03-10-2014, 08:38 AM

The “Chowder Rule” has become a very popular metric over at SA among dividend growth investors. While the underlying concept is simple enough, and grounded in common sense, I think the “rule” derived from it is very misleading and possibly even dangerous.

The “rule” is simple enough: to find stocks that have a desirable blend of initial yield and dividend growth, add the two numbers together and determine whether they exceed a minimum threshold, which might vary by company type. If you want more detail, here is how Chowder himself explains it.

I agree that there is absolutely a balance to be considered between initial yield and dividend growth. Many dividend growth investors will only consider a lower-yielding stock if it has a high dividend growth rate. Reasonable minds may argue about this balance, and each investor will have to decide how to address these dynamics in their own stock selection.

But in my opinion, to add these two numbers together and use the result as a metric for evaluating a stock makes little sense. Just on the face of it, you are adding numbers that are entirely different. Yes, they are both expressed as percentages, but that does not mean that they are in the same “units,” if you will. Yield is the percentage of your purchase price that you will receive in dividends. The dividend growth rate is the rate at which the dividend has grown. If shares of company XYZ yield 3 percent, and the dividend has a growth rate of 10 percent, the resulting Chowder number of 13 does not measure anything. You are not getting 13 percent of anything, and there is nothing that is growing at a rate of 13 percent. The yield and the dividend growth rate are both important numbers, and there is a relationship between the two, but they must be evaluated separately in light of each other, and not falsely rolled into a single number.

You might think that I am being overly picky here, and that the Chowder number is only one of many things an investor might consider. But I think there are a lot of newer investors over at SA looking for information and guidance, especially about dividend growth investing, and having this metric touted as a “rule” is both misleading and dangerous. Indeed, I’ve generally ignored the Chowder rule, but was inspired to write this when I read this recent article that doubles down on the Chowder rule by referring to it as “Total Dividend Return.” To me, this is truly misleading and dangerous – I do not see how the Chowder number is a measurement of any type of total return that an investor might expect.

I’ve seen some suggestion that underlying logic of the rule is that the dividend growth rate is some sort of proxy for the share price appreciation that you might expect, and that is how you get to “total return.” But I’ve seen no analysis supporting this contention, and even if it is true that a high dividend growth rate does correlate to a relatively fast increase in share price, this does not mean that adding the dividend growth rate to the yield gives you any sort of a meaningful number.

Maybe the Chowder number’s meaning is obvious and apparent to everyone but me, and I’d be glad to be enlightened. But in my opinion the rule makes little sense on its face, and I think it is scary that not only does it go completely unquestioned, but seems to be taking on great significance among DG investors over at SA. Read the many comments to the recent article and you’ll see many accolades and several newer investors jumping on board with the approach. As of this moment, there are 190 comments to the article, and exactly one of them questions, gently, the basis for the rule, though that question did not seem to generate serious discussion.

To be clear, I am a fan of Chowder’s articles. He has written many excellent pieces on dividend growth investing and has helped many new investors find their footing with the strategy. Indeed, I was heartened to see that Chowder himself jumped into the comments thread of that article to note that the Chowder rule should only be applied after other important criteria were met. Chowder is undoubtedly a force for good among DG investors over at SA. I just worry that the “Chowder rule” is inappropriately becoming part of the dividend growth gospel.

What am I missing?

The “rule” is simple enough: to find stocks that have a desirable blend of initial yield and dividend growth, add the two numbers together and determine whether they exceed a minimum threshold, which might vary by company type. If you want more detail, here is how Chowder himself explains it.

I agree that there is absolutely a balance to be considered between initial yield and dividend growth. Many dividend growth investors will only consider a lower-yielding stock if it has a high dividend growth rate. Reasonable minds may argue about this balance, and each investor will have to decide how to address these dynamics in their own stock selection.

But in my opinion, to add these two numbers together and use the result as a metric for evaluating a stock makes little sense. Just on the face of it, you are adding numbers that are entirely different. Yes, they are both expressed as percentages, but that does not mean that they are in the same “units,” if you will. Yield is the percentage of your purchase price that you will receive in dividends. The dividend growth rate is the rate at which the dividend has grown. If shares of company XYZ yield 3 percent, and the dividend has a growth rate of 10 percent, the resulting Chowder number of 13 does not measure anything. You are not getting 13 percent of anything, and there is nothing that is growing at a rate of 13 percent. The yield and the dividend growth rate are both important numbers, and there is a relationship between the two, but they must be evaluated separately in light of each other, and not falsely rolled into a single number.

You might think that I am being overly picky here, and that the Chowder number is only one of many things an investor might consider. But I think there are a lot of newer investors over at SA looking for information and guidance, especially about dividend growth investing, and having this metric touted as a “rule” is both misleading and dangerous. Indeed, I’ve generally ignored the Chowder rule, but was inspired to write this when I read this recent article that doubles down on the Chowder rule by referring to it as “Total Dividend Return.” To me, this is truly misleading and dangerous – I do not see how the Chowder number is a measurement of any type of total return that an investor might expect.

I’ve seen some suggestion that underlying logic of the rule is that the dividend growth rate is some sort of proxy for the share price appreciation that you might expect, and that is how you get to “total return.” But I’ve seen no analysis supporting this contention, and even if it is true that a high dividend growth rate does correlate to a relatively fast increase in share price, this does not mean that adding the dividend growth rate to the yield gives you any sort of a meaningful number.

Maybe the Chowder number’s meaning is obvious and apparent to everyone but me, and I’d be glad to be enlightened. But in my opinion the rule makes little sense on its face, and I think it is scary that not only does it go completely unquestioned, but seems to be taking on great significance among DG investors over at SA. Read the many comments to the recent article and you’ll see many accolades and several newer investors jumping on board with the approach. As of this moment, there are 190 comments to the article, and exactly one of them questions, gently, the basis for the rule, though that question did not seem to generate serious discussion.

To be clear, I am a fan of Chowder’s articles. He has written many excellent pieces on dividend growth investing and has helped many new investors find their footing with the strategy. Indeed, I was heartened to see that Chowder himself jumped into the comments thread of that article to note that the Chowder rule should only be applied after other important criteria were met. Chowder is undoubtedly a force for good among DG investors over at SA. I just worry that the “Chowder rule” is inappropriately becoming part of the dividend growth gospel.

What am I missing?