My recipe to beat the market

The S&P 500 is a difficult index for fund managers to gain an edge, but James Hackman, manager of the Neptune US Income Fund, says he has found the recipe to outperform over the medium to long-term.

Einstein called it the eighth wonder of the world for very good reason - yet the power of compounding remains underappreciated by many investors who remain obsessed by short-term performance.

If you are able to find cheap or, at the very least, reasonably priced companies that are able to consistently grow their dividend, you give yourself a very, very good chance of outperforming the S&P 500. There are plenty of other ways to do it but I believe the odds are more in my favour by going down this route.

Reinvesting dividends contributed close to half of the S&P 500's total return between 1930 and 2013. It's hardly surprising then that companies that pay dividends have beaten non-dividend payers not only overall, but consistently.

Not just a matter of yield

It's not as easy as simply finding companies that have a high dividend yield, though. Companies that have grown their dividend have significantly outperformed those that have kept their dividend at the same level, and wiped the floor with those that have cut their dividend.

The power of compounding is of course the biggest driver of performance, but a company that is able to consistently grow its dividend encourages capital discipline and also long-term capital appreciation; share prices have to rise for the yield to stay the same.

I like companies that have a proven record of converting profits to cashInvesting for dividend growth also helps investors to avoid dividend cuts. My strategy is to look for companies that are set to grow their dividend ahead of the benchmark which is currently forecast to grow at c. 6% per annum. A high yield may attract investors in the first place, but it doesn't protect you from dividend cuts.

In order to find these companies, I employ a strict bottom-up screening process. My starting point is a yield of 2%, which cuts down my universe of companies to 260. I then apply various tests to ensure I am achieving not only dividend growth but sustainable dividend growth at a reasonable valuation.

For example, I like companies that have a proven record of converting profits to cash and that I believe will grow their balance sheet cash after capex, buybacks and dividends.

Whittling down

What I'm left with is a list of 135 companies, which I filter down to 50-65 based on where I am seeing the best opportunities. I take into account Neptune's sector expertise but given the importance of dividend growth, this is very much a fundamental stockpicking approach.

Dividend growth is of course central to the process, but in order to maximise total returns over the medium to long-term you've got to make sure you don't pay over the odds for it.

You've got to be extremely wary of the price you're paying for safety at the moment. Companies such as AT&T and McDonalds have re-rated even though earnings growth has been relatively lacklustre.

We've also had a handful of highly established names recently cut their dividends, such as Freeport-McMoRan and ConocoPhillips. Taking an active approach and being selective is therefore extremely important.

James Hackman manages the Neptune US Income fund.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.