All Dividend-Growth Investors Are Not Created Equal

Includes: KMB, KO, MCD, MMM, VIG
by: The Financial Lexicon

Income-focused investors come in all shapes and sizes. Typically, you might associate an income-focused investor as someone who buys bonds. But there are other investments investors might turn to for income. Renting a real estate property is one example. Other popular examples include equity- and mortgage-REITs. And yet another example is the so-called "dividend-growth stocks." Examples of such stocks include 3M (NYSE:MMM), The Coca-Cola Company (NYSE:KO), Kimberly-Clark (NYSE:KMB), and McDonald's (NYSE:MCD). These stocks, and others, can be found on the S&P 500 Dividend Aristocrats list, a list of S&P 500 companies that have increased dividends every year for at least 25 consecutive years. At this time, there are 54 companies included on the list. In addition to individual dividend-growth stocks, there even exists the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), which tracks the NASDAQ U.S. Dividend Achievers Select Index. That index currently consists of 146 stocks with at least 10 consecutive years of increasing dividend payments.

As someone who is interested in and benefits from dividend-growth stocks, I have read countless articles on the subject. One topic that never seems to receive adequate attention in commentaries on dividend-growth is the following: All dividend-growth investors are not created equal. This is an incredibly important fact to remember when either writing about dividend-growth stocks or when reading an article that offers you instruction on dividend-growth investing. What do I mean by all dividend-growth investors are not created equal?

Among income-focused investors, there are at least four different types of dividend-growth investors. They are as follows:

1. Those who are currently wealthy enough to live solely off their income in retirement. These investors will never have to sell a dividend-growth stock unless they so choose.

2. Those who are currently not wealthy enough to live solely off their income in retirement but believe they will be one day. The ones who end up correct will never have to sell a dividend-growth stock.

3. Those who are currently not wealthy enough to live solely off their income in retirement, believe they will be one day, and end up wrong in their belief. These people will likely have to sell their dividend-growth stocks at some point in their lives.

4. Those who are currently not wealthy enough to live solely off their income in retirement and believe they never will be.

Much of what I read seems geared toward the investors who fall into the first and second categories. It is the third and fourth group of dividend-growth investors, however, that I am concerned about. The reason I am concerned for these investors is that much of what one reads regarding dividend-growth investing operates under the following four assumptions:

1. Corporate earnings will continue to grow at a pace that allows for future dividend increases.

2. Dividends will increase in the future at a rate that will outpace your personal inflation experience.

3. If a stock you own for "dividend-growth" declines, it is a buying opportunity.

4. The stock market is destined to go higher over time.

It is hard enough for many people to build a portfolio of such a size that it will last them through retirement, let alone one that, in concert with other income sources such as Social Security, will allow them to live exclusively off their income. Investors falling into the categories of those who in retirement will never be living solely off their income need to be aware that timing matters and that hope is not a strategy. If you will need to sell a stock at some point in the future, you cannot simply hope you have picked a point in time to initiate a new position from which earnings and dividend growth will continue at a pace sufficient to keep the dividend rising and the stock from falling.

Also, if you own a stock that you may need to sell at some point in the future, and that stock begins to drop below your cost basis, you cannot operate under the same assumptions as those who have the ability to hold the stock for the rest of their lives. Individual stocks can go lower and never recover to previous levels. That can turn into a big problem for you if you don't end up wealthy enough to hold stocks for the rest of your life.

Concerning the broader-market and the assumption that equity indices are destined to go higher over time, let me ask the following question: If the market is a forward pricing mechanism and supposedly prices in all known and expected information, how much of the future returns that everyone "knows" we will get have already been priced into the market? Moreover, if you "know" the market is heading higher over the undefined long-term, please answer the following questions. What will GDP growth be over the coming decades? What will capital expenditures, margins, and earnings growth look like for corporations over the coming decades? How much inflation or deflation will we experience over time? What multiple will the broader stock market indices trade at year-by-year over the coming decades? What will retail sales growth be in the years ahead? And what type of wage growth will employees realize year-by-year in the decades to come?

I do not expect anybody to be able to answer these questions with any accuracy. I am simply trying to make the point that there are so many unknowns that will affect stock prices in the future. Successful dividend-growth investing through individual stocks will require you to actively manage your passive portfolio. Even if you have a diversified portfolio of dividend-growth stocks, in order to realize the full benefits of dividend-growth investing over time, you will need to select the dividend-growth stocks that will be winners over a period of many years. This is especially true for those investors who fall into the previously mentioned third and fourth categories. The smaller your overall portfolio value come retirement and the more you are forced to draw down your principal year in and year out during retirement, the more important it will be for you to focus not just on income but also on principal protection. Perhaps a diversified portfolio of individual dividend-growth stocks is your favorite way to capture both income and principal protection. But I want to make sure people think through the fact that a lot of what is written about dividend-growth investing operates under the assumption that you will accumulate enough wealth to live off your income streams (investment income, Social Security, etc.). That will not be the case for all investors.

If you are one of those investors for whom income streams in retirement will not cover expenses, don't forget the importance of principal protection. Of course income is important. I think it is vitally important. But a focus on principal protection is also of great importance and, depending on the investor, could end up making or breaking your retirement. If you are an investor who will one day need to draw down your principal, you will have a different set of concerns than those investors who truly do not care how the principal value of their investments perform. Keep this in mind the next time you read an article about dividend-growth investing.

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.

Additional disclosure: I am long numerous dividend-paying and dividend-growth stocks not mentioned in this article.