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Why Dividend Investing Will Always Be Better Than Buying the Entire Stock Market

June 17, 2013
The Dividend Guy Blog

The Dividend Guy Blog

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I’ve read a lot of comments about the potential dividend bubble for the past 12 months. Some investors are afraid to see so much money leaving bonds and money market funds to be piled into dividend paying stocks. Most investors are craving for revenue and dividend stocks are pretty much the answer to this desire… unless they continue to starve with their bonds and CDs paying less interest than I pay my kids!

But the fact remains: dividend investing is far more solid than a simple bubble created by a few retirees looking to receive a big fat check every month. While this investing strategy might look like flavor of the year since 2009, I can tell you it will continue to work out for decades to come.

Dividend Investing has Outperformed the S&P 500 Since The Very Beginning



You can do some research on the internet, the conclusion will always include the same fact: dividend growth stocks generate a better return than pure capital appreciation. In fact roughly 50% of the total stock market return comes from dividend payout. Trying to select pure growth stocks without dividends is like claiming you can ignore 50% of the stock market return in your portfolio.



But following a few case studies and buying dividend stocks for that sole reason would be a bit simplistic… even borderline stupid. It’s your money after all, are you here to make money or to gamble it on some geek studies?

Let’s dig deeper to see if there is a reason why dividend stocks are better than any others…

Dividend Payouts Require Cash Flow



By definition, a dividend is paid from a company’s after tax money. Therefore, the company must first generate sales, then earn sustainable profits, pay its taxes, save/invest for the future… and then pay dividends to its investors. There is no point of bleeding the company’s cash flow into dividends simply to please investors. Most companies paying a dividend because they make money and believe they will continue to do so in the upcoming years. Isn’t this the first reason why you would buy shares of a business in the first place: because your investment will generate positive future cash flow? A company paying dividends strongly believes in its ability to do so.

Dividend Growth Requires Profit Growth



Thinking that any stock paying a distribution is a good fit for your portfolio would be, here again, kind of ridiculous. There are multiple reasons to pay dividends besides having a sound balance sheet:

It may want to attract more investors, pushing the stock value higher.

It may be done to please a major investor who wants its money back.

The management might have overestimated their capacity to growth their business in the future.

The management might have underestimated competition.

Since picking just any stock with a dividend yield is not sound investing practice, the second step would be to pick a stock with a positive dividend growth for at least five years. You can become quite picky and require stocks with up to 25 consecutive years of dividend growth. They are called the Dividend Aristocrats.

A constant dividend growth requires, by definition, a constantly growing profit. Therefore, if you pick a company that increases its dividend payouts by 5% for the past 10, 15 or 25 years, chances are its profits are following the same trend. I’m asking you once again: wouldn’t you like to buy a company that believes whole-heartedly in its ability to generate future positive cash flows PLUS showing a strong history of profit growth? We are getting closer to what any investor would call a “perfect investment”, right?

Profit Growth Requires Sales Growth



It is true that a company could cut its costs for a few years and generate profit growth this way. This is a good solution to cut fat but management must make sure it doesn’t cut too much and jeopardize future growth.

This is why I like to combine both sales and earnings per share on the same graph. I want to make sure that both are on an uptrend. A company making more profit but showing a slowdown in sales or, worse, a decline will lift a red flag. On the other hand, a company with both sales and profits going up will definitely lead to more dividend growth in the future. This is how you can beat the market.

Sales Growth Requires Competitive Advantage



What’s the best reason why a company’s sales grow? The company has a competitive advantage. It can be a total leadership in its market, new innovative products, better locations, better process, strong branding, etc, etc, etc.

A company without a competitive advantage can’t really push its sales higher over several years. It will rapidly hit the ceiling and will have to cut on their costs to increase its profit. It will eventually hit them as you can’t continue to grow simply by cutting costs.

By selecting a dividend growth stock, you select a company with strong cash flows coming from increasing profits generated from more sales. Sales growth is often linked to a competitive advantage. Aren’t we drawing the picture of a perfect company for any investor by now?

Investing in Companies with Competitive Advantage is the Key in Becoming a Successful Investor



Regardless of your investment strategy, you will be investing for several years. Most investors have money allocated to investments for more than ten years. If you don’t want your face pressed up against your trading screen for the next ten years, you might want to select a more passive investing approach than day trading.

The best way to become a successful investor for the next decade is to find companies with competitive advantage. It is sometimes hard to define what kind of advantage is sustainable or not. This is why I focus on dividend growth stocks to make sure I pick businesses with all the qualities mentioned in this article.

With simple filters like dividend growth, dividend payouts, earnings per share and sales growth, you can easily find strong companies with a competitive advantage.

No need to do extensive research to know if a company is coming with “the next big thing”.

No need to hope for a homerun with your next pick; most of your stocks will be singles or doubles with dividends.

No need to track your portfolio on a daily basis, dividend investing is meant for the long term.

When you think about it, dividend stocks beat the overall market in general simply because they are rewarded by investors for their sustainable business model. A model allowing them to pay dividends for years.

A Word of Caution – Not All Dividend Stocks Were Created Equal



It’s not because a company shows strong dividend metrics that it is automatically a buy. For example, Radio Shack (RSH) was showing strong dividend metrics not so long ago and everything collapsed rapidly since their business model wasn’t a great match for today’s economy.


Rating: 2.6/5 (9 votes)

Comments

shaved_head_and_balls
Shaved_head_and_balls - 10 months ago
The next bear market will wipe out a decade of dividend payments. At that point, we'll see how well the dividend chasers sleep at night. Oh wait, I forgot that Bernanke eradicated bear markets. Never mind.
cdubey
Cdubey premium member - 10 months ago
A very weakly reasoned article. Many statement here are empirically wrong or at the very least not clearly defined. A few examples:

> Dividend Growth Requires Profit Growth

A company can drive dividend growth by buying back shares -- no need to increase profit.

> Sales Growth Requires Competitive Advantage

This statement suffers from misunderstanding of falsifiability. It cannot be tested. One can always claim that the sales of the company were increasing because they had X as the competitive advantage and then they stopped increasing and/or went down because they stopped doing X or X eroded over time. Things are easier to explain with the benefit of hindsight.

> With simple filters like dividend growth, dividend payouts, earnings per share and sales growth,

> you can easily find strong companies with a competitive advantage.

This is a testable hypothesis. And one needs only one counter-example to show that it is false. Look at Telefonica until 2010, a year before they cut their dividend [morningstar]. Compare figures from 2003 and 2010. Sales more than doubled, dividend went up 8.3 times, payout ratio always< 56% -- averaging around 50%, EPS went up 5.6 times ...

> A Word of Caution – Not All Dividend Stocks Were Created Equal

> It’s not because a company shows strong dividend metrics that it is automatically a buy.

This sentence will take care of the mistakes of pretty much every strategy. If a stock does not work for any number of reasons -- we refile it to one of the ideas which did not work out.

If you buy 50 stocks using a screener which most dividend investors agree on, maybe the failure rate is small. It has also been true historically that their combined performance will beat the total market index. But this is a big assumption that what has worked historically will also work in the future. It has failed many astute fund managers and investors alike. You only need to look at any number of quant trading strategies -- which have since stopped working once the mispricings were discovered.

As the previous commenter mentioned -- I will be very interested in seeing how the new dividend investors behave in the next bear market.
batbeer2
Batbeer2 premium member - 10 months ago
Thanks for an article worth reading.

1) The graph "dividends versus capital appreciation". I don't fully understand what that graph proves. On the face of it, the graph seems to imply capital appreciation is usually greater than the dividend return.

In fact, if we take the "best" decade for dividends: the 30's, the graph says the CAGR for the index was -5%.... my math is terrible but I take that to mean stocks were almost cut in half from 1930 to 1940. The next decade, the dividend yield was 6%. That's up from 5.4% in the 30's. Doesn't that mean dividends too were almost cut in half?

What am I missing?

2) On a more fundamental note, I don't understand how the payment of dividends makes me richer. A company I own writes me a check. The company gets worth a bit less and I get worth a bit more. For the sake of this discussion, I'll ignore taxes.

How does this make me richer? I'd prefer the company to be run by management with some ideas about putting the cash to work. My best example would be DJCO.

Berkshire, Fairfax, Markel, Leucadia and Loews are some others. Just off the top of my head, that's a portfolio of six well known compounders. Are there six dividend aristocrats that did better?

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