Dividend Growth Investing, Lesson 9: I’ve Loaded My Portfolio with These Stocks

[nbox type=notice]Note from Daily Trade Alert: Welcome to Lesson 9 of our exclusive series on Dividend Growth Investing (DGI). As many people already know, DGI is an exciting investment strategy designed to help anyone generate safe, steadily-growing income over the long-haul. To guide us through this special series, we’ve commissioned the expertise of Dave Van Knapp, author of Top 40 Dividend Growth Stocks for 2013.  If you’re just joining us, we encourage you to start with Lesson 1. Otherwise, see below for Dave’s ninth installment…[/nbox]

Dividend Growth Investing, Lesson 9: Why I’ve Loaded My Portfolio with Dividend Growth Stocks
by Dave Van Knapp

So far, this series of lessons about dividend growth investing has focused on specifics:

This time, let’s take a step back and consider a broader question:

[wp_ad_camp_1]What are the advantages of being a dividend growth investor?

What is there to like about dividend growth investing?

Why should you do it at all?

Personally, I’ve created a real-money portfolio based entirely on dividend growth stocks like Johnson & Johnson (JNJ), McDonald’s (MCD) and Chevron (CVX).

In short, these are the 14 reasons why I’m a dividend growth investor…

1. Dividends bypass the market
Market prices and dividends have utterly different mechanisms for converting corporate earnings into cash in your pocket.

“Mr. Market” translates earnings into market prices. Unfortunately, Mr. Market sometimes goes haywire and takes stock prices through irrational swings that have nothing to do with long-term business performance.

On the other hand, companies themselves determine dividends. Dividends are declared and paid by the corporations, not the market. Corporate dividend policies rarely go haywire.

2. Dividend investing can relieve obsession over market volatility
Many dividend growth investors find that the strategy lifts a great worry off their shoulders.

In dividend growth investing, you profit from being the owner of a business that sends you some of its earnings each quarter. You don’t look at stock shares as parimutuel betting slips or lottery tickets. Instead, you become a true investor: You partner with your businesses, sharing in its success over the long term.

You don’t care so much about the daily prices offered by Mr. Market for your stocks, any more than a gas-station owner thinks daily about what he could sell his business for. That helps dividend growth investors take the market’s ups and downs in stride. You do not have to win trading battles against other investors to be successful.

3. Dividends are real cash
Every dividend is a positive return to shareholders. It’s cash in your pocket. Dividends are completely transparent and immune from accounting manipulation or trickery.

4. Dividend investing provides ongoing feedback about your investment
Because (most) dividends are paid quarterly, they provide feedback about your investments directly from the companies themselves. If a company pays and increases its regular dividend according to an established schedule, that in itself is important information about how that company is performing as a business. You are a partner in that performance.

A dividend increase can normally be interpreted as a positive sign that management has confidence in the company’s prospects. A company with a well-established dividend policy will look ahead a few years when considering each year’s increase to see what it can afford. So a healthy increase is usually a good sign. A frozen dividend or skipped increase is useful feedback too. Perhaps that company needs to be watched more carefully, if not sold.

5. The best dividend growth companies are outstanding businesses
Dividend growth companies typically have:

  • Proven, time-tested business models
  • Steady growth
  • Sustainable competitive advantages (moats)
  • Solid balance sheets
  • The strength needed to survive recessions
  • Defensible market share
  • Reliable cash generation
  • Low debt

It requires an outstanding business to increase dividends for many years in a row. Weak businesses simply cannot do it.

6. Dividends increases continue even when stock prices decline
Even when a dividend stock’s price is falling, it still has a positive return component via the dividends.

For example, below is a 10-year chart of Johnson & Johnson (JNJ). Notice how the dividend (blue line) has continued steadily upward, with annual increases, to its current value of $0.66 per share (quarterly), while the stock’s price (orange line) has gone up, down, and sideways.

Notice the period from 2005-2012 when JNJ “traded sideways.” Many price-obsessed investors considered JNJ to be “dead money” for nearly a decade. Dividend growth investors never saw JNJ as dead money. We saw the blue line. (Disclosure: I own JNJ.)

7. You do not have to sell the stock to get the dividend
Dividends are sent to shareholders directly by the company. If a stock pays no dividends, its total return comes solely from price changes, and you can only realize those if you sell the stock. There is no other benefit from ownership.

A problem with confining your returns to stock prices is that they are determined by the irrational Mr. Market. In contrast, a carefully selected portfolio of dividend growth stocks is pretty reliable about its dividend returns.

Critics of dividend investing sometimes state that “a dollar is a dollar,” so what difference does it make if you get a dollar from dividends or a dollar from selling a few shares? The difference is obvious. In order to get your hands on a dollar of capital value, you must sell shares. Your “wealth” is embedded in those shares. Once sold, they are gone. They can no longer benefit you, since you no longer own them.

So the huge difference between getting a dollar from dividends or from capital is that you still own the shares in the first instance and don’t own them in the second.

8. Dividend payouts rise over time
Hundreds of dividend companies have a long history of increasing their dividend regularly. Companies such as McDonald’s (MCD), Coca-Cola (KO), and Johnson & Johnson (JNJ) have increased their dividends every year for decades. It is logical to expect that they will continue to do so if they possibly can. (Disclosure: I own McDonald’s.)

 

This is the most powerful aspect of dividend growth stocks. It is why dividend growth investors are often content with stagnant stock prices. It is why retirees – seeking income that keeps up with inflation – become attracted to dividend growth stocks. It is why many income investors consider dividend growth stocks to be more attractive than bonds, whose yields are fixed.

9. Dividend stocks tend to be less volatile
In September 2011, the New York Times, in an article titled “The Dividend as a Bulwark Against Global Economic Uncertainty,” referenced an ongoing study of dividend stocks by Ned Davis Research. It reported that Davis’ study showed that dividend growth stocks are less volatile than other stocks.

The smoother price ride generally makes dividend growth stocks easier to hold during times of market volatility. Beyond that, the dividends themselves help cushion portfolio losses when equity prices are declining. Dividends have gentle trends that are fairly predictable. For that reason, dividend growth stocks tend to attract owners who are less likely to sell shares in a panic when the stock’s price drops. That cadre of long-term owners tends to dampen the price volatility of such stocks. Indeed, such owners may take advantage of bargain prices to buy more, helping to counteract the prevailing trend in the market.

10. Your principal can grow too
Both dividend growth and price growth come from a common source: earnings growth.

In each case there is an intermediary between you and earnings growth. In the case of the stock’s price, the intermediary is Mr. Market. In the case of the dividend, it is the company’s management and board of directors.

As we have seen, Mr. Market is often irrational. He can send the price of a stock plummeting even though its earnings are rising.

With dividends, however, the intermediary (the company’s management and board) can be helpful. They can smooth out the flow of the dividend compared to the variations in the company’s earnings. If the company is committed to annual dividend increases, they can make those happen even if they hit a bad patch for a year or two on the earnings front.

Here is the same chart as earlier, except that I have added JNJ’s earnings to its price and dividends.

What is the smoothest, most predictable line? The blue dividend line absolutely stands out for its smoothness compared to the other two. JNJ’s management, knowing that they have a rock-solid company with a positive long-term outlook, has smoothed the dividend. It’s a beautiful thing.

The red line, which shows the company’s earnings per share (EPS) each quarter, is surprisingly volatile, reflecting seasonality and the vagaries of computing earnings in the face of many unique events.

The orange line is Mr. Market’s price line. If and when you sell, you will receive whatever price Mr. Market has determined for the shares that day. Hopefully, that will be more than you paid for them. So the dividend stock investor potentially gets positive returns from both sources of total return: dividends and price appreciation.

11. Historically, dividend growth stocks have outperformed the market in total returns
Not only might your principal rise over time, but historically dividend growth stocks have in fact outperformed the broad market in total returns. Numerous studies have shown this. They differ in methodology and timeframes, but the similarity in their conclusions is overwhelming.

One such study was published by Robert Arnott and Clifford S. Asness, “Surprise! Higher Dividends = Higher Earnings Growth, (December, 2001). This study suggested that in companies that paid out a low ratio of their earnings as dividends, one often saw inefficient empire building, the funding of second-rate projects, and poor internal investments. These money-wasting companies delivered poor subsequent growth.

In contrast, in companies with higher percentages of earnings paid out as dividends, the authors found more carefully chosen projects with better returns.

A strong dividend program suggests that management is probably making smart decisions with the cash remaining after dividends are paid. Some companies squander their retained earnings. In the best dividend growth companies, management is disciplined about projects, acquisitions, and costs. The result is a more efficient and focused business.

12. You can reinvest dividends to accelerate the compounding effect
Shareholders can do three things with dividends: Reinvest them, keep them, or spend them.

If you reinvest the dividends (either in the same stock or elsewhere), the reinvestment brings into play a second layer of compounding. (The first layer is the rising dividends themselves.) As you purchase more shares with the dividends, the number of shares you own goes up. Those shares then generate additional dividends, which can then be reinvested, creating a virtuous circle of dividends reinvestment more shares more dividends, etc. This builds wealth at an accelerating pace. Your share base grows faster and faster because of the reinvestments. The growing number of shares increases the dividends you receive.

13. Rising dividends protect against inflation
One of the risks that we must all deal with is inflation. Inflation erodes the purchasing power of money over time.

My own studies have shown that the income from dividend growth stocks generally grows faster than inflation. Speaking personally, sometimes I think that the only benchmark I care about as an investor is inflation. I don’t care so much whether I beat “the market” so long as I beat inflation.

14. You do not need any more wealth to generate 4% income rather than 4% from sales
It requires no more money to acquire a portfolio of stocks that pays a dividend stream of 4% than to acquire a portfolio of stocks that must be sold piecemeal to generate the exact same 4%. I focus here on 4%, because that is the amount often recommended to be “safe” to withdraw from a retirement portfolio.

The point that 4% of organic income from dividends equals 4% of synthetic “income” from selling assets is obvious, yet it is missed by many. Those people for some reason believe that living off investment income is only for the very wealthy, while they embrace the 4% withdrawal rule for everyone else. It’s the same number! And you don’t have to sell shares to get it.

— Dave Van Knapp
Author of Top 40 Dividend Growth Stocks for 2013

Top 40 Dividend Growth Stocks for 2013 [advertisement]
Dividend growth stocks may be the single best investment you can make. They offer both the growth potential of stocks plus reliable growing income. Over long periods, dividend growth stocks have produced the best total return of any category of stocks. Top 40 Dividend Growth Stocks For 2013: A Sensible Guide to Dividend Growth Investing offers an exclusive list and analysis of 40 top dividend growth stocks for 2013, as well as a complete step-by-step manual on how to build and maintain a portfolio of dividend growth stocks.