The following is a post from Ben Reynolds, who blogs at Sure Dividend
Those who have invested in Dividend Aristocrat stocks have done well in recent years. Over the last decade, the Dividend Aristocrat Index outperformed the S&P500 by 2.88 percentage points per year. Deciding which Dividend Aristocrat stocks to invest in goes beyond examining stocks individually. Viewing investment decisions from a portfolio level helps investors to make better selections.
The current Dividend Aristocrat stocks cover a wide variety of businesses. Businesses whose returns are dependent on different factors increase diversification better than businesses that are in the same field. The more closely related a stocks returns are to another stock, the higher the correlation. Stocks that moved exactly the same way every day would have a correlation of 1. Similarly, stocks that moved exactly opposite each other every day would have a correlation of -1. A correlation of 0 implies the stocks returns are not related at all; they come from different factors.
Dividend Aristocrats & Correlation
There are currently 54 Dividend Aristocrats. Of these, 53 have price data going back 10 years or more. AbbVie is the only Dividend Aristocrat that does not have a long price history due to its recent spinoff from Abbott Laboratories. The average correlation coefficient of the 1,484 pairs of Dividend Aristocrat stocks with 10+ years of price history is high at .81. While the average is high, there are several stocks that exhibit very low correlation to one another. The 10 lowest correlation pairs of Dividend Aristocrats are:
- .12 – McDonald’s & Medtronic
- .18 – Family Dollar & Medtronic
- .19 – Cintas & Nucor
- .21 – Consolidated Edison & Medtronic
- .24 – Leggett & Platt Co., & Nucor
- .25 – HCP, Inc. & Medtronic
- .27 – Family Dollar & Nucor
- .27 – Coca-Cola & Medtronic
- .29 – Nucor & Medtronic
- .30 – Sigma-Aldrich & Medtronic
There are several companies that recur repeatedly on the lowest correlated pairs list above. Medtronic & Nucor in particularly come up over and over. Medtronic has an average correlation to other Dividend Aristocrats of just .49. Similarly, Nucor has an average correlation of .49 to other Dividend Aristocrats over the last 10 years.
Quality & Correlation
The correlation coefficient is a useful tool in determining what businesses to add to your portfolio. The lower the correlation between a stock and your total portfolio, the higher the diversification gains will be. Diversification is not the goal of investing. I believe investing for long time periods in high quality businesses that have a history of rewarding shareholders through dividend payments will result in solid investment returns. It is more important to find high quality businesses than it is to find businesses that are uncorrelated with one another. High quality businesses have strong competitive advantages that allow the business to grow earnings and dividends consistently and continuously. These businesses are likely to have strong operational performance even during recessions. Given the choice between a portfolio of high quality businesses that are highly correlated to each other, and a portfolio of uncorrelated businesses that did not have competitive advantages, I would chose the high quality portfolio every time. Once you have identified high quality businesses, then examine how well the business fits into your overall portfolio.
Where to Find High Quality Businesses
An Excellent place to find high quality businesses is the Dividend Aristocrats index. A business that has paid increasing dividends for 25+ years either has or at one point had a strong competitive advantage. I use quantitative rules backed by academic research such as The 8 Rules of Dividend Investing to further determine what businesses are likely to make sound investments over the next several years.
Minimizing correlation between your stocks will reduce portfolio standard deviation. Standard deviation is not risk in itself; it is merely a proxy for risk. With that being said, stocks with low volatility bounce around less, making it easier to sleep at night. Even better, low volatility stocks have historically outperformed the market. A portfolio of high quality dividend stocks that seeks to reduce the correlation between each holding will likely provide capital and income appreciation in addition to the safety and peace of mind that comes with knowing you hold high quality businesses in a portfolio designed to reduce volatility.
About the Author: Ben Reynolds runs the Sure Dividend which focuses on high quality dividend growth stocks suitable for long-term investing