Why I'm Focused On Dividend Growth Rates

by: Chumpmenudo


My dividend growth portfolio has enjoyed excellent total returns so far.

I believe dividend growth track record is a very useful screen to identify great companies.

A focus on a fairly controllable metric like dividend growth can lead to excellent total returns.

After finding Seeking Alpha a few years ago, I began reorganizing my IRA to reflect my changing investment philosophy. In 2012, I set about building a dividend growth portfolio for retirement, and have been recording the journey on a blog.

2013 was my first full year with an established dividend growth portfolio, and the results were good. The portfolio's total return in 2013 was 32.95%, slightly beating the S&P 500 index over the same one year period.

When I started my blog and the redesigned portfolio in 2012, my intent was a hybrid portfolio of stellar dividend payers and less stellar, but faster-growing stocks that would eventually morph into an income-producing juggernaut at retirement. Over time, I found it difficult, and somewhat counterproductive, to try and group my holdings into two categories. Thus, I simplified my approach, and began buying good stocks at attractive valuations. My definitions for "good" have been evolving, and for valuation, have been deteriorating, with fewer bargains evident versus 2012.

And while I've continued to change my investing "rules," one tenet of my investing principles that hasn't changed is dividend growth. While I've bought several companies that pay small dividends, these same companies have a dividend growth track record of raising the dividend for at least several years. I've found that a great dividend growth track record is a useful screen to identify excellent companies.

First, why do I care about the dividend before I retire? In one of my earliest articles, I explored the effect of dividend growth on total return.

As my simple analysis showed, and as my favorite author at Seeking Alpha, Chuck Carnevale, has stated:

Although the focus is often mostly on the dividend income, for many dividend paying stocks it is merely the icing on the cake. Whereas the cake is the capital appreciation component that is often overlooked in favor of yield.

Nevertheless, I have come to believe that the discipline required by a company to pay a dividend back to shareholders every single quarter, and grow that payout to shareholders every year, is a great indicator of earnings stability and future share price appreciation.

Throughout my career I've followed Peter Lynch's precept of "pay yourself first." Applied to companies in which I own stock, the dividend paid to shareholders is the perfect application of this principle. Management pays the dividend first, then decides how to reinvest what remains of retained earnings. As with individuals, this prevents management from "wasting" the money. This may come across as a bit cynical, but I firmly believe this to be true.

Taking this logic one step further, I believe that a stable, growing dividend is an indication of great corporate management, discipline, and deference to shareholders. And ascending a final mental step, I believe any enterprise that pays a consistent, growing dividend over long periods can very likely be considered a great company. Therefore, via the transitive property (the engineer within is always fighting to come out), long track record of dividend growth = great company.

So a growing dividend has become a consistent theme of my investing over the past 1.5 years, and my results have been pretty good so far. Looking at dividend growth in my IRA since 2010, you can see the effect of transitioning to dividend payers/growers:

Back in 2010, I was invested mostly in index funds and ETFs. By late 2012, I had transitioned the portfolio to approximately 32 dividend growth stocks. Dividend payments, which are reinvested, have been growing at a compound annual growth rate of over 21%. The increase in income from 2012 to 2013 was only 7.35% due to timing of increases, and some heavy positions in lower yielding stocks. Here was the Chumpmenudo portfolio at year end, sorted by position size:

Looking carefully at my dividend growth has given me a real appreciation for the "Chowder Rule," re-stated here from a Chowder article at Seeking Alpha.

When you take the current yield and add it to the 5 year compounded annual growth, I want to see a number of 12% or better when the yield is 3% or higher, or a number of 15% or better when the yield is under 3% but above 2%.

While I don't stick to Chowder's rule perfectly, I do keep it in mind, and agree that it's very important to consider the combination of current yield and dividend growth rate.

Looking at my holdings, I was surprised by the dividend growth rate. The weighted average (by position size) one year increase in dividends for this portfolio was a remarkable 31.32%. Looking ahead to 2014, I've set myself up for a nice annual raise, I control the size of the raise, and irrespective of movements in share price, my yearly increase is virtually guaranteed.

I admit that an income of $12,704 is nothing to get excited about, and I certainly can't live on the income this portfolio threw off in 2013, but I still have around 15 years until retirement, and to some degree, I can control how that income grows. I'll continue to hold and select stocks that keep growing the dividend. If I assume retirement in 15 years, It's fun to project some different income scenarios, again, independent of stock price fluctuations. Here are those dividend income projections, with dividends reinvested:

In the chart above, every scenario starts with my actual $12k in dividends from 2013. But going out 15 years to retirement, you can see that the rate of dividend increases is a major factor in determining my income at retirement.

Reinvesting dividends that are growing rapidly every year, has an amazing compounding effect; this is what Lowell Miller refers to as your "compounding machine." The chart below shows that effect, comparing income growth without reinvested dividends versus with reinvested dividends. Dividend growth rate coupled with reinvestment is very powerful.

Click to enlarge

Can the Chump portfolio sustain a 20% dividend growth rate? Probably not, but if I'm focused on this metric, I can sure try to keep it above 10%. Looking back up at my holdings, and the one year dividend growth column, I count 9 of my 32 holdings that raised the dividend by at least 20% last year, and another 7 of 32 that raised the dividend by more than 10%. And depending on the weighting of each stock, I can tilt the scales toward the higher dividend growth stocks by rebalancing. Even if I can't maintain a 20% compound annual growth rate over time, I'd be quite happy with 15%, which gets to me to an income of $126k per year at retirement, and importantly, I don't have to sell any shares to get it.

This is where I think we folks that focus on dividend growth are on to something. If I keep my portfolio focused on two highly controllable metrics, current yield and dividend growth, the so-called icing on the cake of capital appreciation, I can virtually guarantee a projected income stream in retirement. Conversely, I think its much harder (and stressful) to focus on capital appreciation. Yes, capital appreciation and total return are of paramount importance to me, but the best method I've found to ensure price appreciation is to buy really good companies, which I define as those with the discipline and strength to pay and grow a dividend.

In summary, I want it all: great total return and plenty of dividend income for a great lifestyle in retirement. The strategy I've adopted thus far is to focus on keeping the dividend stream growing at a healthy clip and using a track record of dividend growth coupled with valuation to choose which stocks belong in the portfolio.

Disclosure: I am long INTC, CSCO, OHI, IBM, ADM, MSFT, MCD, WFC, KMI, JPM, AAPL, CSX, CVX, SO, KO, PM, JNJ, WAG, WMT, MDT, DE, HAL, VMI, MO, O, COP, AFL, EMR, GD, BBL, KSS, DOV. 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.