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Investors are routinely drilled on the risks of extrapolating too much from the past when trying to predict the future performance of a stock – but when it comes to dividends, the past can be a useful guide. Indeed, when dealing with dividends, there are actually very few options when it comes to forecasting what will happen next.

On one hand, income seekers can track dividend yields – or the ratio of current payouts to current share prices – as a measure of what their cash will buy them. They can then try and protect themselves by looking at metrics like dividend cover, what analysts are forecasting and even use demanding accounting tests like the Piotroski F-Score to try and judge the security of that dividend. Dividend yield strategies such as the well known Dogs of the Dow (or Dividend Dogs of the FTSE 100) screens require annual re-assessments to weed out the stragglers and disappointments. But it can still be a costly strategy, both from the point of view of those annual trading costs and the risks of dividend cuts that can occur very suddenly when you are focused purely on yield.

Searching For Dividend Reliability

While the past and the present come with risks attached, one of the advantages of analysing dividends is the behavioural bias that tends to influence management when rewarding shareholders. In other words, companies think very carefully before implementing and then increasing dividends, not least because they fear the repercussions of making a cut further down the line – and that is an advantage to investors in search of dividend longevity, reliability and growth.

In a 1985 paper entitled A Survey of Management Views on Dividend Policy, US academics Baker, Farrelly and Edelman found that management were ‘highly concerned with dividend continuity’ and seemed to believe that dividend policy affects share value. The findings tallied with a seminal 1950s paper by Lintner in which a behavioural model was presented whereby managers typically ‘smoothed’ dividend increases over time and only made upward changes when they were sure earnings could support the increase.

As a result of this and a steady stream of academic and market evidence, long term dividend growth has earned a reputation as a yardstick for dividend reliability. In his 1994 book Beating the Street, ex-Fidelity fund manager and investing legend Peter Lynch, put it like this: “The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row. Moody’s Handbook of Dividend Achievers – one of my favorite bedside thrillers – lists such companies. Here’s a simple way to succeed on Wall Street: buy stocks from the Moody’s list and stick with them as long as they stay on the list.”

Top of the Class

For the sake of clarity, Moody’s Investor Service, which created the handbook that Lynch referred to, has since been sold to Mergent (whose Indxis division runs the dividend data operation). Mergent track and index the data and then sell it to big money management institutions that use it to create funds. Dividend Achievers are companies that can boast a history of dividend increases that spans 10 years and also meet certain liquidity requirements. S&P, another index specialist, runs the Dividend Aristocrats series, which requires a stiffer 25 years of dividend growth to make it onto their index. Like Mergent, it runs UK and international versions as well.

The UK version of the Dividend Achievers index, which was launched in 2010, only requires stocks to have grown dividends over five or more consecutive years and they too must meet liquidity and investibility requirements. Currently, the top ten holdings account for just short of 63 percent of the index on a weighted basis but there are 113 companies on the list, with a median market cap of £1.25bn.

At the end of April 2012, the UK portfolio had produced a trailing twelve month dividend yield of 3.74 percent and a 5-year dividend growth rate of 12.07 percent. Over three years the portfolio produced an annualised return of 18.96 percent versus 14.58 percent for its MSCI UK benchmark. If you’d like to see a simplified version of this approach, we’ve set it up here. By way of comparison, the equivalent Dividend Achievers portfolio in the US boasts 199 companies with a median market cap of $3.69bn (£2.37bn). At the end of May, its TTM dividend yield was 3.10 percent and the 5-year dividend growth rate was 8.99 percent.

Watch For Red Flags

For investors with a preference for dividend growth over the quick hit but potential risks of high yield, the Dividend Achievers series is a handy guide to the past. And for those that buy in to the evidence that company management have a habit for acting conservatively when opting to increase dividend payments, the track record – or the dividend growth streak – could be worth serious scrutiny. That said, of course, it is still no ultimate protection against disaster – as shareholders of the likes of RBS and BP know all too well. In the first quarter of 2012, UK-quoted companies raising payments outnumbered those that cut them by 3.8. 1 – but that still means 26 companies reduced their dividends in the first quarter. And that will be keenly felt by those shareholders that took the hit (Value Line’s Reuben Gregg offers an interesting US perspective on this). So while medium term dividend growth could be a buy signal to investors, likewise the sudden suspension of dividends should be a red flag.

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