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Summary

  • Dividend growth investing is one of the most popular and time-tested stock market investment strategies.
  • Who among us are truly dividend growth investors? Do you pass the two key tests?
  • Will you be ready to not only withstand, but capitalize on the potential risks that lie ahead?

It is one of the most popular and time-tested stock market investment strategies. It is dividend growth investing, or DGI, which is a strategy that focuses on companies that consistently increase their dividend payouts each year, supported by the predictable long-term growth of earnings per share. The recent success of this strategy, coupled with the yield-starved zero interest rate environment over the last several years has attracted scores of new dividend growth investors, both young and old. But with so many newcomers to the strategy, it raises an important question. While you may have fully bought into the approach over the last few years, are you a true dividend growth investor? And are you truly ready to not only withstand, but capitalize on the potential risks that may lie ahead.

One key characteristic more than any other defines the true dividend growth investor. And it is a factor that many have not yet experienced in any meaningful way. It is the ability to withstand a substantial decline in the principal value of your dividend growth investments, potentially over an extended period of time that could last many years. This aspect is critically important, for as long as you are receiving the increasing dividend stream from your DGI strategy, the principal value of your portfolio at any given point in time should be inconsequential. While the adherence to this discipline is easily stated, it is far more difficult to carry out in practice, even for the most experienced members of the club.

Two Key Tests For The True Dividend Growth Investor

Two key qualitative tests are worth conducting to determine whether you are truly a dividend growth investor.

TEST 1

The first, can you remain CALM and firmly dedicated to your dividend growth investing strategy in the face of a substantial decline in the value of your portfolio over an extended period of time?

Place yourself in the following scenario to test this point. Suppose you have an investment portfolio of $2,000,000. It represents a significant portion of the savings that you have worked a lifetime to accumulate. And it is the money that you cannot replace with additional earned income to help support yourself in retirement. Now suppose over the course of two or three years, the value of this portfolio shrinks from $2,000,000 to just $800,000. As it continues to fall, the daily financial media is increasingly filled with stories about how the market could lose another 10% to 20% of its value in the future, if not more. Do you have the fortitude to withstand such pain and stick with your dividend growth investing guns? If you ponder this scenario and your answer is yes, you have passed the first test in determining whether you are a true dividend growth investor.

TEST 2

This leads us to the second test, which is an extension of the first test from above. Can you not only remain calm, but do you actually become increasingly EXCITED in the midst of a substantial decline in the value of your portfolio over an extended period of time?

Revisiting your $2,000,000 scenario from above, can you not only shrug off the fact that the principal value of your investments have fallen to just $800,000, but you also find yourself giddy with enthusiasm at all of the exceptional and deeply discounted values the stock market is offering dividend growth investors in the market wreckage? Going one step further, did you strategically tuck some reserve cash away in advance to capitalize? If so, you have passed the second and more defining test of the true dividend growth investor.

Much Easier Said Than Done

It has been a very long time since even the most time-tested dividend growth investors have had to face the prospect of these two critical tests for any meaningful amount of time. Of course, this statement might seem utterly absurd at first. After all, did we not just emerge from an experience less than a decade ago when these very same dividend growth stocks (NYSEARCA:SDY) lost more than 50% of their value? Yes, this is true. But what was notable about the path of dividend growth stocks during this financial crisis period from July 2007 to March 2009 is that they were only down marginally, at less than -10%, in this bear market until the aftermath of the Lehman collapse in October 2008. In other words, the virtual entirety of the staggering loss experience was confined to just five months from October 2008 to March 2009, before the stock market (NYSEARCA:SPY) came roaring back on the rocket fuel of unprecedented Fed stimulus that restored virtually all of these additional losses within the next twelve months. So while the pain was traumatic, it was also fleeting. In fact, a cool-headed long-term investor might have checked the value of their portfolio a small handful of times at most over such a short period.

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What about the bursting of the technology bubble from March 2000 to March 2003? Once again, the losses bypassed dividend growth investors until the final stages of the bear market in early to mid-2002. And in many cases, dividend growth stocks posted solid gains over the duration of the bear market at the time, as it was grossly overinflated sectors at the time such as technology, media and telecom that bore the brunt of the damage.

How about the stagflationary mess back in the 1970s? First, any declines in portfolio value were obscured in part by the fact that market is priced on a nominal basis. Even on an inflation adjusted real basis, many dividend growth stocks once again held up better than the overall market over the duration of this secular bear market from 1968 to 1982, thanks to the fact that many of these companies are sourced from industries traditionally with greater pricing power, such as food, household products and healthcare, as evidenced by representative dividend growth names such as Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO) and C.R. Bard (NYSE:BCR).

In short, the last time that a dividend growth investor had to endure substantial portfolio losses for an extended period of time was during the Great Depression in the 1930s into the early 1940s. During this time, stocks in general lost nearly 90% of their value from their peak over a three-year time period, and took another 25 years to fully recover this lost principal value. To put this into the context of today, it would be the equivalent of a $2,000,000 portfolio falling in principal value to $216,281 by 2017, and then having to wait until 2042 until the principal value of your portfolio was once again worth $2,000,000. Now that is an ultimate test of resilience and discipline.

"If you can't stomach 50% declines in your investment, you will get the mediocre returns you deserve"

- Charlie Munger

It is a grand testament to the merit of DGI as a sound long-term investment strategy that it has been so long since investors have been tested in such a way. Of course, the same could also have been said of homeowners up until around 2007. And it is this point that reveals the inherent weakness and potential risk for unsuspecting dividend growth investors. For not even the legendary 83-year old Warren Buffett or his trusted 90-year old partner Charlie Munger have had to truly put their true dividend growth investing mettle through such a rigorous test over an extended period of time. In fact, one would have to go all the way back to the generation of Buffett's mentor, Benjamin Graham, who would be 120-years old this year, to find those investors that not only had to stick to their discipline but also survive for so long in such a punishing environment. As a result, investors may wish to ponder the possibility of expanding Mr. Munger's quote from above to stomaching greater than 50% declines in your investment for a period of many years to test their conviction even further.

So What?

So why are we even bothering to ponder this question today? After all, it's been more than 75 years since dividend growth investors have truly taken a major and prolonged hit to the chin with their investment strategy. Why now?

Here's why. Whenever you here the worrisome expression "chase for yield" and all of the risks it denotes, know that dividend growth stocks are part of that discussion. They may not be the most leveraged asset class in the group that includes high-yield bonds (NYSEARCA:HYG), senior loans (NYSEARCA:BKLN) and preferred stocks (NYSEARCA:PFF), among others, but they are right in the heart of the discussion. As a result, if this current "chase for yield" that has been going on for several years now eventually turns sour, we should expect that dividend growth stocks could take a disproportionate and unexpectedly large hit in the aftermath.

Valuation is also an issue. With the average dividend growth stock currently trading at 20.0 times trailing 12-month earnings, and the median stock an even higher 21.7 times trailing 12-months earnings, which is historically high on both counts, the room to the downside purely from a valuation standpoint is considerable.

Lastly, there is no guarantee that the Fed is going to ride to the rescue the next time around. During the heat of the financial crisis in late 2008 and early 2009, the Fed came rushing in with what was once considered extraordinary stimulus to save the global financial system. In the years since, the Fed has quintupled the assets on its balance sheet from less than $900 billion to roughly $4.5 trillion. And in the end, it appears that the Fed may be belatedly coming to the conclusion that all of these efforts to inflate asset prices to support an economic recovery have not worked. Thus, they cannot be expected to provide even more stimulus to boost asset prices the next time stocks correct in a meaningful way in the future, particularly now that their balance sheet is stretched beyond all recognition.

None of this means that a Great Depression scenario will erupt for dividend growth stocks the next time we enter a bear market. But it does suggest the possibility that these stocks could lose 50% of their value or more for a period longer than a few months during a future bear market.

So What To Do?

Does this mean that dividend growth investors should sell everything and go running for the hills today? Absolutely not. I myself continue to hold a number of dividend growth stocks, with no intention of selling them in the near term. But it also does not mean that dividend growth investors should simply bury their heads in the sand under the false comfort that they can just stay the course fully invested and weather any short-term declines in portfolio value along the way, for the future may not be as kind as the past has been. It is always worthwhile, regardless of the market environment, to assess the qualitative and quantitative risks that may impact the value of your portfolio. And today is certainly no exception in this regard.

To this point, there is a good reason why famed disciplined investors such as Warren Buffett and Seth Klarman are holding historically high levels of cash in their portfolios today. It's not because they have abandoned their discipline. On the contrary, it is because of their strict adherence to their discipline that they are holding historically high cash levels. And we can rest assured knowing that when the next major bear market finally arrives, both Mr. Buffett and Mr. Klarman, among others, will not only remain calm, but will be enthusiastically salivating at the opportunities that become available before their eyes. With a staunch dedication to all facets of a true dividend growth investing approach, this can be you too.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met. The author is long PG, PFF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. I am long stocks via the SPLV and XLU as well as selected individual names. I also hold a meaningful allocation to cash at the present time.

Source: 2 Key Tests For The True Dividend Growth Investor