Dividend Growth Investing: Myths 11-15

Includes: AHGP, DRI, INTC, VIG
by: David Van Knapp

Last year I wrote two articles about myths in dividend growth investing. Interest was high; the articles generated more than 600 comments combined. Since then, a few more myths have turned up. So as a public service, let's put them under the microscope.

To reset ourselves, here are Myths 1-5 and Myths 6-10:

  • #1: The only sensible goal in investing is total return
  • #2: Dividend growth investors don't care about total return
  • #3: Income from "selling a few shares" is the same as dividends
  • #4: Dividend growth investors think they have found a free lunch
  • #5: Each dividend growth stock must maintain its performance for 30 years
  • #6: You need more money to live off of income than withdrawals in retirement.
  • #7: Dividend growth investors don't care about current yield, they only care about yield on cost.
  • #8: Dividend growth stocks are all large-cap U.S. stocks concentrated in a few industries, therefore a dividend growth portfolio lacks diversification.
  • # 9: The S&P 500 is a good proxy for a dividend growth stock portfolio.
  • #10: Dividend growth investors select stocks based only on yield; dividend growth investing = high-yield investing.

Myth #11. Dividend growth investing does not involve analyzing individual stocks

The falsity of this myth seems so obvious that it should not need to be highlighted, but one runs into it again and again. Usually the way it comes up is when a trained investment advisor, steeped in the principles and traditions of Modern Portfolio Theory (MPT), comes onto an income-oriented thread and criticizes the dividend growth strategy based on broad statistics derived from ETFs, academically selected groups of stocks created for statistical analysis, or general market performance.

The first time I saw this myth was a few years ago, when I first started writing about dividend growth investing. Here's how it was stated: "2008 proves that dividend investing does not work." That was the extent of the analysis. Apparently what was meant is that stocks experienced a general price failure in 2008, so therefore investing in dividend stocks was not a good idea.

More recently, a commenter on my original "myth" article purported to show that dividend growth stocks do not outperform by citing a study that showed (according to him) that the a fake portfolio made up of the top quintile of dividend growers, reconstituted at the end of each year since 1981, failed to outperform the S&P 500 over the study period.

Most dividend growth investors pick stocks individually. That comes as a shock to some of the critics, who believe that stock-picking is incredibly dangerous. But it is through stock-by-stock analysis that dividend growth investors select the cream of the crop, the true stalwarts that reliably deliver growing dividends year in and year out. The ivory-tower statistical subsets of stocks do not represent any dividend growth investor's actual portfolio or experience.

Do some stocks turn out to be stinkers? Absolutely. But veteran dividend growth investors have learned that if you diversify sufficiently to reduce the impact on your portfolio of any single blow-up, and if you choose your stocks carefully based on fundamentals, value principles, and dividend track records, the income from your whole portfolio will not blow up. Instead, it will go up steadily each year. Average annual increases of 6% to 7% or more are not unusual.

What is unusual is a decrease from one year to the next across a whole portfolio. Some experienced dividend growth investors have never experienced such a decrease, not even in 2008 or 2009. I started in 2008, and I have never come close to having a year-over-year decrease in dividend flow.

A corollary to this myth is that when it is invoked, the critic invariably uses total return as the metric of interest (see Myth #1). While some dividend growth investors do look to total return as their central goal, and most are at least moderately interested in it (see Myth #2), many or most are simply trying to build an income stream that will be sufficient for retirement and grow faster than inflation.

Most in the dividend growth community have learned by now how to respond to critics who try to change the playing field from income to total return. It used to be a subtle tactic, but nowadays it usually stands out like a sore thumb and is evident immediately.

Myth #12. You can replicate a good dividend growth strategy with ETFs.

In a series of articles last year (1, 2, 3), I studied eight of the largest and most prominent "dividend" ETFs. These were my conclusions as stated at the end of the third article:

  • I found no dividend ETF that could or should be used as a proxy for dividend growth investing when making comparisons to other stock investment strategies.

  • Individual, careful stock selection (including due diligence on company fundamentals) beats shotgun approaches based on dividend characteristics only.

  • Attentive management (buy and monitor) beats passive index-following.

  • The flexibility to react to events as they happen (such as dividend cuts) beats annual portfolio reconstitution.

Finally: The ETF companies don't "get it" about dividend growth investing. On the websites I examined, performance was presented primarily or exclusively in terms of total returns. While distributions were dutifully reported, none of them highlighted dividend returns or the growth in their distributions. None spoke at length about the pros and cons of dividend growth investing during your accumulation years nor during retirement.

That said, someone just getting started, with little money to invest, may choose a low-cost dividend ETF as a way to get their feet wet. I certainly would not criticize that. It does give you instant diversification and an investing approach that could be said to be at least directionally similar to a true dividend growth strategy. If I were choosing one ETF to get started, I would simply select the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) because of its low expense ratio.

That said, the amount necessary to get a good start in individual stocks is less than some might think. You can start a 15-stock portfolio with $15,000. At $8 per purchase, that would give you an expense ratio of 0.8% (VIG's expense ratio is 0.18%). You could easily achieve a yield of 4% right off the bat (VIG's is 2.2%).

Each investor must decide on his or her comfort level in selecting individual stocks and when to make the transition from an ETF like VIG to individual stocks. Many start out directly with individual stocks, but you should do what is comfortable for yourself.

Myth #13. Stocks with high yields have low dividend growth rates, and vice-versa

This is an example of a broad statistical observation that is generally accurate but not really relevant, since there are significant exceptions. Since dividend growth investing is a stock-by-stock strategy, the exceptions can become exactly the stocks that you want to invest in.

For example, in my eBook, Top 40 Dividend Growth Stocks for 2013, I identified several stocks that sported what I would call reasonably high yields and high 3-year dividend growth rates (DGRs, as calculated through 2012). These included:

  • Darden Restaurants (NYSE:DRI), 4.4% yield, 27% DGR
  • Alliance Holdings (NASDAQ:AHGP), 5.8% yield, 17% DGR
  • Intel (NASDAQ:INTC), 4.1% yield, 16% DGR

Alliance Holdings typically increases its dividend several times per year; it has already announced a 3% increase for its first payment in 2013, with other increases likely to come throughout the year.

I do not consider stocks like these to be exceptions that prove the rule. Rather, they are members of the overall universe of dividend growth stocks. The general inverse correlation between dividend yields and DGRs does not apply to them. They might be considered to be outliers from the general statistics.

But in a way, all of dividend growth investing is about finding outliers. After all, only about 500 stocks can reasonably be considered to be legitimate candidates for the strategy at all, out a total stock universe well in excess of 10,000.

Some investors - especially those with lots of time until retirement - like to emphasize higher DGRs over current yields. As the list above shows, that trade-off is not always necessary.

Another thing to keep in mind is that while initial yields on cost are locked in at the time of purchase (assuming no later dividend cut), future rates of dividend growth are speculative. You can make informed guesses, but to forecast that a stock with a most recent DGR of 15% or 20% will be able to maintain that rate for 10 or 15 years is not realistic. A more likely long-term forecast might be that a stock's DGR will level off in the 6% to 7% range at some point in the future. Even that, of course, is speculative, as the future is unknown to us all.

Myth #14. Younger investors should take on more risk, because they have more time to make up losses

For years, standard advice in the investment industry has been that younger investors should take on lots of risk, because they can shoot for high-growth moon-shots. If they succeed, great. If they fail, they have plenty of time to make up for it.

Frequent commenter "chowder," one of the wiser contributors to Seeking Alpha, has a different point of view that I believe is compelling. I have cut-and-pasted from several of his comments here. I feel no need to add to what he has said on this subject.

I am opposed to conventional wisdom that young people go for growth and take risks because they have time to make up for it when it doesn't work. This irrational (in my mind) concept has inexperienced investors taking on the most amount of risk. It's akin to hitting the lottery. Very few people will have long term success with it….I say start with quality Blue Chip companies and start building that income replacement stream now. Once a young person has a nice income flow to count on, they can branch out for more exciting investments.

When I see comments like >>> seeking more aggressive growth opportunities makes perfect sense, <<< it tells me people do not understand the power of compounding. They might know what it is, but they aren't relating and assimilating it into any kind of action plan. If you have 40 years to grow, the first 10 years of compounding is critical. It takes 10 to 12 years for compounding to get any real traction and start to multiply. Punch some numbers into an online compounding calculator and test them out yourself. See the difference between 20 years and 30 years, or even better, between 30 years and 40 years. It's incredible the difference those 10 years make. I say start the compounding process first with "core" positions and once those are established, you still have plenty of time to chase growth. Do it the opposite way and you don't have enough time to compound properly.

[It is said,] >>> being young gives you a tremendous advantage over many investors. You have time on your side, you can afford to make mistakes, and you can seek growth more aggressively than most investors. <<< Been there, done that. It's another Wall Street cliche that sets you up to fail. Wall Street is telling people with the least amount of experience, to take on the most risk. ... And that's a sound business plan? ... Really?

It's the compounding effect of dividend growth that younger people are neglecting. They are chasing the dream as opposed to building it. We expect young people, who have the least amount of investing experience, to take the most risks because they have time to make up for it. I say start building a dividend growth portfolio, using quality companies, reinvest the dividends, and let compounding do your work for you. Compounding is the magic ingredient and the younger someone is, the more powerful it becomes. When you chase capital appreciation, you assume everything will work out fine. Life doesn't work that way.

Myth #15. Broad statistics are helpful in assessing individual stocks

If someone asked you what the weather is going to be tomorrow, and you quoted him historical climate statistics for the month, you would not be helping him much. He is interested in tomorrow, a specific day, not in historical averages. (Of course, the up-to-date forecast for tomorrow may be wrong, but that is a different issue.)

Dividend growth investing is all about picking individual stocks that will perform well for the goals you have for them. So the data that is most helpful in making those selections is data that is specific to each individual stock. The group performance of large numbers of stocks can be safely ignored; its only use is in describing broad trends.

That seems obvious, but it is striking how often that basic principle gets ignored. My experience is that it is ignored most often by trained professionals who wish to criticize dividend growth investing. This occurred recently on my first "myth" article. A well-known author and asset manager dropped by to criticize, basing his remarks on a few broad studies that were almost completely off point. Here is an example.

The propensity of firms to pay dividends has shown a global decline - the percentage of firms paying dividends globally dropped from 71 percent in 1991 to 61 percent in 2012, with declines occurring in both US and international markets. Thus, a dividend paying strategy has become less and less diversified. In 1991, creating a portfolio that captured 50 percent of global dividends required about 320 companies. By 2012 that figure had dropped to just 220. The typical portfolios we build for our clients contain over 10,000 stocks.

My reaction to those statistics is, so what? I am not trying to capture 50%, or any percent, of global dividends. I am trying to build a reliable growing income stream that meets my needs and beats inflation. If my selection process filters out those stocks that dropped their dividends, what difference do their actions mean to me? After all, the stock-by-stock filtering that protects you from dividend-cutters is the central process in executing the strategy.

Many asset managers (like the one just mentioned) believe that building a portfolio specifically for income and income growth is nonsense. They believe that the only proper goal of investing is total return (see Myth #1). In their world, Modern Portfolio Theory rules, and MPT has little to say about dividends other than that they are irrelevant to total returns. As a result, such individuals usually have nothing intelligent to say about income growth investing. They are surprisingly unfamiliar with its tenets and methods, and they reject the income goal itself.

My suggestion is to tune them out unless and until they come up with insights that are relevant to the task at hand.

That completes Myths 11-15. Will there be more? It's hard to tell. Last year I thought I was done at #10, but different ones continued to pop up. Maybe in a year or two, we will have five more.

Disclosure: I am long DRI, INTC. 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.