I'm a music fan. One of the things I like to do when reading SA articles is to turn on the Bose and have it playing in the background and relax to music while I'm reading the articles and the comments. And one of the things I like about this time of year is listening to Christmas music. The thing about Christmas music though is that most of the songs have been "covered" by many different artists with their particular style applied to the song. At any given time I may be listening to a Contemporary, Celtic, Country, Pop, Rock and Roll, Doo Wop, or Classical artist version of the same song. And I usually enjoy listening to each of the different versions.
The same thing applies to the frequent discussions on SA about the pros and cons of dividend-growth investing. With somewhat predictable regularity someone will author an article describing how dividend investing is inferior to other methods or visit the comments section of a dividend article and attempt to antagonize those who follow that methodology. I enjoy reading the many different pro and con versions of both, even those that tend to belittle dividend growth investing. One can learn a lot simply by listening and contemplating others' points of view even when presented negatively. With that said, the following is intended to be my "cover" of the arguments in support of dividend-growth investing and response to those who deride it.
It's probably important to define some terms prior to getting in to the meat of the argument. Investopedia defines dividends as --"a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders." It goes on to further explain that --"dividends may be in the form of cash, stock or property. Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth." That last statement probably covers the most frequent comment I hear from the non-dividend growth crowd in that rather than paying dividends to shareholders, the revenue would be better utilized by the company elsewhere, such as in growing the company. But is that actually correct?
In a study (this link is to a pdf copy) conducted by Robert Arnott and Clifford Asness and published in the Jan/Feb 2003 edition of the Financial Analysts Journal, which was studying dividend policy in regard to payout ratios, the authors constructed an index for stocks from 1871 to 2001 and determined that "the historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low." They went on to state that "our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth."
Follow up studies were conducted in 2005 and 2006 in foreign markets, including Canadian, Australian, Japanese and European markets, and confirmed the conclusion reached by the Arnott/Asness study that higher dividend payments actually lead to higher earnings. And dividends help drive higher market prices. In the book "The Intelligent Investor" by Benjamin Graham, it states "Analytical studies have shown that in the typical case a dollar paid out in dividends had as much as four times the positive effect on market price as had a dollar of undistributed earnings."
Other studies, such as one conducted by Zhou and Ruland titled "Dividend Payout and Future Earnings Growth," and published in the Financial Analysts Journal, May/June 2006, have demonstrated that companies with a high dividend payout record tend to exhibit strong earnings growth. Those same companies have also exhibited a tendency to provide better returns to investors over time. As this link shows (Page 4), dividend growth companies outperformed non-dividend paying companies by 8.7% per year over a recent 30-year period. Why is that? It's believed to be that companies that pay dividends are, in general, better managers of capital and are more disciplined.
I am not trying to refute the notion that high-growth companies can grow earnings very fast, reaching 25%, 30%, 40% or even greater growth very quickly. This has been amply demonstrated. What has been demonstrated as well is that those high rates of growth are not sustainable. If they were, we would all be investing in the companies that could sustain it. Again in The Intelligent Investor (Chapter 11 - Common Stock Analysis), Benjamin Graham stated, "it is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable, rather than dilute your results to a mediocre figure, merely for diversification's sake. But this is not done, because it cannot be done dependably" (emphasis Graham's). Identifying those high-growth companies after the fact is pretty easy, before the fact not so much. But identifying the dependable dividend growth companies doesn't require trying to determine them before the fact. They've already demonstrated the dependability. Whether it's the S&P Dividend Aristocrats or on David Fish's List as shown here, they've already declared their intentions by their consistency.
The second part of the retaining the earnings argument leads to the question of whether management will use the proceeds more wisely than paying dividends. This requires certain assumptions on the part of the individual investor and at best is a guess. The Arnott & Asness study stated that many CEOs will utilize earnings for empire building, which is not necessarily bad, assuming the empire building is in the best interests of the owners of the company. But some of these attempts at empire building result in getting the company outside of its area of expertise and end up blowing up in the company's face, such as Microsoft (NASDAQ:MSFT) purchasing aQuantive and later taking a $6 billion charge. To paraphrase the late Senator Everett Dirksen $6 billion here and $6 billion there and pretty soon you're talking real money. Some may say that if one doesn't trust management then don't invest in that company. While investing in a company implies belief the company will be successful going forward, it doesn't necessarily require 100% faith in management or to assume their decisions will always be correct. That's why we use the expression "buy and monitor."
Company management will sometimes purposefully make decisions and take actions that aren't necessarily in the best interests of the owners. The Wall Street Journal recently published this article that indicated CFOs often use accounting ruses to report earnings that don't fully reflect the companies' underlying operations. The survey of 169 CFOs indicated that about 20% of them fudge the numbers by about 10%. Why would they do that? 93% of them said that it was to influence the stock price. I can think of a number of reasons they would want to influence the stock price and not all of them to the benefit of the individual owner. Share buybacks can be used to fudge earnings numbers or reduce the impact of stock options issued. I am not trying to be critical of management in general. I think there are a number of sincere CEOs and other executives who run companies with the best interests of stockholders at heart and are very good at their jobs. But there are also a number who are primarily concerned with feathering their own nest and doing what's in their own best interests. They are subject to the same human frailties and emotions as all of us, including fear and greed. Mistakes can and will be made. Identifying these up front is not always easy or even doable. It requires an investor to maintain a keen eye on their investments.
Another frequent derogatory comment is that dividend growth investors don't care about total return. This is simply ridiculous. Total return is one thing that every investor is concerned with, but with dividend growth investing it's not the over-riding concern, especially a short-term concern. By focusing on building the income stream and making sure it's growing, market fluctuations that can lower total return one year and increase them next year won't drive the dividend investor out of their positions. By investing in solid dividend-paying companies dividend growth investors get total return benefits along with their dividends. As the above links show, you can have your dividends and your capital appreciation, your cake and your icing. It's a both/and proposition, not an either/or.
Dividends don't make a company good. The company is good because it generates enough revenue to distribute profits back to the owners on a regular and continuing basis, and doesn't put itself in a hole doing so. And even though a company pays a dividend there is no guarantee the company always will, nor does it mean the company itself is a good investment. I hold McDonald's (NYSE:MCD) as one of my dividend growth companies. It's paid an increasing dividend for 36 years, growing them at a 20.4% clip over the past five years. I believe it's a solid quality company. But it recently missed an earnings estimate by about $.04 per share and has garnered a lot of negative publicity from naysayers concerning its future. Whether it's a McDonald's or a Microsoft, I am still required to do my due diligence to make sure that I am investing in quality companies, companies that will continue paying me my portion of the profits. Benjamin Graham believed the payment of dividends was a requirement for including a company in an investor's portfolio. He said, "One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test" (Chapter 11 - Factors Affecting the Capitalization Rate).
I am a dividend-growth investor because it meets my goal of building a steady stream of income. Whether it is better or worse than another method cannot be determined without considering the purpose, goals, time frame, emotional discipline, temperament, and other factors of each investor. It doesn't mean other methods won't work, that other methods should be completely disregarded, or that it's the best for everyone. Maybe those critics who deride dividend growth investing think they are trying to be helpful, maybe they have good intentions, or maybe they simply know how to increase page views. Regardless, dividend growth investing works and if done correctly, works well. But keep in mind, it's called dividend growth investing, not dividend trading. Nevertheless, call it what you will, dividends are money in the bank.
Personally, dividend growth investing helps me deal with the stress of ever changing market environments. By focusing on building a growing income stream along with being a defensive investor concerned with protecting established positions, I am able to sit still with the confidence that the companies in which I'm invested will continue paying that growing income stream. Being invested in quality companies with a sound history of paying growing dividends helps with market volatility and allows me to understand that fluctuating market prices can be taken advantage of or ignored.
I like dividend growth investing because as an owner of a company I like getting my profits returned to me on a regular basis. This allows me to reinvest that income to reduce my cost basis, acquire ownership in other companies, reduce the amount of capital I have at risk, use it for living expenses, or simply increase my Christmas music collection. Like the song says, "Santa can't bring me what I need, cause' all I want for Christmas is my dividend."
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.