Owning dividend-paying stocks can be a sensible part of any investment plan.
Dividends generate income, improve yields, and contribute to total returns.
Dividend paying stocks provide investors with income, which is important for retirees, but they can also contribute to the long-term growth of your account balances.
I recently wrote an article, "Dividend Growth Investing: An Introduction To Creating Wealth." That article was intended to be the starting point for a series on the strategy of Dividend Growth Investing and to hopefully arrive at a clearer understanding of how to best use the strategy for the purpose of creating wealth over time.
One of the criticisms of DGI that seems to come up quite often in any discussion of the strategy is that DGI is best suited for older people and is not the best course of action for younger investors.
You see, according to the critics, a younger investor has time on his side. The younger investor can assume more risk, because his time horizon for investing is greater than the time horizon that an older investor has left. The younger investor "should be taking on more risk to build a larger portfolio value from capital appreciation" according to the conventional wisdom. After all, the argument goes, in the end, "size matters."
What I Know:
No one has a crystal ball that allows them to accurately predict the future, but each of us has enough information that is readily available to us in order to at least make a reasonable guess as to how things might work out in that future.
When I look at the five companies that we highlighted in the first article, Coca-Cola (NYSE:KO), Procter and Gamble (NYSE:PG), Colgate Palmolive (NYSE:CL), Johnson and Johnson (NYSE:JNJ) and Kimberly Clark (NYSE:KMB), I cannot say that these companies will perform in the future like they have in the past.
But each of these companies has a history that allows me to have a reasonable expectation that holding them into the future will provide me with an increasing dividend income and continued revenue and earnings growth so that those dividends might also be continued into the future. No guarantee, but a reasonable expectation.
What You Should Know:
So, let's get back to our main question here: "Is DGI a good strategy for a younger investor?" From my own perspective (and I know how that irritates some people) I can answer with assurance that "yes, it is." And to expand on that opinion, DGI is best appreciated when the investor reinvests those dividends over a long period of time. As some DGI call it, the "miracle of compounding."
One of the main factors in assembling a portfolio of DG stocks is to find stocks that have been growing their dividends. Nothing complicated here. If a stock pays a dividend, then that is what it is: a stock that pays a dividend. But, if a company increases its dividend every year, for a long period of time, then it is a dividend growth stock, that is, the dividend is growing. That is not to imply that one is intrinsically better than the other. It just helps to clarify the definition of what a dividend growth stock is.
For those who are not aware, David Fish updates a list of companies that are known as the Dividend Champions, Contenders and Challengers. Some DGI refer to his list as "the CCC stock list." Here is a link to that site.
Time Is Money:
The companies in our list of 5 are companies that I would consider "core" holdings. They meet all of the metrics for DG stocks and are Dividend Champions. Let's take a look at how a long term holding in each of these companies would have rewarded an investor who has been holding for a long time.
A Set It And Forget It Approach:
In our previous discussion of the 5 core holdings, a table that I shared showed the annualized total return for each holding, since 1987 through 2013. It was pretty impressive for a couple of reasons.
First, over that period of time, the stock market had plenty of ups and downs to challenge the nerves of the long term investor. In spite of the market gyrations, buying and holding these core companies resulted in a very nice return on investment.
If we look at total return, from my perspective, we need to include capital gains and dividends to arrive at our total return number. These are dividend growth stocks after all, and the dividend is part of the total return received.
One of my practices as a DGI, is to reinvest dividends. The reason I do that is because reinvestment allows me to compound my returns over time. As dividends are converted into additional shares of the company paying those dividends, the additional shares magnify the income from those dividends.
Rather than break down each of the five core stocks, I've decided to use Colgate Palmolive for the purpose of our example. Our construct is an investor who purchased $1000 worth of Colgate Palmolive stock on January 4, 1987 and held onto those shares through today.
Our $1000 purchase in 1987 would have gotten us 46 shares of Colgate Palmolive stock. Had we decided to take the dividends and not reinvest the same dividends, but use them for other things, we would have ended up with 368 shares of CL worth $23353.28. The gain in shares is due to stock splits over the course of our ownership.
On the other hand, had we reinvested the dividends over the same period of time, today we would own 529 shares of CL worth $33624.20. The current income, based on the current dividend payment of $1.44 a share annualized would throw us an additional $231.84 with the reinvested shares.
Continuous Additions To Our Holdings:
I have to admit that I love accumulating shares in my own core holdings. When companies that I own appear to be priced at a value, I like to add additional shares to my existing holdings.
As a DGI, a "set it and forget" it approach, as in our first example here, doesn't work for me. As long as a company continues to meet the 8 point metric that I outlined in the first article, then I am still a buyer of that company.
When that company is priced at a value to fundamental then, again, I am a buyer of the stock as money becomes available. But let's just say that an investor were to purchase additional $1000 increments of CL every two years since 1987. How would that investor have fared?
With dividends reinvested, this strategy would have seen our investor purchase 440 shares at a cost of $13,793.55. With stock splits and dividend reinvestment over the years in this time frame, the portfolio would own 2165 shares of CL, worth $137,832.28 and that holding would be producing $3117.60 in income this year.
Colgate Palmolive has grown dividends 9.0% the last year, 9.4% over the last 3 years, 11.3% over the last 5 years, and 11.4% over the last 10 years.
When an investor purchases dividend growth stocks and reinvests dividends back into his position, he is practicing a form of "dollar cost averaging."
Since Dividend Growth Rates give us an indication of future dividend increases, it is possible to create a portfolio of dividend growth stocks and to project income expectations moving forward.
While nothing is guaranteed, it would seem that stocks with a long history of increasing dividends annually are a good place to begin looking for potential additions to your own portfolio.
My own target metric for DGR is to be larger than inflation, which means I tend to look at DGR's of 6% or more over a 3-5-10 year window.
When allowing the compounding effect of reinvested dividends (for additional shares) and the DGR, the portfolio value is enhanced greatly.
Purchasing additional shares of your core holdings on a "priced at a value" metric will add even more success to your investing strategy.
Disclosure: I am long KO, PG, CL, KMB, JNJ. 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.