Dividend growth investing (DGI), if done correctly, is a very wonderful and self-reinforcing strategy. The idea is pretty simple — if one buys stocks of high-quality companies which are increasing dividend at a rate which is higher than the inflation, then one hopes to increase his buying power over time. The compounding works fantastically in these cases.
Furthermore, it is quite easy to follow the strategy and one can define a good criteria of when to buy or sell a stock. Ideally, for a dividend growth stock the time to sell is never. But sometimes a company's business may face adversities which might be difficult to fix. In these cases, DGI offers a simple criteria to exit the stock — sell if the growth in dividend is less than the inflation. Simpler still, if the company does not increase its dividend in a particular fiscal year then you sell and re-deploy the cash.
If DGI is so awesome — why do I not follow it?
Let me indulge myself a bit and let me tell you some of the problems I have with DGI.
Learning opportunities. I love investing. It is not only a means to get financial independence, but it also offers me a chance to learn new things. Let me offer myself as an example. When I started at the end of 2009, I started in effect, from zero. I read a few books. "One Up on Wall Street," "Beating the Street," "Stocks for the Long Run," "A Random Walk Through Wall Street," "Contrarian Investment Strategies," "Little Book That Beats the Market" and "The Richest man in Babylon." That is all. I thought I had learned enough and settled on dollar cost averaging and choosing stocks in a “contrarian” way. This did not turn out very well and I ended up losing 10% of my portfolio.
This was enough to shock me into starting my education again. Around this time I stumbled upon the excellent book, “The Little Book of Behavioral Investing,” by James Montier. This was a watershed book for me as it opened my eyes to a completely new idea. I then started delving deeper and deeper into behavioral psychology. I discovered the excellent authors Daniel Kahneman, Daniel Gilbert, Dan Ariely and a very excellent book Influence by Robert Cialdini. I also read "Lord of Finance" by Liaquat Ahamed which had an excellent introduction to the philosophy of John Maynard Keynes, which in turn led me to Hayek and the Austrian School of Economics. I started with the “One Lesson in Economics” by Henry Hazlitt and am trying to make my way through it.
The pitfalls I encountered led me to this learning process. If there were no pitfalls and I was convinced that my approach works — I had fewer reasons to continue my education.
DGI offers such a model. It is easy to define. And it works quite well. You do not need to do a lot of work to learn it and your portfolio is on autopilot. Ergo, you have fewer opportunities to learn new things.
Diversification versus due diligence. One of the core philosophies of DGI is to diversify the income stream. A dividend investor does not want to be concentrated in an industry and suffer quite badly if somehow the industry goes into a tailspin. A dividend investor keeps a lot of stocks and none of them occupies more than 5% of the portfolio.
Now it is not very difficult to argue that if you are managing a portfolio of 20 stocks (at least) then you cannot do due diligence on all of them. Furthermore, with new money coming in, you have to find new opportunities.
This leads a trade-off between diligence and diversification. If you want to diversify, you cannot be on top of each of your companies. Furthermore, a company’s share price falls in anticipation of a dividend cut. And given that a dividend investor does not sell his stock until after the dividend cut is announced, he gets the short end of the stick. This happened with, for example, Telefonica (NYSE:TEF).
Cash. A dividend growth investor deploys his cash without caring about the market. He buys when the company is undervalued, i.e. has an okay dividend yield and has been ratcheting up dividends. He may look at the dividend discount model to ascertain the value — if he wishes. But he buys companies whenever he has cash.
I, on the other hand, like to keep ample cash. Currently my portfolio is 50% in cash and 50% in stock. I still managed a 15% performance last year (beaten by the S&P 500 by a margin of nearly 3% with dividends). The cash helps me when the markets are panicking.
Most dividend growth investors I know are buying stocks and have been doing this in the last three months or so. I have made very minor changes in my portfolio. The selling has been higher than the buying for me. I believe that when a market dip comes, my cash will protect me against opportunity cost.
- High Yield Dividend Stocks in Gurus' Portfolio
- Top dividend stocks of Warren Buffett
- Top dividend stocks of George Soros