Performance comparisons to market indexes are an anathema to most Dividend Growth investors. When queried, a typical reply is, "As a dividend growth investor, I could care less how I do relative to the market." While the primary goal of a DG portfolio may be to produce an increasing stream of income from dividends, it should also perform respectively against standard market measurements. If it does not, that is an indication that the portfolio may be lacking in some respect that will cause negative future consequences, especially for the younger investor in the accumulation years. This article describes the potential pitfalls and proposes correctives.
Many DG investors hold high yielding stocks, which boost income but have slow growth characteristics. "Income Stocks" is really a better name for these. They often include REITs, MLPs, Utilities and Preferred Stock. They sometimes include distressed companies and firms with unsustainable payout levels. These can boost current portfolio yield but are inappropriate for long-term holdings, for inevitably they become mired in debt and fail.
There are many advantages to holding dividend paying stocks. Companies that pay dividends do better for a number of reasons. In selecting just which dividend stocks to buy, the investor should consider where they are in their investing career. During the accumulation years, from perhaps age 25 to age 55, it is important to hold companies that have high dividend growth rates, even if it is at the cost of higher yield. Rather than setting the primary screen for a dividend growth portfolio at a yield of 3% or 4%, the primary screen might be a DGR hurdle of 10%. This differs from an approach where you can add together the yield and DGR and come up with a magic number, 12 perhaps, that is satisfactory. The DGR, Dividend Growth Rate, is the factor that compounds the return over time. Over the years, it makes an increasing difference. While a "Chowder Rule" of 12, the sum of the yield and DGR, might be perfect for Chowder or for me, if you are 20 or 30 or 40, it might not be for you. I believe it is preferable to use entirely separate yield and DGR hurdles. I also believe it is better to not have different acceptable DGR for different types and classes of stocks. That would mean that a younger investor with a DGR hurdle of, let us say, 11 probably will not own many REITs or Utilities. That is the way it should be.
Due diligence should be done to verify that growing revenues and earnings are present to support the dividends.
I believe and am fond of saying, "Investing risk involves being in a situation which leads to a high probability that I might not have the money I need when I need it." Note that it is a personalized risk. Usually our individual differences determine the risk of any action or behavior. Here are some examples from outside of the world of investing. A three-year-old crossing a busy city street alone is at risk; a 30-year-old doing the same thing is at much less risk. An accomplished professional stunt driver can do things with a car that you have been rightly warned, "Don't try this at home". Objects are not inherently risky; it is their use and usually misuse that adds the risk. Is a 1962 Chevy with a 409 cubic inch engine, the high performance car of an earlier era, a risky car? I can tell you that it sure would have been if I had one in 1962 when I was 16 years old. The risk level of the whole county would have gone up. However, in the hands of a mature adult, the risk to the driver or others is no greater than with any other car.
A measured amount of risk taking is essential to life. If we do not eat, surely we will not get a food borne illness. However, we will starve. "A ship is always safe at the shore - but that is NOT what it is built for," Albert Einstein. We ameliorate risk by properly preparing food. In the case of a ship, we set many safety standards and require the captain and crew to be licensed to operate it. Managing risk is a big part of life.
If you and I make the same investment, it could put one of us at risk, but not the other. That is to say, many of the investments we make are not inherently risky. They are only risky if they create a situation that means the person holding them is moved toward, not away from, the probability of losing money or not having enough money when they need it. We often consider the buying and selling of options to be a risk laden activity. While that is true for many who might try it, it is a sure and certain way for some skillful traders to enhance their returns. If I were to trade in metals futures, there is a high probability that I would lose money. However, if Freeport-McMoRan Copper and Gold sells copper for future delivery, they are hedging their production against the risk of a price decline.
Understanding risk in this context makes the concept that one stock is inherently and quantifiably more risky than another seem a little naïve. Risk implies a dynamic situation concerning how a set of circumstances will affect a person or group of people. I do not believe that the creators of MPT were using the full capabilities of the human mind, that is the left and right sides, in developing their ideas of risk. I believe they fell into a very sophisticated form of circular reasoning without the application of psychological and social understanding. To deem the essence of risk as a mathematical function has limited utility. Risk is not the same for all. As St. Paul said to the early church goers in Corinth, "One man's meat is another man's poison."
Suitability for Investment Horizon
We discern from the above that understanding the risk of investments considers the suitability of a given action, of buying and holding a stock, in the context of who is buying it and for what purpose. To illustrate this further, let us consider the purchase of one of two different stocks. Assume that ConocoPhillips (NYSE:COP) and Southern Company (NYSE:SO) both yield 4.4%. The stocks are quite different in their DGR characteristics. Conoco has a DGR of 13.2% and the Southern Company has a DGR of 3.0%. For purposes of this illustration, let us assume that you are in your early 40s and that I am in my late 60s. I want $440 a year in dividends, so I buy $10,000 worth of SO. Let us say you figure that is a good idea and do the same thing. My investing horizon, for planning purposes, is 10 years. That dividend will certainly be very secure for that time with a large, well-managed regulated public utility that provides a stable income as "widows and orphans" stocks should. It should keep up with inflation. It is a good and safe investment for me. I calculate that the compound annual interest rate will be 6.4%.
You, on the other hand, have an investing horizon of 40 or more years. If you buy this same stock, this very slowly growing stock, will you have the money you need when you need it 40 years from now? Perhaps you will not. You are putting yourself at risk with this investment because it is too conservative to accomplish your goals. However, if you bought ConocoPhillips, there is a good chance that you would have a whole lot more money in the future. In a one sense, the dividend is not as secure as it would be with a utility. However, a much larger return over time justifies any investment risks by alleviating the risk of not having the money you need at a future time. Let me quantify that.
The rate of dividend growth determines the compound interest rate. Your investment of $10,000 at a DGR of 13.2% provides a compound interest rate of 14.1% for 40 years. This creates a bonanza of a little over $1.9 Million. That same $10,000, if you invested it in SO with a DGR of 3.0%, at 6.4% compound interest would provide you only $119,500 after 40 years, a 20-fold difference in eventual results. If it seems incredible, it is. Albert Einstein said, "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
I present three sample portfolios below. The Bad portfolio has a 200 basis point yield advantage over The Good. How long should your investment horizon be to return that 2% difference you give up by buying The Good? The answer is a little over 11 years. If your investment horizon is only 10 years, then The Bad portfolio will do just as well as The Good. We can see this in the increasing return curve as time goes on for The Good portfolio.
Let me offer some examples of choices, which I have divided into three groups, three little portfolios. The ones labeled The Good are the best examples of suitable stocks for the long-term investor who is accumulating wealth. Microsoft (NASDAQ:MSFT), McDonald's (NYSE:MCD) and Intel Corporation (NASDAQ:INTC) will pay you growing dividends for years to come, as will BCE Inc. (NYSE:BCE) and ConocoPhillips (COP). The Bad might be good income producers for the older or the retired investor. These stocks are less suitable for the younger investor. The Ugly, even with their good-looking yields, are not good investments at all.
The Good - We invest $5,000 in The Good. Over a 20-year period, we assume a stock market growth rate of 3%. The total accumulated dollars due to dividends is $26,239. Accumulated principal is $9,031. The ending balance is $35,270. The total return is 605.4%, giving an annual return of 10.3 %.
The Bad - We invest $5,000 in The Bad. Over a 20-year period, we assume a stock market growth rate of 3%. The total accumulated dollars due to dividends is $16,670. Accumulated principal is $9,031. The ending balance is $25,701. The total return is 414.0%, giving an annual return of 8.5%. However, due to its higher yield, at 10 years, it is still about even with the Good, which then goes ahead of it.
The Ugly - We invest $5,000 in The Ugly. Over a 20-year period, we assume a stock market growth rate of 3%. The total accumulated dollars due to dividends is $6,531. Accumulated principal is $9,031. The ending balance is $15,562. The total return is 211.2%, giving an annual return of 5.8%. In general, the future does not look good for these companies; I do not advocate buying them, or SDOG, which is the horse they rode in on.
The basic data from the above came from Seeking Alpha, wealthtrace software provided the calculations..
Measurements of Success
Measurements of success of your performance should not be solely against our own goals as you may unknowingly have sub-par results. I suggest a two-step corrective. First, compare the performance of your portfolio against the S&P 500 index or another relevant index at least annually. You do not need to worry about "beating" it, but if you consistently fall behind you should determine why. Second, use some of the free software on the web, such as wealthtrace, to see if your individual holdings align with your goals. If not, you could be at risk of not having the money you need when you need it. Choose instead to take corrective actions and be as wealthy as you would like to be.