The one most critical aspect about dividend aristocrat (that I have been fan of) is increasing the annual dividend consistently for 25 years consecutively. This has been a cornerstone for any company to be known as dividend aristocrat. In last one year or so, the global economic environment is driving most of these aristocrat companies to slash/cut/freeze their dividends. Suffice to say the total number of dividend aristocrats is shrinking. This has resulted in business media and blog-o-sphere debating about the need to change the standard that defines dividend aristocrat index. The S&P index committee has also indicated that it may consider relaxing certain standards required to qualify for aristocrat index. One school of thought says S&P should reduce the number of years of continued dividend increases.
In its recent update, S&P reported that dividends paid by companies in S&P500 index reduced by approximately 15% (for first quarter of this fiscal year). This actually captures the whole gamut of companies that are above average, average, and below average. While I do agree that there has been reduction in dividends payments, I do not believe this is right parameter to demonstrate strain on dividends. One cannot compare a bunch of the good, the bad, and the ugly (index), with the bunch of the exemplary (aristocrat). Division I teams do not play with Division III in the league. League is among equals.
For the sake of argument, let us assuming one can make comparison. Since 1989 the Dividend Aristocrats Index has returned an approximately 9% annualized return, against 6.5% for the S&P500 index companies. This in itself tells us there is wide difference in aristocrats and full set of index companies. If we also look at the current downturn since October 2007 peaks, then also aristocrat index has outperformed the S&P500 index companies.
I recently read two or three articles in blogosphere (forget to bookmark them for my reader’s reference) which discussed and concluded that since January 2008, dividend aristocrat has underperformed S&P500. First, the authors attempting such comparison perhaps do not understand dividend investing (dividend investing for 4 months!). Second, the reason they were under performing, because they did not drop by the same level as S&P500 index. I am digressing….
At an outset, I do not like an idea that it is necessary to lower the standard so that number of companies can be increased. A university should not lower its passing standard just to increase the number of passing student. It should not work that way.
However, I also believe in the notion of continues evolution and adapting to ones environment. If we do not adapt we will become extinct. From a long term perspective, I believe, rather than lower the standards; S&P committee should re-calibrate the index methodology. At a very fundamental level, dividends are paid when companies continue to make increased profits year after year. This is driven by economic environment.
If a new index is devised, then it should take into consideration the external factors such as US economy, global economy, and peer performance of the corporation. The past history of 25 or more years should be used for calibration. The back testing of the new index (after calibration) should demonstrate very similar results with lowest possible error. This has two advantages viz., (1) the new index will be compatible to past history; and (2) this will capture the external factors that drive the growth in dividends.
Redefining the qualification process by lowering the standards will demonstrate that collectively US economists have accepted the fact that US economy will not grow in future. Collectively they have resigned to the fate that companies will no longer grow to the levels seen in past 25 years. Collectively they have given up on the fact that managements of US corporations can no longer be expected to provide growing dividends.
Suffice to say, I am against lowering the standards. But I am open to the idea of modification which is properly calibrated to demonstrate it does not mess with the past, and it captures reality of new economic environment.
I would like to know what your thoughts are, so please leave your comments below.