One of the primary benefits of dividend growth investing is that the DGI methodology encourages you to purchase more shares, rather than sell, during a stock market correction. So long as you purchased stable companies that are able to maintain, if not grow, their dividend every year, then your quarterly dividend checks will buy even more shares during such a correction. Once the stock returns to a fair value, then you have disproportionately benefited by reinvesting dividends while the stock was depressed.
This benefit relies on the premises that stock prices will eventually revert to a reasonable value based upon a company's earnings (and many other factors), even if the stock price at times oscillates wildly around it. A simple example is the historical PE ratio of the U.S. stock market of 15. Dividend growth investors, as well as value investors, rely on this premises of mean reversion as part of their investment. After all, if there was ample precedent of a segment of stocks remaining depressed for a prolonged period of time, then we may want to be mindful of our exposure to that segment for fear that such a prolonged depressed period occurs when we need to sell those securities, and our discipline to continue to reinvest dividends in down markets would not be rewarded.
Prior Bear Markets and Returns to New Highs
Fortunately, we have history as a guide on this topic. Looking back to 1930 for the Dow Jones Index ("DJIA"), 1970 for the FTSE and to the early 1980s for the Nikkei and Heng Seng ("HS") Indices, we can see that stocks often recover from a bear market within 2-3 years. However, there are many situations in which it has taken significantly longer for a given country's securities to recover from a bear market. As you can see from the below chart, it can take 10 to even 20 years for a market to reach new highs after a bear market. In fact, only the U.S. stock market, as represented by the DJIA, has reached a new high in the past 7-8 years. Since the 1970s, all of the above indices have experienced droughts lasting at least seven years at some point during that span.
|Average (std dev.)||6.2 (6.5)|
"Systematic Risk" is the risk inherent to the entire market, i.e., events that have an effect on the entire market and cannot be avoided through diversification. "Unsystematic Risk" is company or industry specific risk that can be reduced through diversification. Purchasing dividend growth stocks in different parts of the world should help minimize your portfolio's unsystematic risk. The above chart illustrates this to some degree. For example, while the DJIA, HS and FTSE markets all struggled from 1987-1989, the Nikkei continued to reach new highs. Then, the FTSE outperformed while the Nikkei, DJIA and HS indices continued to struggle. Most recently, the DJIA has reached all-time highs while the other indices have struggled to varying degrees.
Simply overlaying the charts from the four indices would show that they do not always move in the same direction at the same time, with perhaps the exception of the stock market crash beginning in 2007-2008, which is an example of systematic risk. There are many reasons for the different countries' stocks performing differently over time, including the fact that each economy has its own currency risk, political risk, monetary policy risk, risk of war/terrorism/acts of God, etc. that can cause bear markets to occur and/or be prolonged, in addition to what may have otherwise occurred even without such intervention.
So while we cannot predict the length or severity of a bear market, we can take very simple steps to minimize the impact of any such prolonged bear market by spreading our investments out across multiple economies. I am not advocating that you need to own a certain percent of stocks in Europe versus Asia, China versus Brazil, or England versus France, but rather simply that you do not put all of your dividend growth eggs in one basket.
Use of U.S. Stocks with Significant Foreign Revenues as a Proxy
Note that it is not sufficient to use U.S. dividend growth stocks that have significant foreign ties as your proxy for foreign dividend growth stocks. Although some of the above risks can be diversified using this method (such as currency risk), not all of them are so diversified. The below correlation chart helps show that some of the major U.S. stocks with significant foreign market exposure are still more aligned with the U.S. stock market than the foreign developed stock markets.
Here is the S&P 500's three-year correlation to ten U.S. companies with some of the largest amount of foreign revenues, all of which pay a healthy dividend.
The average of the above ten stocks is 0.78. By comparison, the Powershares International Achievers Index (NYSEARCA:PID) has a three-year correlation to SPY of 0.77 and the WisdomTree Emerging Markets Equity fund's (NYSEARCA:DEM) correlation to the SPY is 0.11. This indicates that much more diversification is received from purchasing emerging market dividend growth stocks than simply foreign dividend growth stocks, and purchasing U.S. stocks that earn a significant amount of revenue overseas will provide similar diversification to holding dividend growth stocks in foreign developed economies. My primary reservation about this conclusion is that this is only a three-year lookback period compared to the 40 or so years used earlier in the article.
This article is based on the premises that dividend growth investors may be tempted to load up on only U.S. dividend growth stocks. Hopefully I have articulated that you need to keep some level of allocation to foreign developed and emerging economies, whether it is through dividend growth stocks or through an ETF or mutual fund. If you only choose U.S. dividend growth stocks, then you are missing out an important benefit of diversification, one that is relatively easy to obtain and can improve your risk-adjusted returns in the long-term. At a minimum, keep some allocation to emerging market funds and either have a healthy portion of your U.S. stocks derive a significant portion of their income overseas, or maintain exposure to foreign developed stocks.
As an aside, you should not compromise the quality of your holdings in your search for foreign developed or emerging market stocks. Rather, if you struggle to reach your target allocation with individual dividend growth stocks, then consider using ETFs such as PID and DEM to maintain your allocation, reinvesting the dividends paid by those funds just as you would any dividend growth stock.
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.