says.

4. Look for strong balance sheets: When a company is stretched, it is more likely to be forced by the market to cut its dividend to pay its debt, Mortimer says. This can hurt a stock. A strong balance sheet means a company is less likely to cut its dividend. 

5. Go with cheap stocks:  Page and Mortimer use valuation gauges such as price-earnings and free cash-flow yield. Be sure to compare a company’s valuation to its peers or its own history, and not the market overall. 

Two of the fund’s holdings that look reasonably cheap right now are ANTA Sports Products ANPDF, +0.77%  and British American Tobacco BTI, +0.58% . ANTA Sports Products sells sports apparel in China, and the stock has been hit by coronavirus fears. (My take is the coronavirus is a temporary setback for companies.) British American Tobacco has been a weak stock because of health concerns about vaping, and increased Food & Drug Administration regulation of tobacco. “We think they are being punished too much,” Mortimer says of the stock. 

6. Make concentrated bets: This is a tactic that many outperforming managers use successfully. It’s better to know a short list of names and invest only in them. These two managers like a portfolio of 35 stocks, with each representing about 3% of the portfolio. In contrast, many actively managed funds stick to 1% positions to get the “benefits” of wide diversification, which can actually hurt performance.  

7. Shop the world: Don’t limit yourself to U.S. stocks. There are rich dividend payers around the world. The Guinness Atkinson managers aim for a 50-50 portfolio mix. The names singled out for this column are all non-U.S. companies, which makes sense from a valuation perspective because many international markets are lagging both the S&P 500 SPX, +0.43% and the Dow Jones Industrial Average DJIA, +0.27% . 

Also, the fund managers recommend industrial conglomerate ABB ABB, +0.70% , whose shareholders may benefit from the sale of its power grid business, and Henkel HENKY, +1.52% , a consumer goods and chemicals business whose stock has been lagging in part because of automobile-sector weakness.

8. Hold for the long term: The Guinness Atkinson portfolio has a relatively low 24% turnover rate, and has kept a third of its positions since its 2012 inception, including Microsoft MSFT, -0.01% , Procter & Gamble PG, +1.08% , Johnson & Johnson JNJ, -0.17% , Aflac AFL, -0.11% , and Royal Dutch Shell RDS.A, +0.04% .

9. Get good at math: Page and Mortimer never went to business school, but they both have advanced degrees in physics from the University of Oxford. This is unusual in investing, but the experience has made them better investors because it helped turn them into quantitative analysts, influenced by numbers rather than “stories.” In this way, the fund managers are less likely to follow the crowd or focus on the size of dividend payouts.

Says Mortimer: “Rule number one: To get good dividend stocks, don’t look at the dividend.”  

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested MSFT, PG, JNJ and RDS.A in his stock newsletter, Brush Up on Stocks

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