ETFs- Page 2 of 3 - Alterna Invest

I stumbled on this question multiple times on a few forums, so I thought I would write a dedicated post on it. Do dividend stocks beat the market is not a well-thought-out question. People who ask this question mean, will I generate greater returns than the market, but that is not what dividends stocks are good at. Dividends stocks are great at building sustainable income, something that S&P500 does not do well. Regardless, let’s run a test and compare the historical performance of a list of Dividend Aristocrats vs. S&P 500 ETF. Dividend Aristocrats vs. S&P500 - SPY Who are the Dividend Aristocrats? Dividend Aristocrats are a select group of 65 stocks that belong to the S&P500 that have 25+ years of consecutive dividend increases. The list continuously changes with the addition & removal of companies that meet the criteria. For this hypothetical test, I will use the latest version of the list that you can find here. Historical Performance vs. S&P500 To make the comparison easier, I will backtest the Dividend Aristocrats vs. S&P500 ETF - SPY. Dividend Aristocrats’ weighting will be equal. Meaning every stock on the list will get 1/65th of our capital. I will also rebalance the portfolio every year. Meaning that once the weights between stocks start to shift, I will sell some & buy some to ensure they stay inline. Here are the results: Note: This test is done on Dividend Aristocrats today, but there were not necessarily on the list back in 1994. Some of these companies are old, but some have only been added to the list in the last few years. From 1994 until today, Dividend Aristocrats massively outperformed the S&P500. Over the period from 1994, this specific Dividend Aristocrat list generated a Compound Annual Growth Rate of 14.44% compared to 10.73% for S&P500 ETF - SPY. Dividend Aristocrats Income growth What’s more impressive, however, is the income that dividend aristocrats generated over the years. If you put $10,000 back in 1994, by 2020, you would be getting over $7,000 in dividends alone. That is the true power of dividend growth stocks. They might start off slow, but consecutive increases every single year add up. Depending on your goals, this could be far more valuable than pure returns. What does beating the market mean? What does it mean to beat the market? Generate greater return in one year, two years, ten years? Consider these two strategies: #1 Invest all capital into S&P500 ETF for ten years. Strategy #2: Invest all capital into a dividend stock that has a history of paying and growing dividends. Strategy #1: Invest in the S&P500 ETF S&P500, on average, grows by 8-10%. S&P grew by 15% in the last decade, thanks to the post COVID bull run. $10,000 invested ten years ago would give you $39,000 today. For some people, this simple strategy could work well. With this strategy, we are not trying to beat the market; we are just buying the market and see where it takes us. One obvious downside with this strategy is that it does not take into account our goals at all. What if I am not interested in growing my capital as much as getting a stable source of income and quitting my job. S&P500 ETF - SPY does pay a dividend, but depending on the time of purchase, dividend yield fluctuates between high 2% and low 1%. That is because the price of SPY fluctuates while dividends remain relatively the same. If you buy SPY today, you will earn 1.3% per year in dividends. $10,000 invested today will generate $130/year in income. Strategy #2: Invest in Dividend paying portfolio or stock Let’s contrast that with a stock that has a long history of both paying and growing dividends. There are a lot of companies like that but let’s take 3M - MMM as an example. [insert 3M info] 3M has been paying dividends since the 80s and has no intention of stopping. On top of that, the dividend has been steadily growing over the years. That means every year; you get a raise. Invest once and receive higher and higher amounts every year. Here is 3M’s dividend history. If we bought 3M ten years ago, we would get $0.55 per share in dividends every quarter. The stock price was roughly $78, giving us a dividend yield of roughly 2.77% per year. Investing $10,000 would generate $277/year in dividend income. At the price of $78, $10,000 is around 128 shares. Today, the same stock is paying $1.48 every quarter. If we held on to our 128 shares. That equals 128 * $1.48 *4 = $757/year in dividend income and shares worth $22,400. So we might think that 3M did not beat S&P on returns, and that would be correct for the period we hypothetically selected here. However, what happens if the market crashes tomorrow? S&P plummets, erasing all of its returns, and so does the price of 3M. But the $757/year in income will remain. Obviously, there are no guarantees that the company is not hit so hard that the management has to cut dividends. But looking at history, it is unlikely. This is a look at 3M's price vs. dividend. Prices go up and down, but the dividend is steadily going up even during periods of recession (grey vertical lines on the graph). Regardless of what the future holds, I can rely on dividend income from companies like 3M with more confidence compared to the price of S&P 500. In fact, we know that the bear market is inevitable and hoping for prices to keep rising is not the smartest strategy. Income vs. Growth The two strategies are significantly opposite of each other not only in the expected outcomes but in the types of businesses we need to invest to achieve our desired results. Dividend-paying companies almost by definition need to have established earnings, profitability, and strong cash flow to cover dividends. On top of that, they need to grow earnings in order to increase dividends consistently. This requires a certain level of prudence that growth companies can afford to ignore. That is the reason why most dividend champions are quite boring old companies. I personally don't think so, but they are definitely less flashy than the latest technology trend stocks. What companies would you rather own: Clorox, Coca-Cola, Kimberly-Clark, Johnson & Johnson, or the latest version of [pick a technology company] that is losing money. These money-losing operations can be great at delivering above-average capital gains, but it does come at a cost. Many of them do not make it. Volatility is way above the market, and you can't expect any income. Unrealized Gains of growth stocks vs. Real Income Important things to keep in mind is that when people look back on how stocks have performed, they consider hypothetical scenarios. We do it with every investment we analyze. History has a lot to teach us. Companies that consistently pay dividends over twenty years are extremely likely to pay them in the future, for example. But we have to always keep in mind that history is in the past, and we invest for the future. When it comes to growth stocks, looking at historical returns paints an extremely attractive picture. Just look at Amazon’s price chart, for example. Annualized return of over 35%. 167,000% total return. It looks incredible. The next question should be, how realistic is for Amazon to grow 35% per year for the next ten years given its current size? Also, consider if you did invest in Amazon all those years back, would you hold on to it? Or would you have sold out a long time ago and locked in your profits? What if you needed money consistently over this period of time? This is where an income portfolio would be a much better fit despite the impressive historical growth of Amazon or any other stock for that matter. Also we are looking at a twenty year plus history of Amazon. Yet, many of us do not think in terms of decades. Imagine you were an investor in Intel back in the 2000s. Great company with great products with "legit" technology, not just a website. Yet, this is what happened to Intel during the worst period of the 2000s. If you had FOMO and got in at the very top and then experienced an 80% drop, would you sell? Resiliency of dividend champions Dividend champions bought at the right price provide level of security that the overall stock market cannot match. They are not risk-free by any means, but take a look at the following five dividend champions and see how their dividends grew during every single crisis we have faced in the last twenty years. Imagine getting a raise in payments every year while the market is going through turmoil. Therefore, it just doesn’t make sense to purely look at returns. Every investor has different goals and there are different assets to fit those goals. If you are unsure where to start, take a look at our Investment Guide. Happy Investing!