How useful is the Chowder Rule for Income Investors?
Is this the perfect formula for dividend growth?
Hi Everyone,
In this article, I want to introduce you to a not-so-widely-known metric that dividend growth investors can use in screening for potential investments:
The Chowder Rule
Before purchasing a dividend stock, income investors face a dilemma: Low yields rarely move the needle much, and high yields are rarely sustainable over the long term. In an ideal world, everyone would invest in high-yielding, high-dividend growth stocks. The problem is that many high-yielding stocks have lower dividend growth rates than lower-yielding stocks. When buying a low-yield stock, we want a high growth rate; when buying a high-yield stock, we can accept a lower growth rate.
The Chowder Rule tries to solve that problem by providing an orientation for the perfect balance between dividend yield and dividend growth. Here’s what its inventor says about the reasoning behind it:
“I decided that as a dividend growth investor, I wanted the dividend and the dividend growth to take pressure off of the share price in the total return equation. I can control the dividend I take on, and I can control the companies I add via dividend growth. I have no control over the share price. So, it made sense to me to focus on what I could control.”
The formula is simple and straightforward:
Current Dividend Yield + 5-year average Dividend Growth Rate = Chowder Number
The desirable Chowder Number depends on the stock and the original starting point.
Here are the 3 rules:
If the initial yield is higher than 3%, the 5-year dividend growth rate plus the yield must be higher than 12.
If the initial yield is lower than 3%, the 5-year dividend growth rate plus the yield must be higher than 15.
If it’s a utility stock, the dividend yield + the 5-year growth rate must be higher than 8.
(Note: Utility stocks are known for their high yields and slow growth rates. They are highly regulated and typically enjoy regional competitive advantages due to high entry barriers. Thus, utility stocks can tolerate a lower number.)
Let’s apply this rule to Coca-Cola and Fastenal
Coca-Cola KO 0.00%↑ has a current dividend yield of 2.94% and a 5-year growth rate of 3.53%. The Chowder Number would be 6.47 and the stock would not pass the criteria.
Fastenal FAST 0.00%↑ , on the other hand, has a current dividend yield of 2.61% and a 5-year growth rate of 14.14%. The Chowder Number would be 16.75 and the stock would be considered a much better pick according to this rule.
The Chowder Rule makes intuitive sense and is easy to understand and apply. However, it is far from perfect and you need to be aware of some problems:
It is unreliable in forecasting future dividend growth because it is looking backward. Nonetheless, by keeping an eye on the payout ratio, you can reduce the risk of purchasing a declining business. Changes in the payout ratio affect the dividend growth rate. An increasing payout ratio can create the illusion of rapid dividend growth, which is not sustainable. The company's earnings may be declining while management attempts to appease shareholders with dividend increases. Just be aware of that when using this rule.
Let’s take a look at another dividend growth stock to display why the payout ratio is crucial when using this rule: Texas Instruments TXN 0.00%↑
Their Dividend Yield is 2.85% and the 5-year growth rate is 17.21%, which brings us to a Chowder Number of 20.06. This is way above the minimum number of 15. So, if we had to choose a stock from those 3, which one would it be? Let’s check their payout ratios to get a better picture:
Coca-Cola: 70.16%
Fastenal: 64.71%
Texas Instruments: 46.77%
Texas Instruments not only has the lowest payout ratio, but also the highest Chowder Number. Based on this rule it would offer the best/safest option among those three, followed by Fastenal and Coca-Cola.
Final Thoughts
Before applying the Chowder Rule you should find high-quality businesses with excellent management worthy of long-term holding. The Chowder Rule comes into play only after identifying a company you want to buy and hold for income growth. It’s one of the final steps in determining whether or not the business is priced to buy.
Dividend Growth stocks have historically outperformed the benchmark and are a great pond to fish in, as I explained in a previous article:
I personally like it for its simplicity and use it as an orientation when I have to choose between income stocks, although I’m not 100% strict when applying it. If a stock has a Chowder Number slightly below the minimum threshold and fulfills all the other criteria I’m looking for, I see no reason to dismiss it.
You won’t find the one formula that works all the time, but instead, a toolbox that provides you with various approaches that help you make safer investment decisions.
I hope you learned something today. Until the next issue. 👋
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Chowder rule. Love it. Great, helpful concept.