In an environment where many professionals consider the stock market to be overvalued and ripe for some sort of a correction, picking stocks can be a difficult, and even daunting responsibility.
Even the best active managers are struggling in the face of these escalating valuations, and investors are looking for ways to help manage risk. In addition, investors have added dividends to their wall of worry, as some are predicting that overall dividend growth rates could slow. How are investors to know how a company might perform in the future? If future dividends can be a strong barometer for company health, is it possible for investors to better predict future dividends?
Dividends have been on the rise since the end of the financial crisis, and growing and paying dividends has been a very important long-term theme. As companies are incentivized to continue paying dividends through downturns, they can provide a natural hedge against volatile markets.
Where this gets even more interesting is when we look at non-payers and cutters, two groups trailing the dividend growers and payers significantly. As displayed in the following chart, not only have dividend growers and initiators historically outperformed, but they have done so with an annualized standard deviation about 40% lower than cutters. The negative momentum placed on a company when announcing a dividend cut is tremendous as it may signal significant issues with the company. Just as uncovering companies poised for dividend growth could be highly beneficial to investors, identifying and avoiding potential dividend cutters is also a powerful investment capability.
Reality Shares set out to develop an analytical tool that would assess securities based on their potential for dividend growth in the future. In doing so, they developed DIVCON®. This dividend health rating methodology allows Reality Shares to evaluate dividends in the pursuit of more intelligent and predictive rules-based security selection. DIVCON seeks to deliver a more accurate picture of a company’s fiscal health and better predict the probability of an increase or decrease in a company’s dividend over the next 12 months. The healthiest companies earn the highest DIVCON scores and a rating of DIVCON 5, meaning they exhibit the strongest likelihood of increasing their dividends, and the least financially stable companies are rated DIVCON 1. This presents an easy-to-understand forward-looking ranking of dividend paying stocks, much like the buy-hold-sell ratings other ratings agencies might issue on securities.
The seven DIVCON factors are weighted, scored and categorized according to their importance. What this means is DIVCON® is able to dynamically evaluate each company’s financial ability to grow their dividend in the future based on a substantial range of fundamental factors. This is not like the rear-view mirror analysis of other dividend and yield systems. This distinction is important, as a company’s dividend history is often a good indicator of whether a dividend may rise or fall, and investors not paying attention to the many other factors potentially impacting a company’s payout decisions can easily be hurt.
So how can investors use this forward-looking data? The DIVCON Leaders Dividend ETF (Ticker: LEAD) uses DIVCON’s uniquely forward-looking methodology to systematically weight and invest in only the healthiest dividend growth leaders – the companies with the highest probability of increasing their dividend in the next 12 months. The Fund utilizes a quantitative evaluation process and seeks to deliver diversified market exposure. The effect is notable – it chooses stocks through a focus on quality rather than just yield, and is designed to offer a higher probability of outperforming, especially when lower quality companies in the S&P 500 struggle. The result is a high-quality, large-cap exposure focused on dividend growers—which have historically outperformed the market.
The DIVCON Leaders Dividend ETF (BATS:LEAD) has historically identified future dividend actions. For example, in the first three quarters of 2016, LEAD portfolio holdings experienced an average 24.7% growth in their dividend, compared to just 14.3% for the S&P 500.
The current market environment is a very opportune time to examine large-cap portfolios for quality. Attractive yields in the Utilities, Consumer Staples and Telecommunications sectors have drawn investors in, but these sectors are likely overvalued and less poised to grow their dividends due to lower company financial health, as predicted by DIVCON. As LEAD identifies the companies most likely to grow their dividend over the next 12 months, it represents a potential strategy to incorporate in a portion of large-cap allocations, bringing the potential for outperformance during dividend growth announcements as well as the possibility of some support during downturns, given the quality and strong financials of the companies in the portfolio. In the current environment, it may be prudent for investors to consider quality for their portfolios rather than just current yield to help manage overall portfolio risk.
To learn more about the DIVCON Leaders Dividend ETF (Ticker: LEAD), please visit http://www.realityshares.com/funds/lead/.
S&P 500: A broad stock market index of 500 large companies based on market capitalization.
Altman Z-Score: Credit-strength test that gauges a company’s likelihood of bankruptcy.
1 Source: Standard and Poors, Reality Shares Research. Dec. 31, 2015 through Sep. 30, 2016. Past performance is no guarantee of future results.
This article is commentary by an independent contributor.
Eric Ervin is President and CEO of Reality Shares, Inc. This article expresses his opinions solely and may not necessarily represent the opinions of Reality Shares. The observations and views expressed in this material may change at any time and without notice.
This material is not intended to constitute an offer, or solicitation of an offer, to purchase or sell any security or financial instruments or to participate in any investment strategy. The securities and investment strategies referenced in this material are not intended as recommendations and may not be suitable for you.
Investors should carefully consider the investment objectives, risks, charges and expenses before investing in Reality Shares ETFs. This and other information can be found in the Fund’s prospectus, which may be obtained by calling 855-595-0240 or by downloading the file from realityshares.com. Please read the prospectus carefully before investing.
There are risks involved with investing including the possible loss of principal. The Fund’s emphasis on dividend-paying stocks involves the risk that a company may cut or eliminate its dividend which may affect the Fund’s returns. Investments in swaps, options, and futures and forward contracts are subject to a number of risks, including correlation risk, market risk, leverage risk and liquidity risk, which may negatively impact the Fund’s investment strategy and could cause the Fund to lose money. Please review the prospectus for important risks regarding the Fund, as each of these factors could cause the value of an investment in the Fund to decline over short- or long-term periods. The Fund is new and has a limited operating history.
There is no guarantee or assurance the methodology used to create the Benchmark Index will result in the Fund achieving positive returns. The Fund may be more susceptible to a single adverse economic or other occurrence and may therefore be more volatile than a more diversified fund. The Benchmark Index is constructed using a rules-based methodology based on quantitative models developed by Reality Shares. These quantitative models may be incomplete, flawed or based on inaccurate assumptions and, therefore, may lead to the selection of assets for inclusion in the Benchmark Index that produce inferior investment returns or provide exposure to greater risk of loss.
Shares of the Fund are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. Market Price is based on the midpoint of the bid/ask spread at the close of the market and does not represent the returns an investor would receive if shares were traded at other times.
Reality Shares Advisors, LLC is the Investment Advisor. ALPS Distributors, Inc. is the Distributor for the Fund. Employees of Dakota are registered representatives of GrandFund Investment Group, LLC, and provide third party distribution services for Reality Shares. ALPS Distributors, Inc. is not affiliated with Reality Shares Advisors, LLC or Dakota.
Eric Ervin is a Registered Representative of ALPS Distributors, Inc.
RLT000506 Exp. 6/30/2017.