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Dividend growth investing, long-term horizon
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Introduction

The start of a new year is a time when many investors evaluate how they did during the previous year. The purpose of this article is to review my investing performance in 2012, which was the first full year in which I followed a dividend growth investing strategy.

Dividend growth investing involves buying the stocks of companies that consistently pay and grow their dividends, then reinvesting those dividends to produce compounding of the dividend income stream. I consider it to be a sensible approach that can work well for investors of all ages, but especially those with long time horizons, such as myself (I recently turned 31 years old).

My primary goal as a dividend growth investor is to create my own dividend growth machine, a diversified portfolio of stocks that produces a sustainable and rising dividend income stream that handily beats inflation over time. My secondary goal is to achieve a satisfactory total return on my investments, regardless of what happens in the market. As discussed in my very first article on Seeking Alpha, I prefer to define my investing success in terms of dividends, not whether I "beat the market" in a given year.

In the following sections, I review how my dividend growth machine fared in 2012. I will be presenting actual results from a real portfolio involving real money.

Input To The Machine

In a previous article I showed how regular investment of new capital can help accelerate the growth of a dividend income stream. New capital represents the input to my dividend growth machine and allows me to buy dividend-paying stocks. Where does new capital come from? It reflects savings of my job income, which can be achieved only by living below my means. I naturally live a relatively frugal lifestyle that allows me to save and invest a considerable portion of my modest job income. The figure below shows the percentage of my net job income that I saved each month during 2012:

There was some variability across months due to occasional travel expenses and a few annual and semi-annual expenses, but I managed an average savings rate of 48%. For comparison, the figure also includes data from the St. Louis Fed regarding the average monthly personal savings rate in the U.S., which hovered between 3% and 4%. Thus, I achieved savings that were an order of magnitude greater than the national average, which provided me with over $17,000 in new capital for investment in my dividend growth machine.

Parts Of The Machine

Dividend growth stocks represent the parts of my dividend growth machine. I aim to invest in the stocks of companies that have the following characteristics:

  • A history of paying increasing dividends for many consecutive years, preferably at a rate that exceeds inflation.
  • Solid financials for operating the business and paying a dividend, as well as revenue and earnings growth that will support continued dividend growth.
  • A stable and sustainable business that I can understand, preferably one with an economic moat, high switching costs, strong brands, or similar competitive advantages.
  • A stock that is priced at a discount to its estimated intrinsic value or is at least fairly valued.

The table below shows the composition of my portfolio at the start and the end of 2012:

(click to enlarge)

I started the year with 16 stocks, which reflected purchases made in the summer and the fall of 2011 as I transitioned to 100% dividend growth stocks. These stocks include several well-known names such as Abbott Laboratories (ABT), Chevron (CVX), Johnson & Johnson (JNJ), Procter & Gamble (PG), and AT&T (T).

During 2012 I used new capital and dividends to make a total of 19 purchases, all of which were discussed on my blog at the time they occurred. Some of these purchases were increases to existing positions, such as General Mills (GIS), McDonald's (MCD), and Norfolk Southern (NSC). Several purchases initiated new positions in stocks such as Cummins (CMI), Hormel Foods (HRL), and Intel (INTC). By the end of the year, my portfolio had increased from 16 to 25 stocks.

I did not sell any stocks in 2012, so there was no portfolio turnover. This reminds me of a great quote from Seeking Alpha author Chuck Carnevale, who said "a portfolio is like a bar of soap; the more you handle it, the smaller it gets." As part of my investing strategy, I try to minimize portfolio turnover and other "frictional" costs of investing. Related to that point, I try to keep transaction fees to no more than about 0.5% of my total cost, and I had a 0.54% ratio in 2012.

Part of my investing strategy also involves monitoring the operating results and the dividend increases of the companies in my portfolio. For the sake of brevity, I will not summarize the operating results for 2012, but the figure below shows the distribution of dividend increases that took effect during the year:

There were dividend increases for 24 of the 25 stocks in my portfolio, with the lone holdout being Archer Daniels Midland (ADM). The mean increase was 10.4%, the median was 8.5%, and 12 companies had double-digit percent increases. Given that dividend growth is a vital characteristic of my investment machine, I was pleased by these numbers.

More generally, I was satisfied with the state of my portfolio at the end of 2012, so little in the way of change was planned for the new year. The only change that was under serious consideration was a potential sale of ADM, for a few reasons:

  • No dividend increase was announced in 2012, which was disappointing.
  • The drought made me realize just how volatile the company's earnings could be.
  • I had not noticed until after buying the stock that ADM has a history of occasional negative free cash flows, which is a bad sign.
  • I questioned whether their attempted acquisition of Australian-based GrainCorp was prudent.
  • I determined that I could find better investment opportunities with more earnings stability, consistently positive free cash flows, and higher yields.

Soon after the new year began, I sold all my shares of ADM for a negligible positive total return. It is noteworthy that I went all of 2012 without a sale and then I started off 2013 with one. However, no other sales are planned at this time. Some readers might be wondering about Abbott Laboratories, which split into two companies at the start of the year (ABT and ABBV). I know some dividend growth investors sold pre- or post-split, but I decided a while ago that I would hold both companies.

Output Of The Machine

Dividends and capital gains represent the output of my dividend growth machine. I selectively reinvest all dividends by combining them with new capital, in part because I consider selective reinvestment to have certain advantages, as discussed in this article. I noted earlier that my primary investing goal is to create a sustainable and rising dividend income stream. The figure below shows the dividends I received in each quarter of 2012:

There were nice increases in dividends from one quarter to the next, and by the end of the year, I had received a total of $1,649.63. Most of my dividends were paid on a quarterly basis, but Vodafone (VOD) pays semi-annually and Novartis (NVS) pays annually. In addition, a few stocks accelerated their Q1 2013 dividends into late 2012 due to concerns about tax increases tied to the fiscal cliff. Overall, I was pleased with the growth of my dividend income stream, and by the end of 2012 my forward 12-month dividend total stood at $2,084.

I also noted earlier that my secondary investing goal is to achieve a satisfactory total return. The portfolio table (see above) shows that my portfolio's value increased by 52%, from $42,830 to $65,137. The figure below shows the change on a monthly basis:

As can be seen, my portfolio's value increased at a steady rate during the year. Of course, the bulk of the increase (82.0%) was due to investment of new capital from savings, highlighting its importance. The rest of the increase came from capital gains (10.6%) and dividends (7.4%). Overall, I was satisfied with the total return of my dividend growth machine in 2012, especially considering that I purchased several undervalued stocks that remain undervalued, thereby increasing the potential for future gains.

Outlook For 2013

I expect my dividend growth machine will keep humming nicely during 2013. I have not planned any major changes to my portfolio or to my investing strategy because they both seem to be working fairly well. I will continue to initiate new positions or add to existing positions when valuations make it prudent to do so. Based on my current savings rate, I expect to make one purchase per month, although that will likely change in the second half of the year. I have been fortunate to get a new job that starts in the summer and will pay me a substantially higher salary than what I get at my current job. As a result, I expect a boost in my savings, which implies more new capital for investment. I am excited about the prospect of accelerating the growth of my dividend income stream going forward.

Source: A Real Dividend Growth Machine: 2012 Review