Why The Dividend Dogs Are The Right Strategy For This Market

For dividend growth investors, the current market environment is challenging to say the least. If you’re leaning on your portfolio for income, the 1.9% dividend yield offered by the S&P 500 just isn’t going to cut it. Targeting the dividend aristocrats is a popular strategy but even the SPDR S&P Dividend ETF (SDY), which targets the highest yielding stocks of that group, only yields about 2.5%. You need a different strategy to get a higher yield without getting too risky.

That’s why I like the dividend dogs strategy. It’s a straightforward strategy that simply targets the highest yielding stocks within a given index. The thought process is that some stocks have high yields because they are currently out of favor. If they become popular again, you have a portfolio that will likely outperform the broader market. If they don’t, you still own a group of stocks that produces an above average dividend.

The ETF play on this strategy is the ALPS Sector Dividend Dogs ETF (SDOG). The fund uses the S&P 500 as its starting universe and plucks the five highest yielding stocks from each of the 10 primary market sectors and equal weights them. According to its fact sheet, the fund “isolates the S&P 500 constituents with the highest dividend yield in their respective sectors providing the potential for price appreciation as market forces bring their yield into line with the overall market.”

Given that Amazon (AMZN), Apple (AAPL), Facebook (FB), Tesla (TSLA) and Netflix (NFLX) are all up more than 28% so far in 2017, nobody really wants to hear about companies like Staples (SPLS), Xerox (XRX) and General Motors (GM). But there are some compelling reasons why the dividend dogs make more sense now than they have in some time.

The contrarian view

Over the past 10 years, growth stocks have nearly doubled the performance of value stocks (141% to 72% as measured by the S&P 500 Growth (SPYG) and the S&P 500 Value (SPYV) ETFs). In fact, growth has outperformed over the past 1-, 3-, 5- and 10-year periods. If you’re a believer that the market moves in cycles, value is due for its turn in the lead.

The market probably needs some sort of catalyst for that switch and Fed policy could be it. At its quarterly meeting, the Fed dot plot report indicated that its members saw four rate hikes by the end of 2018 even though the inflation rate is back below the Fed’s 2% target. The combination of low inflation and higher rates could quickly choke off economic growth. In that scenario, it’s very likely that growth would begin underperforming.

It’s really cheap

After several quarters of double digit year-over-year earnings growth, the market is still looking expensive. The forward P/E ratio of the S&P 500 still sits at around 19. The forward P/E of SDOG? Just 14. That kind of valuation yields two benefits. First, it can provide some much needed downside protection in the event that the market turns south. Second, buying at that valuation is akin to buying stocks off the bargain rack. You’d look for that kind of deal if you were shopping for clothes. Why not look for that kind of deal with your investments too?

The dividend yield

Probably the biggest reason that investors would target the dividend dogs is because of the dividend yield. SDOG has a yield of 3.4% based on distributions over the past 12 months. That’s nearly twice what you’ll find from the S&P 500. I’m a particular fan of this yield considering it comes from a well-diversified portfolio that doesn’t lean on real estate to achieve it.

Real estate is a favorite sector of dividend hunters because of its high yields. The problem is that real estate is interest rate sensitive. With the Fed forecast multiple rate hikes over the next several quarters, returns on real estate could be under pressure as alternatives such as bonds look more attractive. Two popular high dividend ETFs, the PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) and the SPDR S&P 500 High Dividend ETF (SPYD), both generate current yields in the 4% area, but also have nearly 25% of assets invested in real estate. SDOG’s 3.4% yield could look particularly appealing if it doesn’t come with real estate’s inherent riskiness.

It’s a proven winner

The dividend dog strategy has been considered a winner over the long-term and this fund is no exception. The Dividend Dogs ETF owns a 5-star Morningstar rating in the Large Value category. The fund has averaged a 15.4% annual total return since its inception in 2012 outpacing the S&P 500 by about 1% per year.

The downside of the fund? Its expense ratio of 0.40% for a simple strategy that only rebalances annually seems excessive. And the fund does have periods of being more volatile than its peers. But overall, this is a solid fund. With a little more uncertainty slowly creeping its way into the financial markets, a bit of defensive posturing isn’t a bad idea. This simple, yet proven, strategy is a good way to accomplish that while getting a nice dividend to boot.

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