This is How You Can Beat the Market Without Fail

2020-01-09

Introduction

With this article I am going to present several ways that investors, especially retired investors, can beat the market without fail.  However, what I will be presenting may not be what you are expecting, particularly if you have a narrow notion of what beating the market means.  In other words, one of my primary objectives will be to expand your mind and attitudes regarding what investment performance is truly all about. 

Moreover, this speaks to one of my biggest pet peeves as a financial professional, which is listening to the common refrain that most active managers can’t beat the market (S&P 500).  The reason this aggravates me so much, is that I have never found it practical or useful as a professional manager to even try to “beat the market.”  Investors are unique, and as such, possess investment objectives that are also unique to their own goals, objectives and risk tolerances.

Simply stated, investing is not a one-size-fits-all.  Therefore, it has always made more sense – to me at least – to manage portfolios that were designed to meet the individual client’s specific goals, objectives and risk tolerances.  In other words, I prefer to design portfolios that get the job done and often without regard to short-term price volatility.

More to the point, the market (S&P 500) simply may not be a suitable investment for every client.  On the other hand, this does not simultaneously suggest that those investors should not invest in stocks at all.  Instead, investors might be better served to build a portfolio of individual stocks that meets their specific goals, objectives and risk tolerances.  A good example could be a portfolio of blue-chip dividend aristocrats with a long history of increasing their dividend every year.  In contrast, the S&P 500 would also include stocks that don’t even pay a dividend.

As I will illustrate later in the article, and in the accompanying video, a quality dividend growth stock with a starting current yield that is higher than the S&P 500 and at the same time fairly valued will produce more dividend income than the market the majority of time, if not over every timeframe.  In other words, it will beat the market based on total income produced, and is highly likely to meet or beat it on a capital appreciation basis over the long run as well.  Superior businesses bought at fair value will generally produce above-average (the market is an average) results over the long run.

Building Investment Portfolios to Meet Your Goals, Objectives and Risk Tolerances

To summarize, total return may not be the only criteria with which to judge a portfolio’s performance by.  The amount of income the portfolio is generating relative to the market may be a more important objective that is often overlooked.  The amount of risk taken would be another.  Nevertheless, generating more income than would be available from the market (S&P 500) is a relevant objective for investors in retirement that are fortunate enough to be able to live off their dividends.  

This would further explain why investors might choose bonds, CDs or other fixed income securities.  These are typically not purchased with the goal of beating the market.  Instead, fixed income investments are normally purchased because of the safety and/or predictability they offer and for higher current income if available.  (Note: this can be difficult to accomplish today due to our long-running low interest rate environment).

Realized Versus Unrealized Gains and Losses

Additionally, performance calculations that include unrealized gains and losses can also be problematic and dangerous to an investor’s long-term financial security.  For example, investors that were pouring money into technology stocks in 1998, 1999 and 2000 were crushing the market during that timeframe.  However, only two or three years later many of those same investors had lost 80 or 90% of their hard-earned money.  The “false profits” (unrealized gains) of the technology bubble magically and in short order dissipated before their very eyes.  Suddenly, the same investors who once were trouncing the market, where suddenly substantially underperforming the market.

The lesson of the story is that unrealized gains can quickly turn into losses, while unrealized losses can quickly turn into gains.  Stock prices are temporary in nature, but fundamentals are more enduring.  Once again, it’s a fact that the market does not always correctly price stocks.  This is precisely why I am on record many times of stating that measuring performance without simultaneously measuring valuation is a job half done.  But more to the point, when I measure stock performance, I consider whether I am measuring an undervalued opportunity or an overvalued risky investment. 

This also empowers me to make a risk assessment of the total returns I may be receiving at any point in time.  In other words, are current market values justified by fundamental values or not?  If not, I recognize that my money is at risk and that inevitably true worth value will eventually and inevitably revert to the mean.

The point is that I first and foremost acknowledge the undeniable reality that the market does not always price a common stock correctly.  Consequently, in addition to measuring performance solely on current market price, I also measure performance based on fundamental value.  I will be elaborating more on this in the video portion of this article.  I believe this approach provides a much clearer perspective of how a given stock portfolio is really performing relative to the specific needs of the investor.

Case Study: Dividend Income and Preservation of Capital

As a portfolio manager spanning many decades, I can tell you with absolute certainty that each individual investor’s case is unique and different.  Consequently, as a portfolio manager, I consider it incumbent upon me to specifically design every individual’s portfolio relative to their unique situation, goals, objectives and risk tolerances.  As previously stated, investing is not a one-size-fits-all exercise.

Just as an example, let’s consider two individuals where both desire maximum current and future income.  However, one has enough money to meet their lifestyle needs and the other doesn’t.  Therefore, even though they have the same objective, and possibly even the same risk tolerances, their situations would require a different strategy and approach. 

Therefore, for the client that has adequate assets to meet their needs relative to the amount of income that can be achieved, I would focus more on the sustainability and growth of the income.  For the other investor I might prioritize the growth component because this investor does not have adequate assets to simply live off their income alone.  In other words, in order to meet their lifestyle, they would be required to harvest a certain amount of principal each year.  This creates many challenges.  When you harvest principle, you have less assets with which to generate future income from.

Consequently, both growth (capital appreciation) and income growth (dividend growth) become progressively harder to achieve over time.  On the other hand, if your assets are large enough to meet your current needs and your portfolio is designed to continue growing your income in the future, you can live comfortably off of the income (and growth thereof) that your assets can generate over time.  Having enough assets to live off the dividend income your portfolio produces is the ultimate dividend growth investor scenario.  Not only can you maintain your lifestyle, but you can also look forward to a raise in pay each year just as you did when you were working.

Therefore, the sad part of this scenario is that investor 1 (adequate assets) can take on less risk whereas investor 2 (insufficient assets) must continue taking on greater risk in order to achieve growth so they do not eventually run out of money.  The point here is that dividend income and growth is much more reliable and easier to predict and manage than capital appreciation.  Therefore, the message to younger investors is to save as much as you can as consistently as you can so that you can eventually accumulate enough assets to be able to live off your dividends and continue enjoying growth of both income and principle over time.

Stock Prices Are Erratic and Unpredictable-Dividends Are Persistent and More Predictable

The title of this section is based on common sense; however, common sense is not always that common.  It becomes very easy to get caught up in all the hype and hysteria that goes with investing in liquid markets where we sometimes neglect or overlook the obvious.

Let’s look at the monthly closing stock prices of the Dividend Aristocrat and Dividend King 3M Corporation (MMM) since calendar year 2000 and note how volatile and erratic they are.  Take special note of the stock action from January 31, 2018 to January 7, 2020, a 29% drop in approximately 2 years:

In contrast, when you look exclusively at the dividend growth line you get a clear perspective of how much more predictable and consistent dividend growth is than price action.  I purposely chose 3M because its dividend growth has been moderately erratic since calendar year 2000.  Nevertheless, although there were times when it grew faster than at other times, it consistently grew.  The same could not be said about stock price as clearly indicated in the previous graph.

To summarize my points, during the time period that stock price fell 30% (primarily due to overvaluation) 3M’s dividend in contrast grew by 15.7% (see yellow highlights on the graph below).  In other words, total return based on price action cannot be counted on because it can change very quickly, as we saw in the case of 3M over the last two years.  On the other hand, dividend growth is much more predictable and reliable.

Therefore, it makes more sense to me to prioritize the measurement of the dividend growth performance from my dividend growth stocks’ portfolio than it does to measure short-term capital appreciation (price action).  I trust dividend growth; I do not trust short-term price action.  Unfortunately, total return calculations can have an unreliable capital appreciation component (price action) that can be both deceiving and fleeting.

How You Can Beat the Market Without Fail

I want to start out by stating that I am confident that the strategy I’m about to share will outperform the market (S&P 500) over the long run on a total return basis.  However, I do not necessarily believe that it will outperform the S&P 500 over the shorter run, although it is possible that it would.  Nevertheless, my point is that from a total return perspective, all bets are off on the short run.  The market is simply too unpredictable (volatile) and most often irrational over short periods of time to have any confidence regarding how it might perform short-term.

On the other hand, there is a significant amount of evidence that suggests that the overall market, and most importantly, each individual stock in the market will eventually reflect its fair value based on its operating success.  In other words, whenever stocks become disconnected from fair value over or under, they will eventually and inevitably revert to the mean.  The exact timing is not precise, but the end result over time is virtually a certainty.  In my experience, every great investor I have ever studied bases their long-term decisions on those realities.

Nevertheless, I do believe that there are reliable ways to outperform the market without fail when your focus is on those elements that are predictable such as dividends and dividend growth as discussed above.  Stated differently, I am supremely confident that investors can build a portfolio of dividend growth stocks that will produce more income than they can get from investing in an index fund (the S&P 500) without fail.  What follows is a simple step-by-step common sense-based strategy that has worked flawlessly for me.

  1. Look for quality: Start out by identifying high quality blue-chip dividend growth stocks.  The Dividend Aristocrats, Champions and Kings are great sources of potential ideas.
  2. Identify attractive valuation: Next, screen the above lists for companies that are fairly valued, which to me means currently offering an earnings yield of 6 ½% or higher – and the higher the better.  Also, the reader should recognize that an undervalued stock provides what I like to call natural leverage.  Future capital appreciation of an undervalued stock will be relative to future growth plus the opportunity for multiple expansion.  Consequently, with an undervalued stock you can expect a lower future growth rate and still generate outsized returns.
  3. Seek above-average current dividend yield: Then screen those attractively valued dividend growth stocks for those that offer current yields that are greater than the market average.  Currently the S&P 500 offers a dividend yield of 1.85%.  Therefore, I look for current yields of 2 ½% or better in order to provide a comfortable margin of safety or cushion.
  4. Look for above-average future growth: After that, I turn my focus to operating growth, both historical and expected future.  With this step I am primarily looking at earnings growth, cash flow growth and EBITDA growth.  Keep in mind that my focus is on sustainable dividends and dividend growth.  Therefore, I am looking for confidence that the dividend is well covered and has the potential to grow at above-average rates going forward.

To complement the above strategy, I also put emphasis on persistent or consistent growth.  Although good results can be accomplished with cyclical or quasi-cyclical businesses, the steady endings tend to engender confidence.  Therefore, it is easier to stay the course with persistent growers, especially during turbulent market environments.

FAST Graphs Analyze Out Loud Video: 9 Dividend Growth Stocks: Greater Income Than the Market – Broadcom (AVGO), Bristol Myers Squibb (BMY), Caterpillar (CAT), Cummins (CMI), Omnicom (OMC), Principal Financial (PFG), Prudential Financial (PRU), Royal Bank of Canada (RY), Simon Property Group (SPG) and S&P 500

In the following analyze out loud video I present 9 dividend growth stocks that I believe can produce more dividend income than the S&P 500 going forward.

Summary and Conclusions

The key to understanding and appreciating the relevance of focusing on dividend income performance over price performance is the recognition that dividends are paid on the number of shares you own.  And are not adjusted by price changes.  Therefore, you could go through a timeframe where stock price is dropping and still maintain your lifestyle because your dividends are increasing. 

This happened with virtually every Dividend Aristocrat and/or Dividend Champion during the Great Recession of 2008.  Even though stock prices were falling, investors in these blue-chip dividend growth stocks were enjoying income growth.  In other words, the dividend income portion of their portfolios were insulated from the ravages of the bear market.

Furthermore, dividend growth investors, especially those in retirement, can rely on dividend growth stocks to provide them an inflation-fighting growing future dividend income stream.  This is a primary advantage of investing in dividend growth stocks over fixed income.  Although this advantage applies under all interest rate environments, it is especially advantageous when rates on fixed income are low as they are today.  To be clear, I am not against fixed income in the general sense if the coupons are high enough.  However, I am not too keen on fixed income in an environment like today where I can get higher current yields that are growing from quality dividend growth stocks.

For these reasons and others, I believe investors are best served by designing their portfolios so that they can meet their specific goals, objectives and risk tolerances.  In my mind, this is a much more rational benchmark than something as vague as worrying about beating the market.  Even if I beat the market, my portfolio may not be meeting my needs.  At the end of the day, stock price volatility – especially over the short run – is too unpredictable to bet my future on.  A continuously rising stream of income makes much more sense to me.

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