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Dividend growth investing, long-term horizon
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Introduction

In a previous article, I provided an annual review of my investing performance in 2012, which was the first full year in which I followed a dividend growth investing strategy. In this article, I review how I did during the first quarter of 2013.

Dividend growth investing involves buying the stocks of companies that consistently pay and grow their dividends, then reinvesting those dividends to produce compounding of the dividend income stream. My primary goal as a dividend growth investor is to create my own dividend growth machine, a diversified portfolio of stocks that produces a sustainable and rising dividend income stream that handily beats inflation over time. My secondary goal is to achieve a satisfactory total return on my investments.

As discussed in a recent article, I think dividend growth investing is a sensible strategy for young investors, and in this review I will show how one young investor (I am 31 years old) is implementing the strategy. In the following sections, you will see real results from a real portfolio involving real money.

Input To The Machine

New capital represents the input to my dividend growth machine and allows me to buy stocks. As someone who is gainfully employed and living below my means, new capital comes from regularly saving a portion of the income from my day job. The figure below shows how much I saved during Q1 2013, along with the quarterly savings in 2012 for comparison.

I managed to save $4,344, which is close to my savings in Q1 2012. The average of $1,448 per month represents a savings rate of 49.8% of my net job income, more than 10 times the national personal savings rate of around 3% (according to data from the St. Louis Fed). I cannot emphasize enough how important it is for young investors to start saving early so they can invest early and reap the benefits of long-term compounding. I realize that many young people are unable to save half of their job income, but even a more modest savings rate of 10% will go a long way toward building a nice dividend growth stock portfolio.

Parts Of The Machine

Dividend growth stocks represent the parts of my dividend growth machine. Before discussing individual stocks, I want to mention a structural change to my portfolio that occurred during the first quarter. At the start of February, I started a Roth IRA and funded it with a full contribution for 2012. The purpose of this action was to give some parts of my machine a tax advantage: dividends and capital gains from stocks in my Roth IRA will not be taxed. I showed in a previous article that taxes have a negative effect on long-term compounding of dividend income, so it is helpful to reduce the impact of taxes whenever possible.

The table below shows the composition of my portfolio at the end of 2012 and the end of Q1 2013, with holdings in my Roth IRA denoted by [R] and various changes highlighted.

(click to enlarge)

I will briefly discuss the highlighted changes to the portfolio:

  • There was a non-transactional change (highlighted in blue) at the start of the year when Abbott Laboratories (NYSE:ABT) split into two companies, a diversified medical product company retaining the Abbott name and a proprietary pharmaceutical company named AbbVie (NYSE:ABBV). I know some investors sold pre- or post-split, but I decided to hold and wait to see how each company performs on its own.
  • I sold my shares of agricultural giant Archer Daniels Midland (NYSE:ADM) for reasons discussed in my annual review; in particular, I was concerned about their earnings volatility, occasional negative free cash flows, and high susceptibility to factors outside of their control (namely, the weather).
  • I more than doubled my overall position in Kinder Morgan, Inc. (NYSE:KMI) by purchasing shares for my Roth IRA. As one of the largest energy companies in North America and operator of an extensive pipeline network, I view KMI as a solid long-term investment with good dividend growth potential.
  • I started a position in Microsoft (NASDAQ:MSFT), buying shares for both my taxable account and Roth IRA. There is a lot of negativity about the world's largest software maker, much of which I think is misplaced and has led to its stock being undervalued. Many investors seem to ignore the fact that MSFT has achieved fairly steady revenue and earnings growth, produces massive free cash flow, and maintains a strong financial position. In addition, it is one of the few stocks in the tech sector with a record of dividend growth.
  • I started a position in Ross Stores (NASDAQ:ROST) in my Roth IRA. I have wanted to own this off-price apparel retailer for a long time, but I kept holding back because of its low yield. However, I realized that it was foolish to avoid an investment with so many positive attributes (strong earnings growth, improving margins, high returns on equity, very low debt, strong dividend growth, plenty of opportunities for expansion, etc.) simply because of one negative attribute. Thus, when the stock dipped over 7% on a single day in March due to a lackluster monthly sales report, I jumped on the opportunity to own a piece of this fine business.
  • Staying on the theme of apparel, I started a position in VF Corporation (NYSE:VFC) in my taxable account on a day when it dropped over 3% (for no apparent reason) to a six-month low. VFC is the world's largest apparel manufacturer and has benefited from organic growth and a string of successful acquisitions in recent years. I think of this purchase as an example of Peter Lynch's "buy what you know" approach: At the university where I work, I see many students wearing The North Face coats and Jansport backpacks, both of which are VF brands. Fun fact: VFC is the world's largest purchaser of zippers.
  • Finally, I increased my position in Vodafone Group (NASDAQ:VOD) in my taxable account back when the stock hit a new 52-week low in February. This multinational telecom company has been undervalued for a while, although some recent interest has been sparked by rumors that its lucrative 45% stake in Verizon Wireless might be sold soon. I don't know if or when that might happen, so I plan to continue holding the stock and monitoring news about the company.

In summary, there was a company split, one stock sale, and six stock purchases during Q1 2013. Given that I am in the accumulation phase of my investing and aim for very little portfolio turnover, it is not surprising that I have made a total of 25 purchases but just one sale since January 1, 2012. I try to keep transaction fees to no more than about 0.5% of my total cost and for Q1 2013 the ratio was 0.46%.

Besides adding and subtracting parts from my machine, I want to make sure all the parts are running smoothly. I monitor the operating results of my companies, but I also stay on the lookout for my favorite announcements: dividend increases! Thus far in 2013, there have been dividend increases for 14 of the 28 stocks in my portfolio, some of which were announced in late 2012 but did not take effect until this year. The mean dividend increase has been 9.6%, which is very nice and well above the rate of inflation. No companies in my portfolio have announced dividend cuts and I expect increases from the remaining companies to be announced throughout the year.

Output Of The Machine

Dividends and capital gains represent the output of my dividend growth machine, all of which is selectively reinvested. As mentioned earlier, my primary investing goal is to create a sustainable and rising dividend income stream. The figure below shows the total dividends I received during Q1 2013, along with the quarterly totals in 2012 for comparison.

My main measure of success is whether there was a year-over-year increase in dividends (affectionately known as the "chowder index"). I received $476 in dividends in Q1 2013, which is a 67% increase over Q1 2012. Of course, some of the increase is attributable to dividends from stocks purchased with new capital, but a sizable chunk comes from companies growing their dividends (all the companies in my portfolio have active dividend growth streaks). Overall, I am pleased with the growth of my dividend income stream, and by the end of Q1 2013 my forward 12-month dividend total was $2,387.

My secondary investing goal is to achieve a satisfactory total return. The portfolio table (see above) shows that my portfolio's value increased by 26%, from $65,137 to $82,205. The figure below shows end-of-month portfolio values going all the way back to the start of 2012.

It is clear that my portfolio got off to a very strong start in 2013 (for those who care, it easily outperformed the S&P 500 index). Using the XIRR function in Excel, which takes into account when new capital was added, I have achieved an annualized return of 20.8% since January 1, 2012. I'd call that a satisfactory total return. Of course, past results are no guarantee of future results, and I would not be surprised to see a more modest return by the end of the year.

Outlook For Q2 2013

The second quarter will bring little in the way of change to my dividend growth machine, mainly due to a temporary suspension of new capital investment. At the end of the quarter, I will be moving to a different state to start a new job, so I will be incurring some moving and start-up expenses. There will also be a short transitional period during which I will have no job income. For these reasons, I have decided to allocate my savings for the next few months to the emergency cash reserve outside of my investment accounts. I do not anticipate needing to use all of it, but I think it is better to be safe than sorry. Thus, my next quarterly portfolio review might not be as interesting, although the second half of 2013 should compensate for that.

Source: A Real Dividend Growth Machine: Q1 2013 Review