Quasi-DGI Portfolio Vs. S&P 500 - Part 4

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 |  Includes: PG
by: DG Ruralist

Purpose

This is a real-time comparison between a small stock portfolio (mostly based on dividend-growth investing, or DGI) and an S&P 500 index fund. The purpose is to: compare 1-year results on the basis of total return and income received, and to serve as a teaching tool. $10,000 is the starting amount for each portfolio. Securities will assume to have been purchased at the closing of February 28, 2013. March 1st, 2014 will be the final comparison date. Reminder, this is not an actual portfolio, but we shall pretend that it is. In addition, I own several of the individual stocks listed, so I do have some actual skin in the game.

This article presents the results from May. To see the rules and assumptions used in this exercise, please see my first article here.

May Results

Without further ado, the total return results are shown below.

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This is end of the first 3 months of these portfolios, so we shall commence with the income comparison.

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Notice that the selected stock portfolio produced 68% more income than the S&P 500 portfolio ($81.25/$48.21-1). Notice the current yields of each portfolio.

Yield on cost (YOC) is an interesting metric that shows the increase of the dividend income compared to the original purchase price. After 3 months of investing, the selected stock portfolio now yields 3.3% of the original investment. This is due to the dividend raises by some of the companies. Reinvesting the dividends will also cause more shares to be accumulated, which will also raise the YOC. Most dividend-growth investors have a goal of a 10% YOC after 10 years of a given investment. Imagine getting back 10% of your original investment, yearly, without having to sell any shares. At that point, you've reached yields commonly attributable to rental income. For the selected portfolio, we would need a CAGR of 12.5% to reach 10% YOC after 10 years. Is this do-able? Through dividend reinvestment and yearly dividend raises, I think this is very do-able.

Why do I like dividends so much?

In case you can't tell, I devote much of my investing time focusing on dividend-paying stocks and growth of the dividends. It's time to share the amazing characteristics of dividends.

1. Consistent, dividend paying stocks are a productive asset.

Let me add context to this philosophical argument of mine. One of my friends recently mentioned how he thought that stocks are no different than baseball cards. He said that a baseball card is only worth what someone will pay for it and that it has no real value (other than the paper it's printed on) and stocks aren't any different. I tried to explain how stocks are pieces of real companies that have an intrinsic value and some have dividends and shareholder rights, but I didn't do a good job explaining.

In my own mind, I tend to split assets (or possible investments) into two categories: productive assets and non-productive assets. I define a non-productive asset as an asset that provides no income. Examples would be gold or art or coin-collecting or non-dividend paying stocks. I define a productive asset as one that provides income to its owners. Examples would be businesses, rentable real estate, bonds, or dividend-paying stocks.

Some people, such as myself, don't like to invest in baseball cards or commodities. We just don't understand non-productive assets. Usually they just sit there. I can wrap my head around productive assets. I realize that passive income is the way to financial freedom. With a non-productive asset, you have to get both the "buy" and the "sell" correct for you to realize income. But with a productive asset, you need only to get the "buy" correct to realize income.

If you look at the long-term historical rates of return of the various asset classes, it's always the productive assets that have the highest total returns. Therefore, I believe the best places for investment are productive assets.

2. Dividend paying stocks outperform non-dividend paying stocks.

You can see the recent study performed by Blackrock here. This further enhances the theory that productive assets outperform non-productive assets.

3. Dividends provide passive income without the need for selling.

Most people plan to invest their money so that they make more money in the future. Examples include a son's college tuition, a down payment for a new house, a car replacement, retirement, etc. Most people don't think about what state the market will be in when it comes time to "cash in." Lots of people were cashing in their investments in 2008-2009 only to find that they had half as much as they planned to have. That's the great thing about dividends: they bypass the market and go straight to your checking account. Dividends don't care about the economy; unlike the stock price, which will swing wildly every single day.

4. Dividend growth is an indicator of shareholder friendliness.

When a company has been increasing their dividend for the past 20 years, the dividend growth becomes a part of the company's culture. Management is expected to keep growing the dividend and they will cut back on other items in order to increase that dividend.

5. Dividends are important to total return.

Approximately 40% of the stock market's total return since 1930 consisted of dividends, while 60% consisted of capital gains. Yes, dividends are a big deal.

6. Reinvesting dividends increases the compounding ability of your investment.

You purchase stock that pays a dividend. You use that dividend to buy more stock, which then pays more dividends. Along with dividend increases by the company, this is a second type of compounding of your investments. Some call this hyper-compounding. Dividend Growth Machine has a great article talking about hyper-compounding.

7. Dividend-growth companies increase their dividends at a rate faster than inflation.

According to the CCC list, the average dividend growth rate of a dividend champion, contender, or challenger was 11.8% per year over the last 10 years. The average dividend growth rate was 10.8% over the last 5 years. Inflation has a long-term average of 3-4%. For retirees living off of income, beating inflation is one of their top goals.

8. An announced dividend raise indicates that the company is actually making more money than last year. (Confirmation of the past)

Some people don't trust accountants or financial statements in general. Some people say, "They can manipulate the numbers any way they want to!" One way to alleviate these concerns is to receive a paycheck from the company. If a company has decided to give me more money than last year, then odds are: they're making more money than last year. Managements may sometimes skew the truth, but cash in my hand is real.

9. An announced dividend raise is an indicator that the company's prospects are bright. (Faith in the future)

Most of us would say that a company's management team is on the mountaintop of a company. They see the whole picture of their company and their industry: the past, present, and future. Therefore, good managements won't just go and raise dividends without having confidence in the future of their company.

10. A dividend freeze or cut is a good indicator to review the company and consider exiting the stock.

To be a self-directed investor, you must monitor your stocks on at least a quarterly basis and review their earnings and outlook. One of your goals should be to avoid the bankruptcies and declining earnings that some companies experience. Long before bankruptcy, however, the dividend will probably be cut or at least frozen. This is a very handy tool to keep in your toolbox. It would be much better to exit the stock losing 10% of your investment rather than 80% of it.

11. Dividend increases are far more predictable than stock prices.

The chart below shows the 10 year price and dividend chart of Proctor & Gamble (NYSE:PG). The grey area is the great recession. The stock price goes for a wild ride, but the dividend just keeps going up!

PG Chart

PG data by YCharts

12. Dividends provide positive feedback during stock price declines.

Look again at the previous chart of PG. Notice that in 2009 the stock price went from $62 to $45. That was an unrealized loss of 37%. But you also saw the company's earnings keep going up or holding steady. You saw two dividend raises during the recession, which also made you smile. If you reinvested your dividends, you also received more shares due to the lower stock price, which means more income in the future. When holding good dividend-growth companies its: heads I win, tails I win again. (Remember, nobody loses unless you sell.)

13. Dividends have a lower tax rate than my ordinary work income.

Qualified dividends receive 15% tax on dividends. This includes most companies like the ones in our selected portfolio. Ordinary tax rates apply to REITs, MLPs, and other partnerships. Even if you're unable to invest in a tax-favored account, investing in a normal taxable account is still a good idea.

14. Dividend paying stocks are less volatile than the market.

If you're concerned about volatility of your investments, there's no way to get around it. It's a fact of life. But it has been shown that dividend paying stocks are less volatile than non-dividend paying stocks by Ned-Davis research. This may give you some comfort with your investments.

15. Seeing 15 years of increasing dividends means the company raised their dividend through the dot-com bust and the great recession.

Some of us worry if our investments will make it through the next recession/panic/depression/end-of-world-scenario. There are 185 companies that didn't just "barely survive" through the last 2 major downturns; they kept increasing those dividends year after year. All of them have taken small hits to earnings over the years, but they had enough confidence and ability to improve those earnings over time. If a company went through the great recession with growing dividends, I can't think of a better indicator to give me confidence in the future of that company.

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.