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The One Sector That Keeps Me Up at Night

As a dividend growth investor in the early stages of putting together a portfolio of core holdings, I am repeatedly struck by how elegantly simple it is to understand how many of the traditional dividend growth stalwarts might increase their profits for decades to come. I'm not talking about analyzing valuation or balance sheets or any of the nitty gritty business of assessing a stock one is considering purchasing. I'm talking about simply understanding at a very basic level how some of these companies could continue to increase their earnings into the future more or less indefinitely. It doesn't take a genius to understand how Johnson & Johnson (NYSE:JNJ), Procter and Gamble (NYSE:PG), or Coca Cola (NYSE:KO), just to name a few, might continue to grow. As a result, holding these dividend stalwarts for the decades-long horizons that most dividend growth investors aspire to is usually not a particularly daunting proposition.

For all the comfort that investing in dividend stalwarts often provides, however, this is emphatically not true for dividend growth stocks in the technology sector. I am a fairly tech savvy individual. I know my way around a command prompt, used Linux for years, understand the basics of programming, and can code a simple web page. But none of that makes me feel the least bit confident about picking dividend growth stocks in the technology sector.

Again, what I mean when I say this is not that I've analyzed their fundamentals, valuation, and the like and concluded that there are problems on that front. I just mean that in a very basic sense I am not confident in these companies' ability to grow their earnings into the distant future. Sometimes, this is because a particular company's products seem to consistently underwhelm and annoy in a banal sort of way. I would say that Microsoft (NASDAQ:MSFT) falls into this category. I feel the same uncertainty, however, about companies on the completely opposite end of the "cool" spectrum. While Apple (NASDAQ:AAPL) wouldn't currently satisfy the self-imposed criteria for most dividend growth investors, it's conceivable that it might do so in the not too distant future. But while Apple might currently be the King of Cool tech-wise, I cannot think of any reason why it is necessarily likely to maintain that title thirty or forty years into the future.

This is really remarkable when you stop to think about it. Neither my own familiarity with technology nor my assessment of the quality of a tech company's products offers any real guidance as to whether a particular company might be able to increase its earnings into the future. This disconnect between what I know about technology now and what it tells me about the future is deeply unsettling to me as a "buy and monitor" long term investor.

Big Bang Disruption Provides an Explanation

One explanation for this disconnect that resonates strongly with me is what Larry Downes and Paul Nunes refer to as "Big Bang Disruption." In a recently published article the two argue that whereas the process of product adoption once followed a bell curve, it now follows a trajectory that is more akin to a shark fin: since products are cheaper and better than they used to be the moment they hit the market, and since consumers have instant access to nearly perfect information about newly launched products, adoption, if it ever occurs, occurs extremely quickly. The converse is also true: adoption of successful products falls off dramatically when other Big Bang Disruptors enter the scene.

The following three paragraphs from the article succinctly identify the source of my anxiety about investing for the long term in the technology sector:

The process of Big Bang Disruption begins as a series of low-level, often unrelated experiments with different combinations of component technologies. This relative calm may give incumbents the false sense that nothing is happening, or in any event that whatever might be happening is not doing so quickly enough to warrant a competitive response.

Yet when the right combination of technologies is assembled and paired with the right business model, takeoff is immediate. Customers from a wide range of segments, including mass market consumers, adopt the disruptor as quickly as its producers can supply it. Market penetration is often nearly instantaneous.

Next, as the disruptor quickly approaches saturation, adoption drops at nearly the same pace with which it took off, leading to a period of rapid if uneven decline. During this period, early warning systems, careful planning, and the agility to quickly scale up and then down are essential both to capitalize on the opportunity of a Big Bang Disruptor as well as to survive the chaos it can bring to existing markets.

Even before reading these three paragraphs, I suspect that many people intuitively grasped that what Downes and Nunes are describing is a source of considerable trepidation for those who would invest in the technology sector.

What To Do About It?

So what is a long term dividend growth investor to do in the face of the dilemma created by Big Bang Disruption? I can think of only three possibilities: (1) spread one's exposure to the sector around by investing in it through dividend paying ETFs; (2) decline to invest in the sector at all; or (3) treat technology like any other sector and follow a "buy and monitor" approach. Each of these approaches is discussed below.

Investing in Dividend Paying Technology ETFs. At first glance, investing in the technology sector via ETFs sounds like a perfect way to gain exposure to the sector without betting all of one's chips on only a handful of companies, any one of which might become a victim of Big Bang Disruption.

I do not currently own any ETFs and had not previously researched dividend paying technology sector ETFs, but a quick search of Seeking Alpha yielded (pun intended) an interested article by TopYields entitled "Dividend Growth: The Case of Technology Dividend ETFs" that discusses the subject in some detail and mentions a number of relevant ETFs, including TDIV, XLK, IYW, DGRW.

After further reading, however, it looks like gaining technology exposure through ETFs comes with a number of drawbacks for the dividend growth investor, including the following:

  • The yield for these ETFs is often below what many dividend growth investors find acceptable and could obtain with a basic portfolio of individual dividend growth stocks. The yield for the ETFs mentioned above, for example, currently ranges from 1.11% to 2.43%.
  • While these ETFs may yield dividends, they are not necessarily focused on dividend growth. In other words, while the stocks included in the ETF have minimum yield thresholds they usually don't have minimum dividend growth thresholds. Additionally, the required dividend history is often fairly short by most standards. For example, TDIV only requires that a stock "have paid a regular or common dividend within the past 12 months."
  • Even those ETFs that focus on dividend growth don't always limit themselves to the technology sector. The technology sector makes up only 19.96% of DGRW, for example.
  • A portion of one's income from these ETFs is lost to expenses. For the ETFs mentioned above the loss amounts to 0.18% to 0.50%.

When combined, these drawbacks are enough to make me reluctant to invest in the technology sector via dividend paying technology sector ETFs.

Declining to Invest in the Technology Sector at All. While it is possible to avoid investing in the technology sector at all, a long term dividend growth investor would seem to be required to invest in technology stocks in order to be properly diversified. If there are 11 sectors of equities, then declining to invest in one of them altogether is a pretty big deal. Furthermore, as TopYield's article makes clear, failing to invest in the technology sector in particular could mean having no exposure to a sector that has seen some of the largest dividend growth as of late:

According to WisdomTree and Bloomberg, "Technology firms have been the greatest contributors to dividend growth over the past five years - accounting for more than 54% of the increase in dividends from November 30, 2007, to June 30, 2013." Moreover, NASDAQ OMX research found that the tech sector realized the fastest annualized rate of dividend growth, which averaged 24.27% over the decade that ended December 31, 2012. The rapid dividend growth continues unabated.

Most dividend growth investors will be reluctant to be totally absent from a sector experiencing such rapid dividend growth.

Treating the Technology Sector Like Any Other Sector. In light of the foregoing, it seems that the only viable response to the threat of Big Bang Disruption is to treat the technology sector like any other sector by investing in individual dividend growth stocks and then carefully monitoring them. This is the approach I've taken in the past and it is the approach I am likely to continue.

This approach is not without risk. In a world where product adoption trends look more like shark fins than bell curves, if one holds stock of an individual technology company, one appears to be betting on that company's ability to generate steady earnings growth from what must surely be a bumpy trajectory of sales resulting from the repeated release of a series of rapidly adopted, then rapidly surpassed, products. One would also seem to be assuming that most or all of the company's future products will in fact be adopted in this manner.

The risk of such an approach is plain to see, but if the alternative is to miss out on the high dividend growth of this sector entirely or to participate in a way that fails to provide adequate yield, adequate yield growth, and adequate exposure to the sector, then individual stock selection appears to be the only real option.

Source: Tech Sector DGI In An Age Of Big Bang Disruption