Are Dividend Growth Investors Doing It All Wrong?

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 |  Includes: AFL, APU, BCE, BRK.A, BRK.B, COP, DRI, EPB, ESV, ETR, HCP, IBM, JNJ, KO, MCD, MO, MSFT, PEP, PETS, PG, RSGUF, TGT, VZ, WMT, XOM
by: Nelson Smith

As I spend time on Seeking Alpha and around various other sites on the internet, I've found that a certain group of investors has been slowly and steadily gaining popularity. These investors look for companies that are some of the largest in the world, and that are mature enough that they've paid a dividend for a number of years, usually decades. They also tend to focus their investment dollars on companies that have a track record of annually increasing this dividend. Yes, I'm talking about dividend growth investors.

Dividend growth investing has grown in popularity for years now, particularly after the financial crisis of 2008-09, as investors seek a little more security in the form of large, multi-national Fortune 500 companies and their dividends. Low interest rates have helped as well, making alternatives such as bonds and preferred shares less attractive. If an investor can only get 4% interest on a McDonald's (NYSE:MCD) bond and 3% on the common stock's dividend, the common stock starts to look attractive, especially considering the price appreciation potential.

I'm not trying to say that dividend growth investing is a terrible method, or that's it's guaranteed to underperform the market, or anything like that. It has its merits, just like momentum investing, or value investing, or most other methods. But I do have a few problems with it, including the fascination with the dividend, the lack of diversity in the names and sectors, and the overvaluing of companies that are well known, household names. Additionally, I hope to show how investors could look at some alternate dividend names, and how other dividend names represent a good chance for higher returns.

Problems With Dividend Growth Investing

I have two major problems with dividend growth investing, and that's the concentration of dividend growth dollars into only a handful of different names and sectors, and the dividend yield having more importance than the underlying value of the security. Let's address them individually.

If you look at most dividend growth investor portfolios, you'll see a concentration of certain names. McDonald's is a favorite holding, so are Walmart, (NYSE:WMT) Coca-Cola, (NYSE:KO) Proctor and Gamble, (NYSE:PG) Johnson and Johnson, (NYSE:JNJ) Pepsico, (NYSE:PEP) Exxon Mobil, (NYSE:XOM) Target, (NYSE:TGT) and perhaps IBM (NYSE:IBM) or Conoco Phillips (NYSE:COP). I've missed a few, but you get the picture.

Notice something? I sure do, and that's the concentration in names that sell stuff to consumers. Even oil giants Exxon Mobil and Conoco Phillips have a big part of their operations dedicated to selling things to consumers in the form of gas stations and convenience stores. Dividend growth investors generally ignore entire sectors, such as REITs, financials, industrials, and technology.

I believe that dividend growth investors put too much focus on companies they are familiar with, as do a lot of investors. They have the attitude that they can understand McDonald's or Coca-Cola because their businesses are simple, they have fairly obvious moats, and because they like the product and they either consume the product regularly or know people who do. It's an investing case of confirmation bias.

Dividend growth investors often cite Warren Buffett as a role model, noting that Buffett, through Berkshire Hathaway, (BRK.A, BRK.B) often has a position in the same companies that they do. Buffett's track record speaks for itself, they argue, so they think they're on the right track.

While I don't want to downplay Mr. Buffett's remarkable success over the years, Buffett's greatest returns were made in the 1950s and 1960s, when he almost exclusively invested in cigar butt stocks - usually small cap names that were trading at depressed levels due to certain circumstances.

These days, Buffett's biggest moves are when Berkshire Hathaway buys up entire businesses. The majority of Berkshire's cash gets put toward these kinds of acquisitions, rather than being invested in the stock market. There are many tales of Buffett getting a company for less than fair market value, simply because it was Buffett buying it. (See, for example, the saga of Clayton Homes, a 2003 Berkshire acquisition)

As I outlined on my own blog, over the last decade (ending at the end of 2012) the book value of Berkshire Hathaway increased approximately 8.5% annually, compared to 7.0% for the S&P 500, including reinvested dividends. That's a solid performance for the Oracle of Omaha, but it's driven largely by his track record of acquisitions, not from investing in individual securities. I'm not sure Buffett is the best comparison.

A Better Alternative

I decided I would try and build my own dividend growth portfolio, concentrating on companies that pay higher dividends, largely operate below the radar, and is more focused on the industrial side of the investing landscape. It has an average yield of 5.8%, and an average five year dividend growth rate of 8.6%, once I took out the huge positive outlier. Let's take a look at what I picked.

Company Symbol Yield 5 Yr. Growth
El Paso Pipeline EPB 7.7% 15.23%
Altria MO 5.2% 8.45%
Bell Canada BCE 5.1% 9.41%
Entergy Corp. ETR 5.4% 2.05%
Rogers Sugar OTC:RSGUF 6.8% 0.00%*
Amerigas APU 8.0% 5.59%
HCP REIT HCP 5.9% 2.87%
Ensco ESV 5.2% 90.37%
Darden Rest. DRI 4.3% 22.42%
Petmed PETS 4.4% 11.20%**
Click to enlarge

*Excludes 5.6% special dividend paid in February.
** Excludes 8.9% special dividend paid in December, 2012.

Striping out the 90% dividend growth rate of Ensco, and adding in the special dividends paid by Rogers Sugar and Petmed, let's assume that this portfolio could reasonably expect a 10% dividend growth rate going forward. It accomplished that over the past 5 years, so let's assume it could do the same over the next 5 years. Let's also assume that an investor invested $10,000 in each name, making the portfolio worth $100,000. Ignoring the underlying prices of the individual stocks going forward, how would this portfolio do from a dividend standpoint?

  • Year 1: $5,800 in dividends
  • Year 2: $6,380 in dividends
  • Year 3: $7,018 in dividends
  • Year 4: $7,719 in dividends
  • Year 5: $8,492 in dividends
  • Total paid out: $35,409

Now let's compare that portfolio to a typical dividend growth investor's portfolio. This portfolio has an average yield of 2.95%, and an average dividend CAGR of 8.30%.

Company Symbol Yield 5 Year Gr.
McDonald's MCD 3.4% 10.13%
Proctor & Gamble PG 2.9% 8.45%
Coca-Cola KO 2.9% 5.92%
Microsoft MSFT 3.0% 16.59%
Exxon Mobil XOM 2.6% 9.51%
Walmart WMT 2.4% 11.72%
Verizon VZ 4.4% 2.87%
Johnson & Johnson JNJ 2.9% 7.49%
Pepsico PEP 2.8% 5.80%
AFLAC AFL 2.3%

4.56%

Click to enlarge

I added Microsoft and AFLAC to our mock portfolio to give an investor access to technology and financials, but this is, for the most part, filled with pretty standard dividend growth names.

How would this portfolio perform over time? Like last time, we'll assume $10,000 invested in each name, for a $100,000 portfolio.

  • Year 1: $2,900 in dividends
  • Year 2: $3,140 in dividends
  • Year 3: $3,401 in dividends
  • Year 4: $3,683 in dividends
  • Year 5: $3,989 in dividends
  • Total paid out: $17,113

I've made the same assumptions for each set of stocks, that they'll both maintain the dividend growth rates from the past 5 years, and the results are staggering. The first group will pay out more than double the dividends that the second group will, yet the second group is filled with companies that get all the attention. What gives?

Conclusion

I'm not saying that beating a group of some of the biggest and most respected companies on the stock market is as easy as using a stock screener to identify companies with high current yields and 5 years of dividend growth. I'm guilty of only looking backwards, a sin that dividend growth investors have committed from time to time as well.

My suggestion is this: if you're an investor looking for dividend names, look beyond the 20 or so that have increased dividends for 25 years. Look at moats, look at payout ratios, and still do your due diligence, but expand your reach beyond the Walmarts and Coca-Colas of the world. Sometimes you're paying a premium to invest in those gigantic companies.

Instead, broaden your search to REITs, to utilities, and to other sectors of the market that aren't as sexy as buying shares in a company everyone has heard of. Look at companies that are temporarily beaten down, and look at companies that yield more than 5%.

If two identical companies exist and one yields 5% with a 5% dividend growth rate, and one yields 3% with an 8% dividend growth rate, it takes over 18 years for the 3% yielding stock to catch up to the 5% yielding stock, and that's not factoring in the increased returns an investor could have enjoyed if they reinvested the additional dividends during those 18 years it took to catch up.

The bottom line is this: if you're looking for dividend stocks, the current yield matters every bit as much as the growth rate. It's time for dividend growth investors to broaden their horizons.

Disclosure: I am long GM:OTC:RSGUF. 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.