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Recently, I have read a number of articles on Seeking Alpha forecasting mediocre results for dividend stocks in the coming years. The catalyst may be rising interest rates as a result of the end of QE, it may be the realization of and popping of a "dividend bubble," or it may be a broader reversion to the mean after a generation of P/E expansion. In this article, I offer my view that these macro forecasts are "noise" that should be considered briefly, filed away, and then ignored by disciplined dividend growth investors.

P/E Compression

Regardless of the catalyst, the forecasters are predicting that the P/E of many dividend paying stocks will compress in the coming years. The P/E ratio is the price that today's buyers of a stock are willing to pay per dollar of earnings. If a business is expected to grow earnings at an above-average rate for a sustained period of time, then today's investors will be willing to pay more per current dollar of earnings than investors in a business with worse prospects for strong future earnings.

In a rational world, the stock's P/E ratio would be based mostly on the business's earnings track record and prospects for future earnings. Over time, the P/E that a business commands on the market may change as earnings potential or investor sentiment changes. In a world where yield is difficult to find, investors may be willing to pay more for today's earnings to get the dividend than they might if bonds or other assets had higher yields. As yields rise and other options become available to those needing income, the prediction is that investors won't be willing to pay as much per dollars of earnings, so the P/E ratio will compress regardless of underlying business performance. Depending on the magnitude of the contraction, a share's stock price could stagnate for a number of years even as earnings grow.

Dividend Growth Investing Response

While this scenario could cause great concern to an investor who judges success based upon the balance reported in a brokerage account, it causes much less concern to a dividend growth investor who judges success by underlying business performance and rising dividend income. In The Power Curve: Smart Investing Using Dividends, Options, and the Magic of Compounding, Scott Kyle gives an excellent example of this mindset:

I learned this positive lesson in a very real way from 2000 to 2002 as the U.S. public markets were heading south during most months. I owned shares in a small but highly profitable sports magazine. The board of directors made the decision to distribute by way of a dividend all the excess profits (read cash flow) each month. As markets around the world -- and the value of people's stock portfolios -- were plunging, this little business was sending me what seemed to be larger and larger checks every thirty days. How could this be? The market was getting pummeled; shouldn't all businesses have been on the ropes? Nope. For most publicly traded securities -- even stocks of top-quality companies and companies caught up in the premature hype of the Internet -- prices in the late 1990s had gotten ahead of what revenues and earnings could justify. Even if top and bottom lines were plugging away at a company, multiple contractions (i.e., declining P/E ratios) had the prices of stocks hurtling erratically.

He concludes:

Bottom line: Block out the white noise, focus on the fundamentals, keep your time horizons in mind, remember that a stock price is not a company -- and be patient.

Rather than fear a decrease in share prices as a result of investors leaving for other sources of yield, I believe long-term dividend growth investors would welcome P/E compression. Our goal is to accumulate shares of great businesses. The more shares we own, the more dividends we receive. In a 2001 essay, Warren Buffett makes the argument that we should welcome P/E compression by analogy:

To refer to a personal taste of mine, I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the 'Hallelujah Chorus' in the Buffett household. When hamburgers go up in price, we weep. For most people, it's the same with everything in life they will be buying -- except stocks. When stocks go down and you can get more for your money, people don't like them anymore.

If the "Great Rotation" out of dividend stocks leads to a two for the price of one hamburger sale, sign me up.

What if I'm not accumulating but am in retirement?

In some sense, this article is particularly easy for me to write as I am in the accumulation phase of investment. I am actively acquiring shares. Were I in retirement and living off of my investments, I think I would psychologically be in a tougher position. As I am not personally in this position, I won't presume to comment. Hopefully in the comment thread, many people will offer their perspective.

Genuine Risks

I do think there are some genuine risks that could occur if interest rates rise and investors respond by moving out of dividend-paying stocks. In the event that a business needs to raise capital, both the equity markets and debt markets will command higher premiums than in the past. An inflated P/E means a company can raise capital through the equity markets with less share dilution than if the P/E is depressed. All things considered, I don't find this a reason to abandon a dividend growth philosophy. I am paying attention to the extent to which I think external financing is necessary for the day to day (as opposed to extraordinary) operations of the businesses in which I am invested.

Conclusion

In the 1993 Berkshire Hathaway chairman's letter, Benjamin Graham is quoted as saying

In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine.

Over the course of a lifetime, Dividend Growth Investors are carefully adding gram after gram to the scales. Stay focused on the mission, and I'm confident the scales will tip your way.

The worst thing that could happen is to stray from a sound strategy when it's unpopular and sell shares when prices are low. For myself, I believe that awareness of P/E compression and expansion and a focus on the business that I own will provide the necessary insulation from daily stock market prices.

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.

Source: Dividend Growth Investors: The Only Thing To Fear Is Fear Itself