How to Invest in the Dividend Aristocrat Index

Posted on Friday, September 21st, 2018 MarketBeat Staff

Investing in dividend stocks is not a flashy way to wealth. Investors won’t achieve the meteoric gains that they might get from a small cap technology stock, but they also won’t be subject to the stomach-churning losses that haunt investors who chase large returns. However, while dividend investing is about consistency and predictability, it doesn’t have to mean investors sacrifice performance. There are a group of dividend stocks that not only consistently deliver growing dividends, they also deliver performance that outpaces the S&P 500. These blue-chip companies are known as the dividend aristocrats.

The word aristocrat conjures up thoughts and images of royalty, and that’s appropriate for these companies. They are investment royalty. They represent the best-of-the-best. And many of the companies that are on the current dividend aristocrat index have been on the list for years, even decades. This is a club that companies who are committed to providing dividends want to be a part of. And that’s why they should draw your attention as an investor.

In this article, we’ll define what the dividend aristocrat index is, the requirements to become part of the club, the current composition by sector, and the benefits of investing in these companies. We’ll also touch on the best ways for investors to gain exposure to the companies in the index.

What is the dividend aristocrat index?

The dividend aristocrat index is a group of blue-chip S&P 500 companies that have a documented history of delivering increased dividends for at least 25 consecutive years. Membership to this club is exclusive, but can be achieved by any company that meets the following requirements:

  1. Their stock must be listed on the S&P 500
  2. They must have at least 25 consecutive years of dividend increases
  3. They must meet certain market cap and liquidity requirements. Currently, a company must have a float-adjusted market cap of at least $3 billion (meaning these are large-cap companies). In terms of liquidity, a dividend aristocrat should have an average trading volume of at least $5 million.

As of August 2018, there were 53 companies that were part of this elite group.

Why are dividend aristocrats good investments?

Any company that has both the desire and the ability to generate increased dividend payments for their shareholders is a stock worth considering for an investor’s portfolio. Dividend stocks are regarded as defensive stocks because of their ability to weather the volatility of both bull and bear markets. Put another way, most of these companies are in industries where consumers and businesses will always have a need for their products or services. Having said that, the ability of these companies to increase their dividend for over 25 years means that many of these companies have a strong, competitive advantage.

But what investors really want is proven performance. With dividend stocks, defining proven performance can sometimes be tricky. After all, dividend stocks are often thought of as something for investors with a low-risk tolerance. Investors get the benefit of low volatility with the tradeoff of performance that may lag behind the broader market.  However, that's not the case with the stocks that make up the dividend aristocrat index. In fact, the companies that make up the index have generated exceptional, risk-adjusted returns over the last 25 years, and in the last 10 years, in particular, they have consistently outperformed the S&P 500 by a large margin. 

Bringing up the last 10 years is significant because it’s easy to talk about the performance of a dividend stock in a bear market. While these stocks are not “recession-proof”, they have proven over time to generate strong cash flows even during a recession. A dramatic example of this would have been in 2008. The S&P 500 suffered a 38% loss. However, the companies that made up the dividend aristocrats index only declined 22%. You would expect that from defensive stocks. But in the last 10 years, the stock market has been on a historic bull run and these dividend aristocrats are still beating the S&P 500 Index, giving investors both higher total returns with less volatility. What more can an investor ask for?

Of course, like any stock an investor may choose to add to their portfolio, not all the stocks on the dividend aristocrat index are equally good investments at a particular time. Investors should pay attention to fundamentals like price-to-earnings ratio and dividend yield to decide which stock(s) may be right for their objectives.

What are the characteristics of dividend aristocrats

Because they are committed to not only paying but increasing their dividends, dividend aristocrats look to generate earnings or cash flow that can be used to pay out these dividends to shareholders. This means that many start-ups and troubled businesses won't make the cut. Also, these companies have to practice smart growth because they are intentionally setting aside a portion of their cash flow to be paid out as a dividend. This purposeful review of capital allocation likely adds to shareholder value. A third characteristic shared by these companies is that the ability to reward their shareholders with cash payments speaks to the idea that these are well-run businesses.

A mix of companies that Warren Buffett could love

Warren Buffett is an advocate for dividend stocks. His dividend portfolio is known for being light in the technology sector, and heavy on high-quality established companies in stable industries. So it shouldn't come as much of a surprise that the sector breakdown of the current dividend aristocrats closely reflects Buffett's philosophy. Consumer staples are the leading sector in the index, comprising 26.4%. Information technology is next-to-last taking up only 1.9%. The complete breakdown* is as follows:

Consumer Staples: 26.4%

Industrials: 17.5%

Health Care: 13.2%

Consumer Discretionary: 11.8%

Materials: 9.7%

Financials: 9.6%

Energy: 3.8%

Telecommunication Services: 2.1%

Real Estate: 2.0%

Information Technology: 1.9%

Utilities: 1.9%

*Source: Standard & Poor’s

To look at this sector mix from another perspective, take a look at how some of the sectors compare with the S&P 500 Index.

Sector

Dividend Aristocrat Index

S&P 500 Index

Consumer Staples

26.4%

9%

Industrials

17.5%

10.3%

Health Care

13.2%

14.5%

Information Technology

1.9%

22.3%

How a dividend aristocrat can fall out of the index

The requirements to become a dividend aristocrat are stringent. And once a company makes the index, they have to continue to meet the requirements to retain their status. Standard & Poor’s is the company that oversees the index. They rebalance the index every year in January. At this time, some companies may be added and some taken off.

How to invest in the dividend aristocrat index

There are many financial websites that provide a list of the dividend aristocrats. Many allow investors to compare stocks based on a number of criteria including price-to-earnings ratio, liquidity, and dividend yield. In many cases, an investor may only need to have a handful of these stocks in their portfolio to get the diversification they are looking for. Many investors get a lot of satisfaction out of performing the fundamental analysis needed to find a quality stock. And, to be fair, not all of these stocks grow at the same rate or at the same time.

However, many passive investors don’t have the time or the expertise to research individual stocks. Fortunately, they have options as well. One of the best ways to invest in the dividend aristocrat index is through index funds or exchange-traded funds (ETFs). These funds provide diversification and a low-cost structure. While index funds and ETFs behave fairly similarly there are some important distinctions, particularly in the way dividends can be reinvested. In an index fund, dividends are immediately reinvested, while ETFs continuously accumulate dividends and distribute them quarterly. However, on the other hand, ETFs provide are more tax-efficient and can offer investors more choices than index funds. Some of the more popular funds are:

  1. SPDR S&P Dividend ETF (SDY)
  2. ProShares S&P 500 Dividend Aristocrats (NOBL)
  3. SPDR S&P Global Dividend ETF (WDIV)

There are several other funds that track dividend stocks, but don’t directly follow the index, or may expand their guidelines to include companies that have issued fewer consecutive years of increasing dividends. However, increasing the range of companies does not necessarily improve performance. The reason why the dividend aristocrats have achieved their status is because of their commitment to providing dividends for at least 25 years, and in many cases far more than that.

Criticism of the dividend aristocrat index

There really isn’t much to not like about the index. If you’re an investor who understands and desires the benefits that healthy, outperforming dividend stocks can add to your portfolio, then investing in this index either by purchasing individual stocks or by buying into an index fund or ETF makes sense. If there’s one critique of the methodology it’s that some of the companies in the index to engage in the practice of share buybacks. On the face of it, it’s a reasonable concern because when a company buys back its own shares it traditionally dilutes shareholder value. However, this is one of those scenarios where context is very important.

Many corporations are under intense pressure and incentivized to buy back shares if their stock is perceived to be overvalued. But issuing dividends and stock buybacks does not have to be an either/or proposition. The key thing to remember about the dividend aristocrats is that if these companies are occasionally buying back their own shares they are also still issuing dividends. And not only dividends but dividends that continue to increase every year. So while some purists may not like the practice of stock buybacks, in practical terms and by definition of the index's own selection criteria, this is not a valid concern. 

The bottom line on the dividend aristocrat index

There is no magic to the companies that are selected to form the dividend aristocrat index. They are simply solid companies who have demonstrated the ability to issue increasingly rising dividends for at least 25 years. Membership in this club is exclusive and while some companies can be removed from the index, the reality is it typically takes a major event such as the financial crisis of 2008 or the long, steady decline of a one-time powerhouse like General Electric to move a company off the index. Most companies are very proud of their aristocrat status and make the ability to add shareholder value through issuing dividends a primary objective of their business.

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