The underlying principle of dividend growth investing is simple: buy stocks that pay increasing dividends every year. It would seem as if you are able to collect a risk-free check that only gets bigger every year that is independen t of t he market or fluctuating share price of your holdings. Dividend growth investors realize that this is not true as they try to determine which companies have long-term earnings stability and growth. But can we take this a step further? What role does valuation play in our decis ion-m aking proc ess as when to buy and sell various holdings?

Timing Purchases With Valuation

Consider a brief examp le: you have two dividend growth stocks on your watch list. Both are identical in every way. Both trade at $10 per share and offer 50 cent per share dividends and generate $1 per share profit. You can own one or the other, or both. Your goal is to increase your dividend income as fast as possible in one year. You settle on buying one stock only. After 6 months the price of your stock increases to $12 while the other stock decreases to $8 per share. Both companies are still offering 50 cents per share dividends. What should you do?

Some investors would just hold tight thinking that the price increase is a feel-good buffer that adds a level of security in case of a future market crash. They continue to hold what they view as a winning stock that still offers 50 cents per share dividend.

The value investor sees things quite differently. The company fundamentals have not changed but the value of his equity or stock has altered. His current price to earnings ratio went from 10 to 12. While his total dividend remains the same, his current yield has fallen from 5% down to 4.16%. While his share price has increased, the value investor now feels concerned since the stock is no longer the great priced bargain it once was. To his way of thinking, the current share price is at a higher risk of falling with less ups ide. Pri ce growth cannot continue to pull away from fundamental growth. What does this value investor do? He looks at the other stock that now has even better value than before. He sells his shares at $12 to buy shares at $8. While the total value of his portfolio remains the same, he now is earning a 7.5% yield on a stock that he perceives as much better value, hence, more potential upside in share price.

Creating a Dividend Growth Strategy With Valuation Timing

Let’s take a look at a dividend growth strategy that incorporates rotating holdings based on valuation.

Our investable universe is derived from the holdings in the S&P 500 High Yield Dividend Aristocrats Index (NYSEARCA:SDY ). These are 50 of the highest yielding constituents of the stocks of the S&P Composite 1500 index with annual dividend increases for at least the past 25 years. All strategy creation and back-testing will be carried out compliments of Portfolio123 .

Our next step is to determine which stocks have the best value. I have found two simple rules that create a synergy.

The first is to separate the top 50% dividend yielding stocks.

The second is to choose the deepest value 50% of the universe by comparing current yield to the 5 year average yield.

In this second rule, a stock trading at a 5% yield where the historic yield is 4% would be considered better value than a stock with a current yield of 3% where the historic yield was 4%.

Testing The System

These two rules alone have created a very profitable system for dividend growth investing. If you started investing with this system in 1999 with $10,000 and re-assessed your holdings every 4 weeks, you would currently be earning $3,255 in annual dividends today. While your current dividend yield is only 3.6%, your yield on cost is over 32%. Although you say you don’t care about the capital appreciation, you also have $90,000 invested. But more than that, your risk was less as your drawdown during the market crash was greatly reduced.

Adding a Valuation Ranking System

But our system need not stop there. On top of these two simple rules you can apply a more complex ranking system to determine which stocks have the best overall value. I like to use the All-Stars: Graham ranking system and refine my strategy so that the best 10 stocks are held based on this system.

For those wondering what is included in this All-Stars: Graham ranking system, I will tell you. This pre-defined system compares the following:

price to earnings

price to book

operating income PE

5 year growth rates

earnings stability over the past 16 quarters

Each stock in our universe is ranked according to these metrics. Of the 20 — 30 stocks that pass our two dividend valuation rules, we keep the best 10 according to our Graham-ranking system.

But can we improve on this slightly? One small modification would be to apply a minimum value rank. This can be a benefit when all of the screened stocks are of mediocre value and it may be too risky to just buy the best 10. Perhaps on ly seven or eight stoc ks are of ‘good value’ overall. So we can add one extra rule that says we only buy stocks when they are 50 or higher on the Graham scale (the ranking is from 0 — 100)

Of course, many dividend growth investors find it distasteful to examine their holdings every 4 weeks. How might this strategy hold up if we only examined our portfolio once a year with a view to holding the best value dividend growth stocks?

The return is still significant with over 10% alpha annually. The beta of this portfolio is only 0.81 with less downside and far more upside than the market as a whole.

Let’s examine the current holdings that this system would generate if we ran the screen today: