Why Dividend Growth Investors Should Embrace the Wedge

Why Dividend-Growth Investors Should Embrace the Value Wedge

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Dividend-growth investing is a highly-effective long-term investing strategy for generating passive income and building wealth. However, it lacks horsepower under the hood and your performance can suffer because of it. Thankfully, there is an option that can boost your output—dividend-value investing. Let’s discover why dividend-growth investors should embrace the wedge.

Wedge investing has its roots in real estate. The strategy involves buying a property at a discount to its potential value and then capturing that value wedge by improving it—known as flipping.

However, the wedge (or value) strategy applies to stock investing as well. This type of investing strategy can significantly improve your portfolio performance—enabling you to (1) lock in higher yields, (2) capture superior total returns, and (3) lower your risk. These benefits can materially increase the speed at which you can build your portfolio and leverage the power of compounding.

Let’s take a look at wedge investing basics, the differences between growth and value investing, the inherent weakness of DGI, and how we can effectively apply the wedge to our passive-income investing to produce increased risk-adjusted alpha—something we should all be interested in!

Table of Contents

What Is Wedge Investing?

Wedge investing has its origins in real estate, where it is one of the oldest and most common investing strategies.

Simply put, it means buying low and selling high.

Typically, investors look for distressed properties in great locations. In other words, properties that are selling below their potential market value—if some repairs and upgrades were done.

For example, you find a single-family residence in a nice neighborhood—one where similar properties are selling for $250K. However, this house has been neglected and treated rather harshly by its former owner/tenants. It has some repair and maintenance issues, and lacks the upgrades found in the other comparable homes in the neighborhood. As a result, it is selling at a discount for $190K.

If you can upfit the home for $25K—bringing it up to the standard of its peers, you have the potential to capture that $250K potential market value and realize a profit of $35K on a flip. Or, if you are an income investor, you could realize increased rent (cash flow).

That’s what we call a wedge dealand it can be a lucrative real estate endeavor when a good one is identified.

Value Investing Is Just a Variation of the Wedge Deal

When it comes to stocks, value investing is just a variation on the classic wedge strategy.

Benjamin Graham—the godfather of value investing—popularized this approach to equity investing.

Like real estate, you look for distressed companies that are selling at a discount to their intrinsic value. The key is identifying businesses that have been beat-down by the market (unpopular) in the short-run. In other words, the market has overreacted to a short-term catalyst—but their long-run fundamentals and outlook remain solid.

This provides you with a value wedge.

However, unlike real estate, there is nothing we can do (e.g., repairs and upfits) to capture that value. Instead, we must wait for the market to recognize the value gap (wedge) and push the price back towards the stock’s intrinsic value.

As such, the value investing (wedge) strategy capitalizes on time arbitrage and requires a long-term investing approach—on average 3 to 5 years, but sometimes much longer.

Dividend-Growth Investing Is a Variation of Growth Investing

Dividend-growth investing is an excellent strategy for long-term passive-income investing. However, it is important to understand that—at its core—it is just a form of growth investing.

As such, it has some inherent risks and weaknesses.

Just like pure growth investing, you are paying for future growth upfront. It’s not called dividend “growth” for no reason!

Stated differently, in order to achieve that desired growth in dividends, a company’s earnings must grow. However, the expectation for that growth is normally already captured in the price of the stock.

This is why strong (popular) dividend-growth stocks typically trade around their fair value and don’t present a value wedge often.

(When they do—go big!  As Buffett would say, when it’s raining gold, put out the buckets—not the thimbles!)

Again, the “growth” part of DGI sounds great… but you’re actually paying for that growth—at least the expected growth (it’s factored into everyone’s valuations). And, like a growth investor, this means you are taking on greater risk for a reduced reward.

This is especially concerning because most dividend-paying companies are not “high-growth” businesses—meaning, there is an even tighter ceiling on that potential upside reward. It’s akin to restrictor-plate racing in NASCAR! The odds of a huge burst of unexpected growth is not likely.

As a corollary, this presents income investors with two evocative drawbacks.

First, because the price already reflects expected future growth, the dividend yield (inversely related to price) for these stocks is typically low. This is further hampered by the fact that their expected growth still requires them to internally reinvest a good deal of their capital—restricting their dividend payout ratio.

Second, any underperformance related to the market’s expectations can result in short- to mid-term total-return issues for the investor. In other words, your upside is limited—but your downside is fully exposed.

Now, hello, I am obviously a proponent of dividend-growth investing. However, we must understand that it is a strategy that requires a very long-term investing horizon. Growth in those dividends (i.e., your passive income) will come… but it will come slowly!

For those beginning their investing with minimal capital, this can significantly delay the impact of compounding. It will happen… but it will happen slowly—meaning your hockey-stick jump in growth will be pushed further down the road.

Caveat: To be honest, I’m a huge proponent of passive-income investing. DGI is just one strategy (tool) in the proverbial PI toolbox. I always encourage my audience (meaning you and my mom lol) to (1) use all the tools they have at their disposal, (2) use the right tool for the right job, and (3) understand how to properly use each tool.

At Wicked Capital, we teach a hybrid approach to passive-income investing that focuses on a blend of both dividend-growth investing (predicated on a value framework) and dividend-value investing. But more on that in a moment…

How Value Investing Fundamentally Differs from Growth Investing

Value investing, unlike traditional dividend-growth investing, capitalizes on the wedge.

Contrary to DGI or pure growth investing, the focus is not on future growth but, rather, on the current value proposition. We are looking for the market to recognize the stock’s “true” current value over time.

This approach has a distinct advantage over growth investing.

You are buying at a discount—meaning, you are not paying for future growth. Expectations are already low and baked-into the depressed share price.

Thus, any outperformance with regard to those low expectations (highly likely with good underlying fundamentals) means you win. The stock should (devoid of other problems) be repriced by the market based on now higher expectations.

Conversely, this provides you with a much better margin of safety. Expectations are already low, and the stock is already trading at a discount—there is only so low it can go (given that it is a long-term quality company). A “fair value” stock can fall much further.

Unlike with growth-oriented investments (where you pay for the growth upfront), this value approach results in a much greater upside, with a smaller downside—contributing to the pronounced value-growth spread. This spread represents the historical outperformance of value over growth.

As we have demonstrated on our website, value investing provides higher long-term returns on average than growth investing (read our article Value Consistently Trumps Growth for LT Investing). The value-growth spread further supports this position.

Specifically, this spread represents a +26.6% value outperformance!

This finding continues to be supported by recent academic research. For example, in a paper by Chan and Lakonishok (2004) published in the Financial Analysts Journal, the authors find, “The evidence suggests that, even after taking into account the experience of the late 1990s, value investing generates superior returns.”

Chan and Lakonishok add, “research on value versus growth generally agrees that value investment strategies, on average, outperform growth investment strategies.”

Finally, they posit that (1) “common measures of risk do not support the argument that the return differential is a result of the higher riskiness of value stocks” and (2) “the reward to value investing is more pronounced for small-capitalization stocks.”

Fama and French (2007) once again confirm the value premium in their paper The Anatomy of Value and Growth Stock Returns, asserting, “Value stocks have higher average returns than growth stocks.”

In trying to assign a cause to the value premium, they note (quite humorously) that:

Behaviorists argue that the investors who determine stock prices never come to understand convergence in profitability and growth. Investors are thus surprised by the deterioration in profitability and growth that tends to occur after stocks move to the growth category and the improvement after stocks are allocated to value portfolios. The result is lower average returns (and negative convergence) for growth stocks and higher returns (positive convergence) for value stocks. In this view, convergence is largely unexpected, at least by the consistently irrational (and learning-impaired) investors that dominate asset pricing." (pp. 53-54)

Fama & French

I tend to agree with the behavioralists rather than the rationalists on this one!

To learn more about this spread, read our article What Does the Value-Growth Spread Really Mean for Long-Term Investors, where we go into great detail about what that spread represents and how best to capitalize on it with a passive-income approach.

Applying a Value Wedge Strategy to Your Passive-Income Investing

Obviously, we are passive-income investors and a pure value strategy doesn’t fit our needs or objectives.

However, that doesn’t mean we can’t apply the wedge concept to our dividend investing! In fact, doing so can materially increase our performance and reduce volatility.

By seeking out dividend-paying companies that are “depressed” in the near-term (i.e., trading at a significant discount to their intrinsic value), we can identify potential value wedges—while maintaining our passive-income approach.

This does not mean a purist (i.e., Benjamin Graham) approach to value. A pure value play is one predicated on book value. Rather, we identify a value wedge when a stock is trading significantly below its intrinsic value—as calculated using a discounted cash flow model.

Thus, a stock can provide a sizeable value wedge and yet still be trading above its book value. In fact, unlike in Graham’s days, it is very difficult to find companies trading below their book value today (and they would not be a dividend payer).

Both DGI and dividend-value investing are both passive-income strategies—they just reside at different points along the overall investing spectrum (each closer to their parent—value or growth).

The dividend-value (or wedge) approach provides us with several advantageous benefits:

  • Larger Total Returns
  • Higher Yields
  • Higher Margins of Safety
  • Lower Volatility
  • Superior Risk-Reward Setups

Leveraging the wedge allows us to tap into the value-growth spread and achieve much larger total returns (dividends + capital appreciation) over time.

Furthermore, a value wedge provides us with a much larger margin of safety and, thus, less risk. The safety net below us is much closer in a relative sense than it is with traditional DGI.

Finally, by utilizing a value approach to our dividend investing, we can lock in much higher yields. As a company’s stock price is depressed, its yield rises. As the stock price recovers over time (moving back towards fair value), we continue to collect passive income at the higher yield.

This not only boosts our passive income by deploying our capital more efficiently, but it provides us with greater total returns over time. And, the higher our flow of passive income, the more powerful the effects of compounding become!

In essence, leveraging the wedge enables us to punch above our weight classwith less risk!

However, as that value gap closes, we will have a decision to make. Because this is a value play and not a growth play, once the stocks price nears its intrinsic (fair) value, we can’t always expect much more—the growth may not be there like a typical DGI stock.

Absent the potential for future growth, we can continue to collect that high-yield passive income we locked in—understanding that, moving forward, we won’t see much in the way of dividend growth or capital appreciation.

Or, we can close the position (collecting the gain from the wedge) and redeploy that capital in a new wedge position.

Why the Wedge Could Be a Great Addition to Your DGI Portfolio

If you have a long investing horizon, dividend-growth investing is a powerful and highly-effective strategy.

However, this doesn’t mean we can’t tweak our investing vehicle to achieve greater performance! After all, our goal should be to deploy our capital as efficiently as possible—not marry a given strategy or embrace a cult label.

By integrating a value framework into your investing plan, you can develop a beneficial blend of investments—on both sides of the passive-income spectrum (value and growth).

Obviously, the longer your horizon, the more you want to skew that mix towards growth. However, even with a long investing window, the wedge can provide tremendous benefits—including introducing more fuel (passive income) to reinvest into those DGI positions in the early years.

Even if you don’t fully implement a dividend-value investing component to your portfolio… you can still apply the concept to your dividend-growth investing by initiating and adding to positions only when they provide some level of discount to their intrinsic value—albeit far less than with a typical value play.

While many DGI folks will encourage you to buy at fair value, I encourage you to “think wedge” and avoid this approach. By putting your capital to work even at a slight discount, you will increase both your yield on cost (passive income) and your potential total returns over time—all why stretching your margin of safety (even if just a tiny bit).

With enough diversification, there will nearly always be value opportunities in your portfolio—take advantage of them!

Regardless of your level of commitment to the wedge, one of the overarching tenets of passive-income investing is to lower our cost basis whenever and wherever we can! We want maximum capital efficiency—it’s all about cash flow (i.e., the amount of cash we can flow into our pocket from the investment of every dollar of capital).

To be clear, there is no best mix or one-size-fits-all solution. It depends on your unique financial situation and your investing goals and objectives. However, regardless of the degree to which you leverage the wedge (or value framework) in your portfolio, it absolutely makes no sense to entirely exclude it!

One Huge Caution about the Value Wedge

As I always stress, quality matters!

Quality is a significant alpha factor that we always want to maintain exposure to.

For example, here is the factor-based approach we utilize with our public passive-income portfolio:

While we are seeking wedge opportunities, it is important to separate short-term value opportunities from long-run value traps!

Like real estate, not every distressed property is a deal! A house may be cheap—but it’s not a great deal if the required repair and upfit costs would exceed your available wedge!

This has undoubtably happened to many inexperienced house flippers. And, it has happened to just as many value investors who misjudged valuations and/or fundamentals—winding up getting caught in a value trap!

Thus, it is critical that we identify stocks that are unpopular and beaten-down due to short-run catalysts and not companies with long-run fundamental problems or outlooks.

Just because a stock is cheap doesn’t mean it’s a value—it could very well be priced that way for a valid reason!

As Peter Lynch aptly notes, “Behind every stock is a company. Find out how it’s doing.”

This dividend-value investing strategy sometimes gets a bad name in some circles (especially within the DGI community) because of the disastrous results experienced by folks that don’t understand this critical distinction! These folks fall prey to the Siren song of “cheap” and pay for it dearly.

The greatly overblown fears of value traps and dire calls to avoid high-yields at all cost (“you’ll just get burned”) are largely borne out of this unfortunate carnage.

I would argue that this is more about a prevailing lack of knowledge, skills and abilities (KSAs) within the DGI world than anything else. Let’s be honest, you can get away with a certain level of ignorance with DGI that you can’t get away with when it comes to dividend-value investing.

As Warren Buffett so eloquently puts it, “Risk comes from not knowing what you’re doing!”

I simply mean that when you are dealing with larger blue-chip (DGI) companies, there is only so much damage you can do. Over 30 or 40 years, you’ll likely do just fine—even if your inner idiot surfaces from time to time. You may not hit it out of the park and become a hero, but you’re also not likely to entirely strike out and become a zero (though index funds may be your best bet).

However, when you are dealing with distressed properties—whether in real estate or the stock market, there is a much higher bar to meet in terms of those KSAs. The rewards are higher… but so are the demands. You need a contrarian mindset and a solid process—one that will require you to be well-versed in fundamental analysis and calculating intrinsic values (preferably using several different approaches).

Thus, there’s a certain sense of security (real or imagined) that folks feel and embrace with DGI—and they often fear and pushback against the relative “unknown” of value wedge investing. However, to paraphrase Benjamin Franklin, we unavoidably sacrifice a certain degree of freedom (or potential reward) when we seek the comfort of security.

So, just to be crystal clear with you… quality (underlying fundamentals) and long-term outlook matter!

To channel the wisdom of the Oracle of Omaha, “Price is what you pay, value is what you get.” Make sure you know what you’re getting!

Finally, when leveraging the wedge, we need to put our “trader” hat on. By this, I simply mean we must know when we are wrong… and when we are wrong, we must get out!

This is a slightly different mindset from traditional DGI where we have much more of a buy and hold forever mentality. With dividend-value investing, we are making a shorter-term (typically 3-5 year) value play.

Yes, we are collecting nice high-yield dividends along the way… but, at the end of the day, this strategy is predicated on the existence of a value wedge (or gap)—one we expect to close over time.

It’s fine (even often necessary) to give our value play some room to breathe, but we must be able to identify and willing to accept when this underlying investing thesis is no longer valid. We don’t want to ride a value trap all the way down! If we are wrong on our thesis, that heavenly yield will go away just as fast as the share price can drop! (Just think GE)

Conclusion

A wedge deal refers to an investment in which an asset is bought at a discount to its potential or intrinsic value. In the case of real estate, the value represented within the wedge is captured by repairing or upfitting the property. With stocks, the value is captured over time as the market recognizes the value—known as time arbitrage.

Dividend-growth investing is an effective long-term strategy for passive-income success. However, it only represents half of the passive-income investing spectrum. The other half can be defined as dividend-value investing—predicated on capturing (1) higher yields and (2) wedge value from stocks trading at a discount to their intrinsic value due to market overreactions to short-term catalysts.

Embracing the wedge (or dividend-value investing) enables dividend-growth investors to improve their overall portfolio performance by tapping-into the value-growth spread. It’s akin to taking a great engine (DGI) and adding a turbocharger to it.

Supercharge Your Portfolio with Dividend Value Investing

Why settle for a portfolio that performs like a Ford Focus… when you can own a Ferrari (with less risk)!

Specifically, capitalizing on value wedges provides several key benefits to passive-income investors:

  • Larger Total Returns
  • Higher Yields
  • Higher Margins of Safety
  • Lower Volatility
  • Superior Risk-Reward Setups

Furthermore, the higher yield provided by these investments can boost passive income—providing benefits to folks in all stages of their investing journey:

  • Additional income (fuel) for new/small portfolios—increasing the impact of compounding
  • Additional income for late-stage investors—reducing the size of portfolio needed for retirement
  • Additional diversification and performance for all stages in between

As a result, I highly recommend that dividend-growth investors embrace the wedge and integrate dividend-value investing into their passive-income investing plan—regardless of the degree to which they do so. The benefits make it a no-brainer—so long as you develop the knowledge, skills and abilities required!

To learn more about the benefits of integrating higher-yielding value wedge positions in your passive-income portfolio, I encourage you to read our article What Joule’s Law Can Teach Us About Investing for Retirement.

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Finally, if you’re interested in dividend-growth investing predicated on a value framework—you’re in the right place! We focus exclusively on helping others be as successful as possible with this passive-income approach to investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!

Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!

We also encourage you to follow along with our public Wicked Capital Passive-Income Portfolio (PIP) through our monthly updates on the website and by viewing the portfolio on M1 Finance at https://m1.finance/1zUclN2JL

It’s a great way to learn from a real-world example of building and managing a dividend-growth portfolio predicated on a value investing framework!

If you’re interested in starting your own portfolio using the M1 Finance platform (which we highly recommend), please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash to invest!

That’s just one more reason to start your dividend-growth investing today! It’s never too soon to start working towards your financial freedom!

Sources:

Chan, K. C., & Lakonishok, J. (2004). Value and growth investing: Review and update. Financial Analysts Journal, 60(1), 71-86. doi:10.2469/faj.v60.n1.2593

Fama, E. F., & French, K. R. (2007). The anatomy of value and growth stock returns. Financial Analysts Journal, 63(6), 44-54. doi:10.2469/faj.v63.n6.4926

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Doug

Doug is the founder of Wicked Capital. He holds an MBA, BBA (Summa Cum Laude), and AAcc from Liberty University and has over 20-years of corporate finance, accounting, and operations management experience--spanning the public, private and nonprofit sectors. He is a member of Sigma Beta Delta International Honor Society in Business Management and Administration, Delta Mu Delta International Honor Society in Business, and Tau Sigma Academic Honor Society. He is also proud to have served his country as a member of the 82nd Airborne Division. His professional wheelhouse is corporate financial reporting, analysis, and forecasting—buoyed by his passion for fundamental analysis and valuation. Doug has been actively engaged in trading and investing for several decades, with a focus on value and dividend-growth investing. He has authored several books and, when he's not busy living the corporate dream, trading and managing investment portfolios, he enjoys playing the drums and spending time with family--especially in the Outer Banks of NC.

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