Based on over 730 comments, at last count, Chuck Carnevale's recent article created a mild firestorm as to the advantages of purchasing dividend growing individual stocks vs. indexing. Is there evidence, other than what the author presented, to back up the claim that retirees would be better off selecting individual dividend growing stocks rather than taking a shortcut and buying a broad-based index fund such as VFINX or VTSMX? To answer this question here is my analysis and assumptions.
I searched the Internet for Dividend Aristocrats and found 54 companies that raised their annual dividends for 25 or more consecutive years. Abbott Laboratories (NYSE:ABT) and AbbVie (NYSE:ABBV) were immediately eliminated due to split issues and lack of historical data. Since dividends are such a hot issue, I selected companies that generated a yield in excess of 2%. This yield screen reduced the number from 54 companies to 33.
Three time frames were selected. The first begins on 6/30/2006 as this date takes in the bear market of 2008 and early 2009 as well as the great bull market since March of 2009. The second date begins on 3/31/2009 as I was interested in seeing how dividend growers performed during a very strong market. The last time frame covers the last two years or from 6/6/2012 through 6/6/2014. All periods investigated ended on 6/6/2014.
All data was calculated using the TLH Spreadsheet, an ExcelTM program that has been tested against three commercial programs for accuracy. All prices are from Yahoo! Finance and are closing prices. This avoids the bid-offer spread, an advantage to the stock portfolio results. No commissions are included, but they would be a minor factor in these calculations. The portfolio carries no cash, a significant advantage over a real world situation where cash is a drag on a portfolio over the periods investigated.
Period 6/30/2006 - 6/6/2014
Dividend Portfolio = 10.6% plus dividends. On average, dividends will add between 2.5% and 3% to the 10.6% value. If an investor focused on the very highest yielding stocks, this would be a bit higher. Many of the stocks on the list show yields between 2.0% and 2.5%. All percentages are annualized. 100 shares were purchased for each of the 33 stocks. I then invested $10,000 or equal amounts in each stock and by coincidence, the Internal Rate of Return (IRR) for the stocks remained the same at 10.6%. In the next paragraph we have the IRR values for two popular index funds, the Vanguard S&P equivalent and the Vanguard Total U.S. Equity index.
VFINX = 7.8% VTSMX = 8.3% Both indexes include dividends.
Over this period, the 33 selected Dividend Aristocrats definitely performed better than the two index funds.
Period 3/31/2009 - 6/6/2014 (Bull Market period)
Dividend Portfolio = 19.6% plus dividends. (100 shares invested in each stock)
VFINX = 21.2% VTSMX = 22.1%
This period is nearly a dead heat if one were to factor in bid-offer spreads, cash drag, and commissions. The dividend growing investor would need to be nearly perfect to beat either U.S. index fund over this time frame.
The portfolio performs slightly better when equal amounts are invested in each stock. When this is the case, the Internal Rate of Return is 20.1% + dividends for the stock portfolio or an improvement of 50 basis points.
Period 6/6/2012 - 6/6/2014
Dividend Portfolio = 22.4% plus dividends when 100 shares are invested in each of the 33 companies.
VFINX = 24.2% VTSMX = 24.8%
When equal amounts are invested in each company the return dips slightly to 22.1% plus dividends. Once more, this is close to an even call, particularly when one is able to select index ETFs that are dividend oriented. But that argument can wait for another day.
What happens if one were able to eliminate the three worst performing stocks during the 6/30/2006 - 6/6/2014 period? If one were able to do this, the performance increases from 10.6% to 11.1% with dividends added on top.
What if the top three performers were missed during the same period? How much is the portfolio damaged? Overlooking the top three companies drops the IRR from 10.6% down to 10.0% with dividends added in both cases. Even by missing the top three performers, the stock picking investor would outperform the VTSMX index fund.
Conclusion: It is not a clear cut case as to which method of portfolio construction is superior. 1) The time frame makes a difference. 2) Assuming cash is invested in stocks at all times is unrealistic. Holding sizable amounts of cash can be avoided if one uses a DRIP program. 3) Assuming no commissions or bid-ask spread is also unrealistic. 4) Depending on the size of the yield, it does appear as if dividend growing stocks hold the edge over either index used in this analysis.
This article leaves at least one question unanswered. What if the index investor populated a portfolio with income oriented ETFs?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.