Dividend Growth Strategies For Younger Investors - Part 2

Includes: AXP, JNJ, KMB, KO, MA, MCD, MCO, PEP, T, V, VZ
by: Integrator

In a previous article on Seeking Alpha, I had written of the benefits to younger investors of a dividend growth strategy in growing dividend income and wealth. This is a strategy that I am hoping to use myself to reach an early financial independence, with a near-term goal of $50k/yr by 2018 in dividend income.

In the article, I had suggested that younger investors have the significant advantage of a long time horizon to invest. This means that even some wide moat companies with smaller current dividend yield, but higher dividend growth should be suitable for younger investors to invest in. Younger investors can afford to wait for the dividends of such companies to be raised significantly over the years as these companies mature, and enjoy strong capital growth and total return in the mean time. This investment strategy could apply to companies such as Visa (NYSE:V) and Mastercard (NYSE:MA) for instance.

However I suggested that the core of any dividend growth portfolio for a young investor should still consist of moderate yielding stocks of around 3% with reasonable dividend growth to really help drive dividend income.

I received some very well considered feedback from the Seeking Alpha community on that article in general, and there was one comment in particular that caught my attention. The substance of that comment was that younger investors in particular would be better served by having much more of their portfolio in more stable, higher-yielding stocks, with lower-yielding, higher-growth dividend stocks kept to a minimum in the early years, and possibly even avoided in the early years.

I share the view that lower yield, higher growth dividend stocks would be used to simply "round out" a younger investors dividend growth portfolio and would be a small minority of the overall portfolio. In fact, it's arguable that in the first few years of investing, a young investor could actually be well served by bypassing these low yield, high dividend growth stocks entirely.

While this may seem counterintuitive for younger investors with long-term investing horizons, the reason for this comes down to the reasonable certainty of return from a dividend stock with higher yield, versus the more uncertain return from capital growth that lower yielding dividend stocks are dependent on. This is a return that is highly reliant on "Mr Market's mood."

Companies like McDonald's (NYSE:MCD), the Coca-Cola Company (NYSE:KO), Pepsi Co (NYSE:PEP) and Kimberly-Clark Corporation (NYSE:KMB) all offer dividend yields of near 3% or more. For investors in these stocks, dividend return contributes a significant amount to the total return that an investor derives. Further, an investor is able to accelerate their investment growth and dividend income by reinvesting that dividend income over time.

In contrast, stocks like Visa, MasterCard, American Express (NYSE:AXP) and Moody's (NYSE:MCO), which have provided reasonable dividend growth over time are far more reliant on strong capital returns to generate total return for investors. These stocks all offer dividend returns of 1.5% or less.

The significance of such a strong contribution from dividend income to a investment return should not be understated. Dividend income makes a significant contribution to a stock's total return and can form the basis for close to 50% of a stock's total return on average, and even more so during periods of poor stock market performance.

Additionally, the impact that reinvestment of dividend income makes on a portfolio return should not be overlooked. Consider the example of an investor who had invested in McDonald's 10 years ago. An investment of $10,000 in McDonald's without dividend reinvestment would be worth close to $66,000, and provide you with an annual dividend income of almost $1800. An investor who had reinvested McDonald's dividends back into McDonald's stock would have an investment value of almost $73,400 and an annual dividend of almost $2500.

The power of dividend reinvestment on investor wealth creation can really be seen over a very long term time period. An investor in The Coca-Cola Company who invested $10,000 about 50 years ago would have had a stock value of almost $500,000. If you think that's impressive, consider the scenario where those dividends were reinvested. That same investor would have almost $1.75M in stock investment in The Coca-Cola company.

So younger investors who are able to stick with a long-term plan and reinvest their dividends over the long term will be significantly advantaged in terms of both capital growth and dividend income. Of course this assumes that they retain the conviction and discipline to stick with such a strategy over many years. It doesn't take much to knock this confidence away, such as devastating bear market or recession of the likes that we saw in 2008 - 2009.

The key with any investment strategy is that you can you stick with it long enough to make it work and see the returns. This is where higher yielding, but possibly slower dividend growth stocks should be preferred in a younger investor's portfolio. While companies such as a Verizon (NYSE:VZ) or AT&T (NYSE:T) may not have the high growth, high return profile of a Visa or MasterCard, a young investor in these types of businesses is getting the advantage of a stable, reliable dividend from a company, which can be reinvested and put to work.

Verizon and AT&T pay out hefty dividends in the range of 5% and also experience less volatility than the broader S&P 500. In other words, higher-yielding stocks give you an incentive to stick around and give the dividend growth strategy time to work. You get paid to wait, even if there isn't any immediate capital appreciation for some time. Additionally, investors in higher-yielding stocks such as Verizon have experienced handsome longer-term returns; for investors in Verizon close to 9% per annum over the last 10 years.

Not only do you get paid to wait, but more importantly, higher-yielding stocks help provide a buffer against considerable market fluctuations. They help make it less likely that downturns in the market will result in younger investors getting scared by volatility and selling out. This is because these higher-yielding stocks can still generate considerable total return purely from the contribution of a high dividend, in spite of the general turmoil that may be happening in the stock market.

Verizon, for example, has a beta of only 0.45, meaning it moves approximately half as much in price as a general move in the market. Similarly, McDonald's has a beta of just 0.4. Thus when the market takes a precipitous dip Verizon and McDonald's don't dip as much, in general. For a younger investor, reducing the amount of tension and stomach churning when establishing a portfolio can be very important in the early years to provide confidence to develop and stick to a strategy.

In 2008 for example, as the S&P 500 went into a nosedive and dropped 37%, Verizon stock not only outperformed the S&P 500 in terms of stock price performance, but in addition still managed to pay out a 5.4% yield, which may have provided a strong enough reason for a young investor to hold onto a stock. McDonald's actually eked out a positive 8% stock return, and provided a 3% yield during that same time period in 2008. In fact, McDonald's stock outperformed the S&P by almost 45% in 2008. No doubt the attraction of investors to the substantial dividend yield in both of these cases provided some basic support for these higher-yielding dividend stocks.

The advantage to younger investors of a higher-yielding stock is they don't need to make bets on capital growth. They don't need to pick which stocks will experience strong capital returns and how quickly such stocks will be rewarded by the market. An investor who had invested $10,000 in Johnson & Johnson (NYSE:JNJ) stock five years ago would have only seen their stock appreciate to approximately $12,000 for an annual return of approximately 4% per annum. That doesn't seem like a great return on the surface.

However, capital growth alone doesn't tell the whole story for a Johnson & Johnson investor. With an effective annual dividend of close to 3.5% per year that was paid to investors over the last five years, a $10,000 investment in Johnson & Johnson would actually be closer in value to $14,000 today, or almost 8% per annum once dividends are factored in to the return.

Lower-yielding, higher-dividend growth stocks can always be added over time by a younger investor once they have gained the confidence with the vagaries of how Mr Market operates and once they have been able to observe for themselves how dividend growth investing creates income and wealth.

Till then, it's hard to go wrong with higher-yielding dividend stocks that pay reasonable dividend returns that can be reinvested, and which generate less volatility than the market in general. This will help provide the conviction to stick to a dividend growth strategy and understand the power of your dividend machine. One can always supercharge the machine with lower-yielding, faster-growing dividend stocks over time.

Disclosure: I am long MCD, MA, V. 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.