With characteristic persuasiveness, well known dividend growth investor David Van Knapp has argued that to get a true picture of one's asset allocation, the capital equivalent of one's income from Social Security and other pensions should be included when determining how much of one's portfolio is invested in fixed income investments. In many cases, the resulting conclusion for the dividend growth investor will be that most of one's non-pension assets can appropriately be invested in dividend growth stocks without the need to put anything in traditional fixed income investments at all.
His argument made me wonder about a related question: in addition to its effect on asset allocation decisions, might having substantial pension income make it appropriate to take greater risks with respect to the selection of individual dividend growth stocks?
What I Mean by Taking Additional Risks
Let me clear about this up front: when I talk about taking additional risks I am not talking about compromising with respect to valuation. I am not, in other words, asking whether someone with substantial pension income should consider purchasing stocks with P/E ratios or other valuation metrics that exceed whatever thresholds one has set for oneself. I, like most dividend growth investors, am extremely value-oriented and think that regardless of what other assets one may have, investing without a focus on value is a mistake.
I am talking instead about investing in companies whose future dividend growth is less certain than is the case with traditional dividend growth stocks. Understandably, the most popular dividend growth stocks tend to be those of large companies that have paid increasing dividends for decades (e.g., PG, KO, JNJ, T, XOM, PEP, MCD, CLX, etc.). What I am asking is whether investors with substantial pension incomes should be more willing than others to search for stocks beyond this relatively small universe. Should such investors be more willing than others to search for stocks of companies that are smaller or that have a shorter dividend history; companies, in short, that generally look like good dividend growth stock candidates but for the fact that they violate one or two of the self-imposed guidelines we have set for ourselves?
Examples of the Sort of Riskier Stocks To Which I Am Referring
Any regular reader of Seeking Alpha will no doubt have come across countless articles that contain intriguing investment ideas. If your experience has been anything like mine, though, following up on many of these ideas would have violated the self-imposed, conservative principles of your dividend growth investing philosophy.
For example, a while back I came across what I thought was a great article about a company called MicroFinancial, Inc. (NASDAQ:MFI). The article (which is sadly now only available to SA Pro subscribers) was convincing, the company's business model made sense to me, and the stock seemed fairly valued and paid a rapidly increasing dividend with a yield that hovered around 3%. But while the dividend had been increasing for the last few years, the company didn't meet my self-imposed prerequisite for a five year history of rising dividends, and with a market cap just north of $100 million the company fell below my self-imposed minimum size requirement.
In contrast to the small cap and relatively unknown MFI, is a behemoth like GE. GE looks like a great dividend growth stock by almost any measure, except that the company cut its dividend in the wake of the financial crisis and so the stock lacks the record of five year dividend growth that is a prerequisite for me and most other dividend growth investors.
The lack of sufficiently lengthy records of dividend growth would also be a problem for the more than 170 "Near-Challengers" (i.e., companies with 4-year streaks of increases) that can be found on the latest version of David Fish's priceless Dividend Champions spreadsheet (this article states that these Near Challengers can be found in Appendix B (on the Notes tab) of the spreadsheets linked to therein).
Assessing Potential Risks and Rewards and Understanding How Having Substantial Pension Income Fits into the Picture
The common thread that runs through MFI, GE, and the Near Challengers is that they all look like fairly solid dividend growth candidates but a rigorous application of common tenets of dividend growth investing would preclude investing in them at the current time. Put differently, if we view failure to comply with common tenets of dividend growth investing as being synonymous with risk then these stocks are riskier than traditional dividend growth stocks.
But how risky are they really? Is investing in a stock that meets, say, 9 out of 10 of our self-imposed criteria really such a risky proposition or is it just slightly less conservative than we dividend growth investors like to be? I think it's the latter. If on the one end you have conservative, rules-based dividend growth investing and on the other end you have pure speculative non-dividend-paying plays (I'm thinking here of investing in, say, TSLA), then investing in stocks like GE and the others we've been discussing here seems to me to be only slightly riskier than investing in more traditional dividend growth stocks.
Furthermore, whatever increased risk is associated with investing in these "9 out of 10" stocks, there are potential rewards of doing so as well. These include: (I) getting in on the ground floor from a price standpoint as a result of the fact that a stock is not yet on the radar of more traditional dividend growth investors; (ii) investing when the company is in the early stages of establishing a history of dividend growth, which is often a period of rapid increases; and (III) expanding the universe of stocks one can potentially invest in.
So, how does pension income fit into this picture? To the extent that one has substantial pension income, one will be that much less dependent on the income generated from other investments and can consequently afford to take on the relatively small additional risk that comes with investing in "9 out of 10" stocks. This is really just a corollary of the obvious fact that if you have a lot of income, you have less need to generate additional income and can consequently tolerate greater risks with respect to that additional income.
Investing in dividend growth stock candidates that satisfy almost all--but not all--of our self-imposed investment criteria seems riskier than investing in dividend growth stocks that satisfy all of those criteria. But there are potential rewards for doing so, and the amount of additional risk seems relatively minor when considered against the backdrop of the entire range of potential investment decisions one might make. Accordingly, in my opinion, an investor with substantial pension income should not be afraid to invest a portion of his or her non-pension assets in "9 out of 10" dividend growth candidates.
Disclosure: I am long 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.