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In a recent Seeking Alpha article titled "Why Do Dividend Growth Investors Like Price Pullbacks So Much?" David Crosetti responded to the following comment:

All you Dividend Growth Investors that claim you love it when stock prices go down so you can buy more are getting what you wished for. I never want my stocks to go down in price no matter what.

Crosetti said that he likes price pullbacks for strong dividend-paying companies because they often represent buying opportunities. He argued, by means of several examples, that purchasing strong companies during pullbacks that are deep enough is likely to lead to outsized income gains and capital gains in the long run.

While I agree with Crosetti, this is not the only reason why dividend growth investors like price pullbacks. In this article I will demonstrate that as long as you are reinvesting your dividends, price pullbacks tend to enhance your long-term returns even if you do not allocate any new capital to take advantage of those pullbacks.

SPY and Four Dividend Growth Stocks

I will consider the most recent 10-year time period for the SPDR S&P 500 ETF (NYSEARCA:SPY) and four dividend growth favorites: Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), and Walgreen Company (NYSE:WAG). Let's start with KO. Below is the price chart for KO for the last 10 years. The "D" markers on the chart signify dividend payments.

Click to enlarge images.

KO Price History, October 2003 to October 2013KO price history, Oct. 2003-Oct. 2013

Source: Google Finance.

Longrundata.com can be used to compute the annualized total return of a stock, with full dividend reinvestment, over a long time period. According to this website, the annualized return for a 10-year investment in KO, starting on Oct. 17, 2003, and ending on Oct. 18, 2013, with full dividend reinvestment was 8.54%.

Now, let's compare those returns to the returns we would have obtained over the same time period in a hypothetical alternate universe in which the price of KO does nothing but go up. Presumably, the investor quoted above would be happy if the price of KO had risen over time according to the red line below instead of how the price actually behaved.

KO Price History, October 2003 to October 2013

Source: Google Finance.

Sure, this investor might have been happier with his investment over this time period, but would he have ended up better off financially? The answer is no. Notice that the actual price of KO is sometimes above the red line and sometimes below it. Whenever the actual price of KO is below the red line, our reinvested dividends in the real world purchase more shares than they would in this alternate universe, and those additional shares serve to enhance our long-term total return.

It turns out that for KO, the extra shares purchased below the red line (when prices are low) more than offset the fewer shares purchased above the red line (when prices are high), leading to a higher total return in the real world than in this alternate universe. Specifically, the annualized return for a 10-year investment in KO in this alternate universe, starting on Oct. 17, 2003, and ending on Oct. 18, 2013, with full dividend reinvestment would have been 8.22%. That is 32 basis points lower than the actual return.

"Wait, that's not fair!" you say. "We should expect prices to rise exponentially, not linearly." OK, fine. Let's look at what would have happened if the price of KO had risen smoothly according to an exponential curve instead. Over this 10-year period, KO's price grew at an annualized rate of 5.55%. Let's consider another alternate universe in which KO's price rises by exactly 5.55% per year. In this alternate universe, the price history of KO is shown by the black line.

KO Price History, October 2003 to October 2013

Source: Google Finance.

Using curve-fitting software, I worked out that the annualized return for a 10-year investment in KO in this alternate universe, starting on Oct. 17, 2003, and ending on Oct. 18, 2013, with full dividend reinvestment would have been 8.29%. This is still worse than the real-world return of KO over this time period.

The following table summarizes the discussion so far.

StockReal-world annualized returnLinear price appreciation annualized returnExponential price appreciation annualized return
KO8.54%8.22%8.29%

Let's repeat this exercise with SPY and three other popular dividend growth stocks. Here are their real-world price histories, with hypothetical alternate price histories overlaid. Again, the red line shows what the price history would be if price increased linearly and the black line shows what the price history would be if price increased exponentially.

SPY Price History, October 2003 to October 2013SPY price history, Oct. 2003-Oct. 2013

Source: Google Finance.

JNJ Price History, October 2003 to October 2013JNJ price history, Oct. 2003-Oct. 2013

Source: Google Finance.

MCD Price History, October 2003 to October 2013MCD price history, Oct. 2003-Oct. 2013

Source: Google Finance.

WAG Price History, October 2003 to October 2013WAG price history, Oct. 2003-Oct. 2013

Source: Google Finance.

The annualized returns over this time period in the real world and in both of our alternate universes are summarized in the table below.

StockReal-world annualized returnLinear price appreciation annualized returnExponential price appreciation annualized return
KO8.54%8.22%8.29%
SPY7.41%7.20%7.24%
JNJ9.20%8.84%8.92%
MCD17.99%17.95%18.48%
WAG7.50%7.13%7.16%

For four out of these five stocks, the real-world return is better than the return would have been in either of these alternate universes in which prices only go up. In all five examples the real-world return was better than the return would have been in the linear price appreciation universe. The reason MCD outperformed in the exponential price appreciation universe should be clear from the graphic above. Specifically, in the exponential price appreciation universe, for most of the 10-year period MCD's price was significantly below its real-world price, allowing reinvested dividends to purchase more shares along the way in that universe.

Summary and Conclusions

In almost all of our examples above, the total return for our dividend stocks was higher in the real world than it would have been in an alternate world in which prices only go up. I would much rather live in this world than in one of those other worlds, not only because it makes investing much more interesting and exciting, but also because it tends to provide better total returns in the long run. The message is simple: Don't fear price pullbacks, even if you don't have new capital to spare. Instead, embrace them. Invest in high-quality dividend-paying companies and let your reinvested dividends purchase more shares at depressed levels, with the confidence that they will eventually guide you to a higher return.

Source: Another Reason Why Dividend Growth Investors Like Price Pullbacks