Dividend Growth Investing 'Is' Total Return Investing

 |  Includes: KO
by: Larry Smith

I recently wrote an article (here) where I discussed my portfolio's returns for 2013. In the article I detailed my returns and expounded on my investing thesis, which is a belief in the merits of dividend growth investing. Over time, I believe dividend growth investing will outperform other investing strategies. I do believe you can make money in the market using various other strategies, but dividend growth investing is the safest, simplest and best for most individual investors.

In response to my article, one commenter made the following statement,

"For a pre-retirement portfolio it is completely nonsensical to have any objective other than total return."

That comment drew this response from another commenter.

"rising dividends and total return tend to go hand in hand. You could look it up."

To which the original commenter responded

"They don't, and I don't want to go into this one more time, but even if they do total return by whatever means should be the objective. I am sure that the DG aficionados are misleading some pre-retirees about their objectives by insisting that total return does not matter. That is very shameful."

That lively exchange continued with a few more comments, but that sample sums up the debate. One person felt dividend growth investing did not lead to total return and dividend growth investors are misleading pre-retirees, while the other commenter stated dividend growth did lead to solid total returns.

Yesterday I had some time and decided I would run some numbers and see if dividend growth investing actually did lead to better total returns. The scenario I have put together involves two portfolios, both valued at $100,000. One portfolio consists of growth stocks that pay no dividends and the other consists of dividend growth stocks.

Portfolio One

The growth portfolio has a value of $100,000 consisting of 2,000 shares at an average price of $50.00. To make this as real as possible, I have the growth stocks growing 8% a year, but every 5th year decline 8%, representing a down market year. Stocks do not go straight up, markets do decline, so I wanted to add two down years over a 10-year period.

Shares x Price Total $ Value 8% Gain/Loss New $ Value
2,000 x $50.00 $100,000 $8,000.00


2,000 x $54.00 $108,000 $8,640.00


2,000 x $58.32 $116,640 $9,331.20 $125,971.20
2,000 x $62.99 $125,971.20 $10,077.70 $136,048.90
2,000 x $67.59 $136,048.90 -$10,883.90 $125,165.00
2,000 x $62.58 $125,165 $10,013.20 $135,178.20
2,000 x $67.59 $135,178.20 $10,814.26 $145,992.50
2,000 x $73.00 $145,992.50 $11,679.40 $157,671.90
2,000 x $78.83 $157,671.90 $12,613.75 $170,285.70
2,000 x $ 85.14 $170,285.70 -13,622.90 $156,662.80
2,000 x $78.33 $156,662.80    
Click to enlarge

As you can see, the growth investor will have gained over 50% during this 10-year period, which is a nice gain

Portfolio Two

The dividend growth portfolio will also have a value of $100,000, consisting of 2,000 shares at an average share price of $50.00. However, the dividend growth portfolio will only grow 4% a year, it will decline 4% a year twice during the 10-year period. However, the dividend growth portfolio will pay an annual dividend of 2.5%, which will increase 5% a year.

Let me counter a couple arguments before they are made.

One, dividend growth stocks tend to be "defensive stocks", they pay a nice dividend, grow more slowly and have steadier earnings. The Johnson and Johnsons (NYSE:JNJ) and Procter & Gambles (NYSE:PG) of the world do not decline as much in a down market as faster growing growth stocks do. For example, in 2008 the S&P 500 declined 38.5% and the NASDAQ declined 41.89%. However, both JNJ and P&G declined only about 12%. McDonald's (NYSE:MCD) another stock often found in dividend growth portfolios actually had a slight gain in 2008. So I think it is fair to have the dividend growth portfolio decline less than the growth portfolio.

Two, increasing the dividend yield 5% a year is conservative, not aggressive. Using David Fish's excellent Drip Investing Resource Center, we see JNJ increased its dividend 6.7% last year and has averaged an 8.2% increase the last 5-years. P&G increased its dividend 7.5% last year and has averaged 10.2% over the last 5-years. MCD recently increased the dividend 5% and has averaged over 13% during the last 5-years. So I believe it is more than fair to increase the dividend 5% a year for the fictional dividend growth portfolio.

For the dividend growth portfolio I will show the price action first, then show an additional chart that shows the dividend growth affect.

Share x Price Total $ Value 4% Gain/Loss New $ Value
2,000 x $50.00 $100,000 $4,000.00 $104,000.00
2,000 x $52.00 $104,000 $4,160.00 $108,160.00
2,000 x $54.80 $108,160 $4,326.40 $112,486.40
2,000 x $56.24 $112,486,40 $4,499.45 $116,985.95
2,000 x $58.49 $116,985.95 -$4,679.44 $112,306.51
2,000 x $56.15 $112,306.51 $4,492.26 $116,798.77
2,000 x $58.40 $116,798.77 $4,671.95 $121,470.72
2,000 x $60.73 $121,470.72 $4,858.83 $126,329.55
2,000 x $63.16 $126,329.55 $5,053.18 $131,382.73
2,000 x $65.69 $131,382.73 -$5,255.28 $126,127.45
2,000 x 63.06 $126,127.45    
Click to enlarge

As you can see, the growth portfolio ($156,662.80) has returned more than twice as much as the dividend growth portfolio ($126,127.45), on price alone.

Portfolio Two's Dividend Returns

The following chart will show the dividend returns the dividend growth portfolio would provide over a 10-year period. All dividends are reinvested in more shares. I used the corresponding stock price, from the chart above, for the year shown. For example, in year four, I used $56.24 as the price at which shares were purchased.

$ Dividend Increase (5%) 2.5% Yield $ Amount (2,500 + div increase) Shares Purchased Total Shares
  $2,500.00 50.00 2050
$125.00 $2,625.00 50.48 2,100.48
$131.30 $2.756.30 50.30 2,150.78
$137.81 $2,894.11 51.46 2,202.24
$144.70 $3,038.82 51.95 2,254.19
$151.94 $3,190.76 56.82 2,311.01
$159.53 $3,350.30 57.37 2,368.38
$167.51 $3,517.81 57.92 2,426.30
$175.89 $3,693.70 58.48 2,484.22
$184.68 $3,878.39 59.04 2,543.26
Total Additional Shares 543.26  
Click to enlarge

Those 543.26 additional shares in year-11 represent an additional $34,257.97 (543.26 x $63.06) in value to the dividend growth portfolio. Therefore, in year-11, the dividend growth portfolio has a total value of $160,385.42 (126,127.45 + 34,257.97), which is more than the growth portfolio's value of $156,662.80.

It should be noted that the additional shares being purchased is an approximate number. Dividends would normally be reinvested and additional shares purchased quarterly. Since stock prices fluctuate every day, the share count could be higher or lower depending on the price that day.

Two additional points should be noted, over a 10-year period a large number of shares are purchased and the longer you hold, the more you purchase. This miracle of compounding is one of the keys to dividend growth investing. The shares you buy with reinvested dividends, pay more dividends and buys even more shares. In addition, in year five, when the stock price fell, the number of shares purchased jumped. Watching share count grow and watching share count grow even more in down years is one of the advantages of dividend growth investing. In my opinion, an investor is likely to trade less and more importantly, not panic and sell at an inopportune time, if he/she sees more shares being purchased while the stock price is down. I know this is true for me, when prices fall I think about all the additional shares I can buy.

When I started this exercise I did not know what the results would be, I thought it would be close, but was not sure what portfolio would prevail. Does my exercise unequivocally prove that dividend growth investing is superior to others investing strategies? No it does not. Nor, was I trying to prove that. What I was hoping to prove, was that dividend growth investing does lead to significant total returns. I do believe I have shown that.

I admit this was a numbers exercise and numbers can always be manipulated. There is no exact set of numbers that can be used that would reflect an actual 10-year period. Some growth stocks would return more than 8%, some dividend growth stocks would return more than 4%. Some growth stocks would flame out after a fast few years and some dividend stocks could decline if the business slowed. What is important for the exercise was that growth stocks returned double in price appreciation what the dividend stocks did. But, when dividends were reinvested, the dividend growth portfolio exceeded the growth portfolio. I do think a 2.5% dividend yield with a 5% annual increase was conservative. I believe most dividend growth stocks grow the dividend faster than that. I also acknowledge a smart trader could trade in and out of growth stocks resulting in a much higher than 8% returns. Or, grab on to the rare growth stock that grows double digits for years. However, I also believe the average investors does not have the time to follow stocks close enough to jump in and out of fast moving growth stocks at the most opportune time. In addition, I also believe the growth stock that grows double digits for years is rare and is subject to large selling when the business growth rate slows.

The Importance of Reinvesting Dividends

As the example above showed, reinvesting dividends is one of the keys to successful dividend growth investing. To drive home that point I thought I would use an individual stock to show the importance of reinvested dividends.

Coca-Cola (NYSE:KO) is another company often found in dividend growth portfolios. KO has been paying and raising dividends for 51 years, so I am confident it will continue for another 10-years, Again, using David Fish's Drip Investing Resource Center, we see KO raised its dividend 8.5% last year, has averaged a 7.5% increase over the last 3-years and 8.4% over the last 5-years.

The chart below will show what an investors approximate total return would be like with KO if they held for 10-years and reinvested all dividends. KO currently trades around the $40.00 range and pays an annual dividend of $1.12. For this exercise I will increase the stock price by $4.00 a year and increase the dividend by 7.5% the lowest of the figures shown above.

Share Price Total Shares Value Div per share Yearly Div Shares Purchased
$40.00 200 $8000.00 $1.12 $224.00 5.60
$44.00 205.60 $9046.40 $1.20 $246.72 5.61
$48.00 221.20 $10,137.60 $1.29 $272.45 5.68
$52.00 216.80 $11,273.60 $1.37 $297.02 5.71
$56.00 222.50 $12,460.00 $1.47 $327.08 5.84
$60.00 228.30 $13,698.00 $1.58 $360.71 6.01
$64.00 234.30 $14,995.20 $1.69 $395.97 6.19
$68.00 240.49 $16353.32 $1.81 $435.29 6.40
$72.00 246.89 $17,776.08 $1.94 $478.97 6.65
$76.00 253.54 $19,269.04 $2.08 $527.36 6.94
Click to enlarge

By reinvesting the dividends, the dividend growth investor has more than doubled their initial investment in 10-years. If dividends had not been reinvested, the original $8,000 would have grown to $15,200 (76.00 x 200). So by reinvesting the dividends the dividend growth investor has increased his/her return by an additional 26%. Obviously this is just an example, KO's price could increase more or decrease and the dividend could be raised more significantly or in smaller amounts. The important take away, is that by reinvesting dividends, the investor significantly increases his/her total return. In addition, the yearly income of $527.36 has more than doubled from the original $224.00 and all the investor has done is reinvest his/her dividends.

Final Thoughts

What I know to be true for me, is that dividend growth investing has provided me the best and most consistent returns. I have been a growth stock investor, a mutual fund investor, and I even tried sector investing, jumping in and out of the hottest sector of the moment. I had some success with all of those approaches, but I also had losses that offset most of the gains. Dividend growth investing, for me, is the best approach for long term investing. Like any investing approach it does take work, but once the plan is put in motion and the reinvesting dividends cycle starts to take hold, it is a beautiful thing to watch.

I will close by saying, I disagree with the commenter, from my previous article, that those that advocate dividend investing are shameful. I do not find anything shameful in advocating dividend growth investing and I have never stated, nor am I aware of too many fellow dividend growth investors stating total return does not matter. What I have experienced and what I am comfortable telling fellow investors is that dividend growth investing leads to growing income and healthy long term total returns.

Disclosure: I am long KO, MCD. 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.