Ted Williams, also known as "Teddy Ballgame" and "The Splendid Splinter", was one of the greatest baseball players of all time. He was considered by many to be the greatest hitter who ever lived, with a career batting average of .344 and 521 homeruns. The last player to bat over .400 in a season when he hit .406 in 1941, Williams once said that there were three rules of hitting. A player would have to abide by these if he wanted to be successful. I have found that these same rules can be applied to investing in solid dividend growth stocks. Like batting, investing requires discipline, preparation, and timing.
The 3 Rules
Rule 1 - Get a good pitch to hit
The first rule of hitting is get a good ball to hit. Williams had a chart of the strike zone, containing pitch locations in which he would be most and least successful. These "happy zones" as he called them, translate to the dividend stocks that give investors the highest chances of solid returns and dividend growth. Another legendary player, Ty Cobb, once said that Williams "demands a perfect pitch". By setting very high standards and not investing outside of comfort zones, investors greatly swing the odds in their favor. Even lots of preparation and good timing will not help if an investor has decided to invest in an inferior company.
Rule 2 - Proper Thinking
To Williams, this meant knowing each and every pitcher he was going up against and not letting the same pitch beat him twice. To investors, this can mean one of the more time-intensive tasks. Do your research in evaluating the fundamentals of the company before and after you invest. Learn from your failures and try not to make the same mistakes twice. With dividend growth stocks it is important to look for warning signs such as an increasing payout ratio, decelerating earnings growth, and changes in projected future demand. Although he loved to hit, Williams was not afraid to draw a walk because he realized that was a better option than chasing a bad pitch and striking out. Investors should have the same mindset.
Rule 3 - Be quick with the bat
The last step comes only after the first two have been accomplished. I believe every investment should be made with a long-term horizon in mind. However, it may be necessary to react swiftly due to changes in the fundamentals of companies that you own. For example, if a company that I owned failed to raise its dividend when expected I would most likely sell immediately and replace it with another. A dividend freeze in a company with a long streak of hiking the payout is a very bad sign and usually a signal to move on.
The Hitting Chart and "Happy Zones"
Williams created a chart that predicted what his batting average would be if he saw a pitch in any location. He believed he would successfully get a hit on about 39% of pitches over the middle of the plate at an ideal height, what he referred to as his "happy zone". These odds are much better than they would be if a pitcher could consistently paint the outside corner and force him into only a 23% success rate. It shows how important pitch selection was in his success as a hitter, as he would have struggled to be even an average player with poor plate discipline. Similarly, investors can wipe out big gains in a portfolio by picking a few "bad pitches".
I have created my own chart similar to Williams', this one relating to Yield on Cost (YOC) in dividend growth investing in order to determine my dividend "happy zones". YOC is simply the current annual dividend an investor is receiving, divided by the cost basis for that investment. YOC a useful metric for seeing how income has increased since the initial investment. It is important to note that YOC and current yield will steadily diverge in dividend growth stocks. Here is an example comparing YOC to initial and current yield.
Although the stock is only currently yielding 4.78%, the lower purchase price and increased dividend make for a YOC of 5.5%. What is amazing is that some investors who have invested in great companies many years ago may now be receiving over 100% Yield on Cost. I have created the following chart to show how many years it will take an investor to achieve a 40.6% YOC, using initial yields and annual growth rates. The 40.6% Yield on Cost is simply an arbitrary amount meant to match Teddy Ballgame's career high batting average, and will vary based upon the type of investor. A younger investor may hope to gain a 50% YOC at some point in the future, while a retiree may want a higher yield and be less concerned about growth. In reality, it is impossible to fully predict the future dividend growth of a company, but the chart will show the importance of dividend growth in achieving high YOC.
The following formula can be used in Microsoft Excel to determine the years required to achieve any specific YOC:
=LOG (Desired YOC/Current Yield, (1+ Expected Growth Rate))
The chart above shows the best possible combinations for reaching the 40.6% YOC rate without dividend reinvestment. It is clear without the visual that a stock yielding 3% with a 7% growth rate will reach a higher YOC than a stock yielding only 2% with the same growth. A more interesting comparison would be the stock yielding 2% with a growth rate of 10% gaining a YOC of 40.6% faster than a stock yielding 5% only growing at 6%. The flaw with this graph is that it ignores the greater income received initially from the higher yielding stock, which could be reinvested to compound growth. The following chart takes annual reinvestment into account, showing the years needed to achieve an annual RYOC of 40.6%. It assumes that stock prices increase by 75% of dividend growth, only slightly raising yield as the company matures.
Look at how much bigger the "happy zones" have become just because of reinvestment. From this RYOC graph, we can see that it would take about the same amount of time for the total income from a stock yielding 2% growing at 10% to surpass another stock yielding 4% growing at 5%. The number of years required to gain a higher YOC is much lower than the previous chart, which is why I choose to reinvest my dividends. Dividend reinvestment allows investors to take advantage of compounding, which greatly accelerates returns. I have labeled my "happy zones" like Williams and aim to select those stocks that will give me the best chance to succeed in my dividend income goals in the future.
Suppose an investor was going to invest $10,000 in one stock and wanted to estimate how many years until he or she would be receiving a 25% YOC, or $2,500 annually in dividends without reinvestment. The investor considers two companies with incredible streaks of raising dividends, Johnson & Johnson (NYSE:JNJ) and Wal-Mart Stores, Inc. (NYSE:WMT). It may initially seem that JNJ would be the better option for generating future YOC with its 3.2% yield, greater than the 2.3% offered by Wal-Mart. However, the trailing 5-year DGR for Wal-Mart is 13.5% while JNJ's is only about 8%. I will use these to project 8% and 5% DGRs going forward. Plugging into the formula above, we can calculate that, without reinvestment, WMT will reach a 25% YOC in about 31 years, compared to over 40 for JNJ.
If the investor chooses to reinvest dividends, however, the result will be different because of JNJ's higher initial yield. WMT will now reach a YOC of 25% in about 23 years. JNJ, with its higher initial yield, will now reach the same YOC in a similar amount of time. This is where it is up to individual preferences to determine an ideal investing strategy. I plan on sticking to my "happy zones" when selecting dividend growth stocks in which to invest because I feel that it gives me the greatest chance to succeed.
Disclosure: I am long JNJ, WMT. 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.