Why Dividend Growth Is My Investment Strategy

Includes: JNJ, MCD
by: Integrator

Dividend growth investing has been my preferred method of investing for the last 10 years. I specifically want dividend growth companies in my portfolio rather than just dividend payers. These are the companies that can increase dividends over the long haul at least 5% per annum or more. There are 10 key things for me that make dividend growth investment my strategy.

Capital preservation - Not losing any of my investment capital is my Rule No 1. If I have my money in a business that is paying increasing dividends, it is also likely that the business is growing earnings and increasing cash flow. In order to consistently increase earnings and dividends over a long period time, it is highly likely that the business has some sustainable competitive advantage and unique value proposition. In my opinion, I'll have the best chance of preserving my capital if I have it sitting in a business with strong barriers to entry and good cash generation. Businesses like McDonald's Corp. (NYSE:MCD), The Coca-Cola Company (NYSE:KO) and Procter & Gamble Co. (NYSE:PG) have solid brand and business advantages that I expect to continue indefinitely. This makes it incredibly likely that your capital will not only be safe in these businesses, but will grow over time as these businesses increase their earnings.

Accelerated independence - I started dividend growth investing in my 20s primarily with an aim of becoming financially independent by the time I was in my 40s. The focus here was on having a diversified income source that would provide expense coverage, not necessarily income replacement. While I'm not there yet, the Integrator $50k fund delivers almost $27,000 in annual dividend income and is well on the way to providing full expense coverage. This creates the freedom to pursue other opportunities, irrespective of monetary return.

Dividend growth stocks create wealth - There's endless debate about whether earnings growth, and hence dividend growth, leads to an increase in net wealth. I fall into the camp of those who believe that the two are related. In my opinion, dividend growth leads to an increase in the stock price over time. A greater cash return from a stock where the risk return tradeoff is unchanged creates greater demand for the stock and a desire to capture that higher cash return. This has the effect of pushing up the price of the stock over time. The Single Greatest Investment by Lowell Miller makes a well argued case for why this is so in my opinion.

Johnson & Johnson (NYSE:JNJ) is a good illustration of this. In 1987, JNJ stock was about $3.00 and the stock paid out about $0.10 in dividends for a 3.3% yield. Fast forward to 2012 and JNJ pays out about $2.45 in dividends. Its stock price? $70.00. Its approximate yield? 3.5%. Not only have JNJ investors been handsomely rewarded with consistent income being paid out to them over time, they have much greater wealth to show for their troubles.

Dividends provide a major contribution to total return - Research suggests that reinvested dividends provide close to 50% of the total return of stocks since the 1930s. What's less obvious is that during major bearish markets such as the 1940s and 1970s, the contribution of dividends to total return can be as high as 70%. Given that bear market cycles are a fact of life, having a contribution from dividends can reduce the likelihood that you experience long periods of excessive negative return and in fact, help create a positive contribution to total return over long periods of time.

Tax advantaged - Dividend income is tax advantaged versus earned income, and significantly so. I'm not just talking about the concessional rate of 15% on qualified dividends. Additional taxes including FICA (social security taxation) as well as Medicare Taxes can remove close to 7.5% of every dollar of your earned income. There is generally no FICA or Medicare Tax payable on income from dividends (although there is a newly introduced Medicare tax of 3.8% on investment income where your income exceeds $200,000). This leaves you with significantly more in your pocket compared to earning that same income from wages or salary income.

Invest in markets without needing fresh capital - When I started investing, I didn't have excess capital, so I would reinvest some dividend income to ensure new investments without needing to come up with new funds. The advantage of a growing dividend stream is that you can still withdraw some dividend income to cover your fixed expenses, with the surplus dividend income being reinvested back into the market.

Keep pace with inflation - I want a real return on my income. A company whose dividends fail to keep pace with inflation is actually creating a decline in my effective purchasing power. The same income effectively buys me less over time if it doesn't increase. A growing dividend gives me an income stream that creates an increase in my purchasing power.

Good corporate discipline - I expect companies that have the capacity to pay growing dividends to have defensible moats and solid barriers to entry. That gives these companies the capacity to pay dividends.

The interesting thing is that once dividends are paid, companies are reluctant to even cut their dividends, let alone get rid of them. Doing so would send a strongly negative signal to the market. This makes it more likely that dividend paying companies will exercise good corporate discipline to ensure there's no excessive or imprudent spending. This will enable a focus on cash generation such that they can continue to pay out increasing dividends to investors.

McDonald's Corp provides an excellent illustration of a dividend paying company with great cost containment and expense management. While operating in an extremely cost competitive industry, McDonald's razor sharp discipline has resulted in sustained operating margin improvements over a ten year period from 14% in 2002 to close to 30% today. McDonald's investors have been similarly rewarded, with dividends increasing from $0.24 in 2002 to almost $2.80 in 2012.

Early warning signals - Slowing dividend growth provides an early warning signal into the health of a business. It can indicate changing consumer tastes, competitive pressures, and a breach of a corporate moat. When your dividend growth slows, you are more motivated to investigate the factors for the slowing growth and take early action with respect the stock than you otherwise may. Slowing dividend growth can also be an early warning sign of an impending dividend cut.

Johnson & Johnson, while an excellent dividend payer historically, has experienced a dramatic slow down in dividend growth rates in recent years. This could be a pointer of things to come. Historically, Johnson & Johnson consistently had dividend growth rates which exceeded 10% per annum. Dividend growth rates in the last couple of years have dipped to just above 6%. Payout ratios have dramatically increased from under 40% to close to 65% in 2012. These factors contribute to some questions about how strongly Johnson & Johnson will be able to increase dividends going forward

Reduced impacts from stock volatility - Having a focus on my dividend income allows me to ignore market fluctuations in stock prices from events that have nothing to do with the underlying business. Threats of war, changes of presidents and the hustle and bustle of politics don't concern me. Provided my dividend income remains constant, my focus remains on the dividend return from a stock as opposed to the price it happens to trade at.

While I believe that all of the above are strong rationale for why dividend growth investing makes sense, the strongest data point for me is the indisputable evidence of a steadily increasing stream of dividend income that gets deposited to my bank account year after year. That's something which is incredibly difficult to ignore.

Disclosure: I am long MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.