Dividend Growth Investing is my preferred investment strategy. I've used this strategy extensively to build up my own dividend income stream over the years. However even more beneficial than the passive dividend income which I have been able to accumulate, a focus on dividends has enabled me to reduce several bad investing habits.
Avoiding buying high and selling low
Negative reactions from Mr Market typically send investors scurrying for the exits. During the depths of the declines in 2009, investors were abandoning stocks and heading for the safety of bonds and cash. Dividend stocks were not spared during the declines. Many of the most stable dividend payers, such as The Coca Cola Company (NYSE:KO) and Colgate Palmolive (NYSE:CL), also experienced significant declines. Coca Cola fell almost 25% during 2008, while Colgate Palmolive was down some 10%.
The declines in the stock prices of both companies were not indicative of any problem in either of the underlying businesses. The operating cash flow of both Coca Cola and Colgate Palmolive actually increased during the 2008-2009 period. In Coca-Cola's case, operating cash flow increased 8% between 2008 and 2009, while for Colgate operating cash flow increased almost 45%. In addition to the improvements in the their respective core business, both Coca Cola and Colgate managed to increase their respective dividends over the period. Between 2008 and 2009, Coca Cola's dividend increased almost 10%, while Colgate increased its dividend around 10% also.
In both cases, the market overreaction actually increased the effective yield on offer. In the case of Coca Cola, market overreaction increased Coca Cola's yield to almost 4%, significantly higher than its 5 year dividend yield average of 2.9%.
Dividends tend to provide a major contribution to total return during bear markets. In fact, this can be as high as 70% during particularly bearish periods. Given this, it is no surprise that dividend stocks tend to hold up well during even particularly bearish periods as investors look to the comfort of the dividend income provided by dividend payers. This was true in the case of both Coca Cola and Colgate during 2008-2009. The stock price of Coca- Cola only declined some 24% during 2008, while the stock price of Colgate only declined some 11% in 2008. In both cases, performance was favorable compared to the overall decline in the S&P 500 of 37% for 2008.
The fact that both the Coca Cola's and Colgate's stock prices held up relatively well makes it less likely that an investor would be forced into panic selling and would feel the need to offload their stock at low points in valuation. Rather, given the fact that an investor could get a higher income return from the business, makes hese stocks more attractive. So rather than looking to panic and sell during the market collapse, I took the opportunity to purchase additional Coca-Cola stock during 2009. Coca Cola is up some almost 80% from the levels it was trading at during its low point in 2008. By focusing on dividend income and company cash flow, an investor can actually be driven to buy low and achieve greater dividend income in the process.
Eliminates the need for frequent trading and chasing returns
Having a focus on generating a rising stream of dividend income helps minimize my need to frequently trade in and out of a stock to chase returns. Not only does this save me significant transaction costs, and commissions that I would otherwise be paying, but it also gives my capital time to compound and allows my dividend income to increase. In order to generate significant total returns, giving your investments the time to compound over a significant period of time certainly helps.
Johnson & Johnson (NYSE:JNJ) is a good illustration of this. In 1987, JNJ stock was trading at around $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. 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.
The Ultimate Dividend Playbook makes a compelling case for why a dividend stocks long term return will be a combination of the initial dividend yield in addition to the long term growth rate of that dividend. Assuming that the long term growth rate in the dividend proxies earnings growth, an investor should be able to determine the total return that they will be able to generate from a dividend stock.
In the case of General Electric (NYSE:GE) for example, General Electric generated a compound total annual return of 11.6% per annum from 1955 to 2006. During this period, General Electric had growth in dividends of 8.3% per annum with an initial yield of just over 3%. Similarly, growth in General Electric's earnings had been 8.6% over the period.
Almost all of General Electric's total return from 1955 to 2006 can be explained by its initial yield and growth in earnings and dividends. General Electric's total return performance over the period comfortably exceeded the 9% long term return in the Dow Jones Industrial Average . This suggests limited need for an investor to try and chase return where an investor can identify a company with an initial yield and expected earnings and dividend growth that would provide a return which exceeds long term market returns.
In my case, this has meant looking to purchase and hold dividend stocks with modest initial yield and consistent earnings and dividend growth. If selected well. this should mean not having to worry about timing the market or trying to and chase market returns and the latest market trend.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.