Among the numerous strategies employed to filter out promising dividend stocks, perhaps none is as well known as the Dividend Aristocrats. This exclusive club, which can be accessed through multiple ETFs, includes only S&P 500 stocks that have increased their dividends for 25 consecutive years.
The Aristocrats portfolio includes both household names and some surprises, all of which have a lengthy track record of increasing payouts to shareholders. While the methodology behind this portfolio is sound, there are a few potential drawbacks.
Flaw #1: No Tech Exposure
Though the Dividend Aristocrats is a sub-set of the S&P 500, the sector composition of the two is quite different. Technology receives the largest weighting in the S&P 500, but has almost no allocation in the Dividend Aristocrats. ADP, best known for its payroll surveys, is the only stock that technically comes from the tech sector.
As of June 30, 2015.
Not that long ago, dividend-paying tech stocks were rare. Nowadays, the tech sector accounts for a huge portion of the total S&P 500 dividends; the $51 billion it pays out exceeds all other sectors. It will be several years before the tech allocation of the Aristocrats reaches a meaningful level; very few tech companies have even cracked the list of “contenders” that have increased payouts for 10 or more years.
In the meantime, the Aristocrats strategy will continue to overlook the largest source of dividends — and dividend growth — among S&P 500 stocks.
Flaw #2: Backward Looking
Predicting stock performance is, of course, extremely challenging. But there certainly are metrics that can be used to evaluate the strength of a company’s dividend. The payout ratio, for instance, indicates what percentage of income is being paid out to shareholders, while simple revenue growth measures the ability of a company to grow cash flows.
In other words, the Aristocrats doesn’t consider any warning signs that dividend cuts may be on the horizon, such as a high payout ratio, low revenue growth, or dwindling cash reserves.
Flaw #3: Panic Selling
Part of the appeal of the Dividend Aristocrats is the use of a rules-based methodology. The portfolio is constructed based on simple numbers; there are no decisions for humans to make in the process. That can be a positive, keeping emotion and biases out of the equation.
It can also lead to sub-optimal changes when companies stop paying dividends. By the time these stocks are removed from the Aristocrats index, any adverse market reaction has typically already occurred.
The best example of this phenomenon is Bank of America (BAC), which was removed from the index in January 2009.
There are, of course, examples when the Aristocrats methodology has dropped a stock before it incurred even steeper losses. (Avon Products (AVP) is one such example.)
The Dividend Aristocrats methodology is a solid starting point for investors looking to identify stable dividend-paying stocks that may deliver long-term value. But it has its shortcomings as well that can be addressed by more detailed research and analysis.
This article, Beware 3 Potential Drawbacks of the Dividend Aristocrats, first appeared on Dividend Reference.