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Ideas for Income Investors. High Dividend Stocks, Mutual Funds etc.
Why I Love Dividend Growth Investing
Posted by: Jason Fieber (IP Logged)
Date: April 22, 2013 07:43AM
Dividend growth investing is an investment strategy whereby an investor primarily focuses on stocks that pay dividends, and have a history of raising those dividends on a consistent basis. Taking this a step further, most dividend growth investors then hone in on businesses that have stable operations, responsible uses of debt with low debt ratios, economies of scale and manufacture and/or sell products or services that people/other businesses want or need on an everyday basis. Typically, a dividend growth investor wants to covert their capital into equity shares with a group of high quality businesses that share profits with shareholders in the form of dividends, thus creating a portfolio of businesses that they are a part owner of.
I consider myself a staunch proponent of this strategy. You can view my portfolio at any time, and you'll see it's mostly filled with high quality businesses that have stable businesses that largely have economic advantages of some type, be it brand names, manufacturing capacity/efficiency, technological advantages, patents, global operations and the like. Some of my largest individual investments are with companies like Phillip Morris International Inc. (PM), Johnson & Johnson (JNJ) and PepsiCo, Inc. (PEP). I have most of my net worth invested in high quality companies that pay out (rising) dividends, and so I thought I would share today why I'm such a fan of this strategy.
It should be noted before I go any further that dividend growth investing is just but one strategy an investor can use, and common stocks are just but one asset class. Although I'm primarily invested in stocks, I do plan to diversify my wealth when interest rates make it prudent to do so. I highly recommend diversifying your individual stock holdings (I'm currently invested in 32 individual companies) and taking that further I strongly recommend diversifying beyond stocks into other asset classes as you feel comfortable. Real estate, bonds, commodities/precious metals and cash (CD's, money market accounts) are the most common asset classes used. I plan to have a portion of my net worth in real estate (either physical ownership or more likely REIT ownership) and bonds by the time I'm financially independent and actually living off the passive income my investments provide.
So, on to some of the wonderful reasons I love dividend growth investing:
1. Stock market volatility mainly provides opportunity, rather than wealth destruction.
For investors that buy an asset with the hopes that they can sell it later for a higher price, market volatility can affect one's emotions quite heavily. This is one of many reasons I don't invest in gold. Buying an asset and then hoping that you're buying it cheap enough that you can sell it later for an amount high enough to factor in transaction costs, taxes, inflation and still come away with a risk-adjusted return that is acceptable is just plain risky and factors in too many unknowns. It also heavily factors in an external market and all the market participants therein, along with all of their emotions. These emotions are what causes wealth destruction. If you buy a stock for $35 because you want to sell it down the road for $40 or more and the stock starts trending down to $30 it's easy to panic, because the rift between what you want to sell it for and what it's currently selling for enlarges. Panic occurs and often an investor looks to get out while they still can. Lack of control over one's emotions is one reason why most investors are probably better off investing in index funds.
Rather, I mostly isolate myself from the stock market's often irrational sways ups and downs by investing in dividend growth stocks. Often, the market's sways are only used for opportunity as I look to buy shares in high quality companies at a value relative to their intrinsic value. If I value a stock by qualitative and quantitative analysis to be worth $50, then I simply look for opportunities when the market is pricing these shares under that price, and the further below that number the better. The lower price means I'm factoring in a margin of safety from errors in my analysis, future fundamental issues with the company I'm investing in and also means that I'm effectively buying more yield for my money as cheaper share prices means I can buy more shares with the same amount of money, and more shares means more dividends.
How did this relative isolation occur? It's because I focus on the growing dividends my equity ownership stakes pay me. The underlying share prices mean little to me other than to offer me an opportunity to average down on my purchases. I don't plan to sell any of my shares to fund my early retirement, so the share prices actually mean very little to me. As long as the companies I'm invested in do not cut dividends or radically alter their business model or fundamentals I'm happy to continue collecting dividends, which I currently reinvest selectively but will later use to pay all my expenses. This means I have little worry over the broad market's emotional reactions to quarterly results, irrationality over major global events that have little to do with the companies I'm invested in and such.
2. It forces me to focus on high quality, proven companies.
Realistically, it's very difficult for a company to pay out dividends for decades on end, all while raising them on an annual basis along the way. There's a lot to go wrong. There are natural disasters, economic cycles, changes in consumer tastes or habits, government regulation, taxes, product recalls, competition, patent expirations and costly infrastructure maintenance among many other things that can hamper a company's ability to pay out, let alone raise, a dividend for 10, 20 or 50 years. Only the best companies with consistently great management, fantastic products, prudent use of capital and leverage and a focus on shareholder return manage lengthy dividend streaks. These are typically very, very high quality companies that stay high quality for very long periods of time. The Coca-Cola Company (KO) has been paying dividends since 1893! That time frame includes two world wars, The Great Depression, Black Monday, Black Tuesday, the end of the gold standard and multiple natural disasters here and abroad. High quality companies overcome setbacks and continue to create value for shareholders over the long-term. High quality companies that continue to pay out, and raise, dividends over very long periods of time have to make prudent use of cash as it's actual cash that's leaving the company and going into the pockets of shareholders. Dividends effectively makes sure that management is doing the right thing, and the cash you receive is "proof in the pudding", because that cash didn't get there from some accounting trick.
Or...I could instead just invest in whatever stock is "hot" at the moment and ignore high quality, proven companies. I could invest in Netflix, Inc. (NFLX) or Facebook Inc. (FB) and hope that they are able to survive major economic changes while increasing the price of my shares, since I have no dividends being paid to me. They don't really have any lengthy history to speak of, but they're hot. So, that must count for something. And, they're relatively cheap. FB currently has a P/E ratio of 1,742. NFLX currently trades for a P/E ratio of 563. Hmm. Why buy into a high quality company like KO, whose shares currently force an investor to pay 22 times earnings when you could just as easily pay almost 1,800 times earnings for an unproven company like FB? Oh, and the former pays you to own it, while the latter pays you zip nada.
3. Typically the dividend growth of high quality dividend growth stocks outpaces inflation, thereby increasing my purchasing power over time.
Not only do the dividends that dividend growth stocks pay out rise over time, they typically do so at a rate that outpaces inflation. According to this source, the inflation rate over the last 10 years has averaged under 4% annually, with a few individual years being far under that number. Many of the companies I'm invested in raise their dividend at a rate that outpaces that number by a large margin. For instance, just recently The Procter & Gamble Company (PG) raised the dividend by 7%, this coming after 56 prior years of dividend increases. High quality, indeed. As these dividend raises continue to increase at rates above inflation, my purchasing power only increases over time as my dividend income will be able to purchase more and more.
Compare this to bonds, for instance, that pay a fixed interest rate to the bondholder. Investing in a 10-year Treasury Note gets you a fixed 1.70% interest rate right now. That means you're likely to receive a negative total return over that 10 years if you were to hold to maturity, because 1.70% is near or under inflation as it stands, and that's before factoring in taxes. Also, that 10-year Note will return your capital back to you as it began, meanwhile the equity issues of high quality companies will likely advance over time as the underlying business becomes more and more valuable. Compare that 10-year Note to the 2.95% yield PG shares currently offer, along with the growth of that yield and the growth of the underlying share prices over the long-term and the choice is obvious.
4. Dividend income is truly passive.
One great thing about dividends is that they are completely passive. People throw around the term passive quite a bit, all the while not actually using it in the correct context. Many people dream of a passive income source that will fund their lifestyle as they see fit, without having to work a 9-5 till' 65 to pay the bills. Passive income means you earn an income with very little or no effort on your part. But, I see passive income being associated with blogging, owning your own business, vending machines and real estate. These are all valid sources for an income of varying degrees, but are they truly passive?
Blogging is definitely not passive, as I typically spend well over 10 hours per week running Dividend Mantra writing new articles and administering the site. Owning your own business is likely not passive at all, as most small businesses require the owner to spend great deals of time to run them, even while 3/4 of start-ups fail. Real estate is very commonly used as a source for passive income, and could come pretty close to completely passive if you use a management company to run your rental properties. However, management companies take a slice of your profits, and still will likely contact you about major decisions like replacing appliances or evictions and the like. Coca-Cola (KO) will never contact me as a shareholder because an assembly line had a minor issue or because one of their thousands of employees had some kind of personal issue. They'll just continue to do business as normal and send me my dividends like clockwork. Dividend income is truly passive, and even better it's an income that is completely location independent. You could even retire abroad, or travel indefinitely if your dividend income was sufficient enough. Dividends are also passive in the sense that they remove you from having to sell shares to receive the income. No action on your part is necessary to receive the money once you're invested in a company that pays out cash dividends.
5. Dividends are reliable and regular, just like bills.
One of the great things about dividends is that you have a pretty good idea of how much you're going to receive, and when you're going to get it. For example, Johnson & Johnson (JNJ) has been paying dividends in March, June, September and December (usually around the 13th of each month) for as long as I can go back. And you know that JNJ is going to send out their $0.61 quarterly dividend as they usually do, only until they raise it (likely to be announced in the next week or so). The regularity of dividends, and raises, is quite attractive as we all exist in the real world where bills are due on a similarly regular schedule. If you're using your dividends to pay all your expenditures, it's quite nice that most high quality businesses pay their shareholders a portion of the profits on a regular and fairly reliable schedule. Contrast that to the earlier used example of real estate, and you can see how irregular things can become with the occasional eviction and the intermittent replacement or repair of something on the property. As a real estate investor you'll likely have a reserve fund for issues like these, but that's money that could be used to earn a return on instead of being used to cushion occasional cash flow issues.
These are just some of the reasons I love dividend growth investing as a viable strategy to not only build solid long-term total returns, but to actually receive a truly passive income source that can fund an early retirement. While there are drawbacks to this strategy (time spent to analyze companies for initial purchase, knowledge/interest required, exposure to a volatile stock market, no guarantee of return), there is no free lunch in life and nothing is perfect. Weighing the benefits against the drawbacks, however, I feel this is a fantastic strategy for generating passive income while investing in high quality assets.
How about you? Love dividend growth investing?
Full Disclosure: Long PM, JNJ, PEP, KO, PG
Stocks Discussed: PM, JNJ, PEP, KO, PG,