Dividend Growth Investors, Prepare To Boost Your Returns

 |  Includes: AGG, SPY, TLT, VIG
by: Dale Roberts


Selecting a group of dividend growth companies can provide a lower risk or lower volatility portfolio.

That lower-volatility portfolio may help some investors weather the next storm, but dividend payers can fall hard as well.

I fear that many dividend growth investors have not conducted a true personal risk assessment.

There can be a false sense of security when it comes to dividends; even the dividends may not hold up in a major correction.

Long-time dividend payers are typically more stable than the broader market. That's why teachers such as Benjamin Graham recommended that most investors invest in companies that have paid a dividend for at least 20 years. That history of paying dividends usually reflects a history of strong management and growing profits. By investing in long-term dividend payers, much of the work of the defensive investor (yes Ben is referring to dividend growth investors) is done. And Ben certainly thought that the dividend parameter would help investors largely stay out of trouble. Dividends and especially growing dividends are like divining rods for long-term value and earnings power and earnings potential.

In the end, an investor's success comes down to the earnings power of the companies that they hold. The other key factor of course is price. Those companies have to be purchased at a reasonable price. A great company that meets all expectations and has wonderful management and meets all earnings expectations can turn out to be a terrible investment if purchased at too dear a price. Success is quality at the right price.

As I wrote in this recent article, Mr. Buffett does not appear to be finding many reasons to increase his stock allocation; in fact, he's holding record amounts of cash, over $51 billion. He sees cash as a call option on future assets, and he prices that call option and does that math as it relates to long-term return probabilities. Warren feels that cash (paying next to nothing) is a better investment than taking a new ownership position in companies at today's valuations. He has sold though, and redeployed; he is concentrating his holdings in fewer positions.

But even more important than the strategy and the companies that you hold, is the ability to hold for the longer term. Mr. Graham and Mr. Buffett's suggested holding period is "forever." I fear that many of the dividend growth investors on Seeking Alpha will not be able to hold on if we have a very significant correction. There are many seasoned investors who send me notes by direct email, they fear for the safety of the untested dividend growth investors. Many of these investors admit that they have never been a self-directed investor through a market correction. Some investors state that they had their lunch handed to them in 2008-2009, but at that time they were not practicing dividend growth investing so, "it's going to be different next time."

One of the tenets of risk evaluation is the question "how did you respond the last time you saw your stocks go down significantly?" If you answered "not very well, I panicked and sold and made a bunch of bad moves," it's likely or possible that not much will change the next time. By definition the dividend growth investor is largely risk averse, they are a defensive investor in the words of Benjamin Graham. That lower risk tolerance level makes me very nervous about their potential reaction and response to a market correction.

The dividend growth investor will be tested in a true market correction. It's possible and perhaps even likely that dividend growth holdings will hold up a little better than the broader market.

Here's how it looked in the Great Recession, using Vanguard's (NYSEARCA:VIG) as a proxy for dividend growth. The chart runs from 2007 to 2010.

While the broader market (NYSEARCA:SPY) was down by over 50%, VIG in its worse days and weeks was down by over 40%. Here's the wonderful actively managed Vanguard Dividend Growth Fund (VIDGX).

It kept its losses to just under 40% in the 37% area, a little better but not much. When the markets fall, so do dividend payers, and the dividends can be affected as well. One of the greatest areas of misdirection that I see on Seeking Alpha is that "it was easy to avoid the dividend cutters and eliminators during the recession." For more of what really happened to investors during the recession, I invite you to read my article, "Losing it Big Time with Bank of America." It details my own experience with that company, and the backdrop to the financials and what made many great dividend growth investments moving into the recession. Even more important than the article, have a read at the comment section where I had invited investors to share their experience(s) moving through that difficult period. Some very experienced investors were able to manage quite well, many others had difficult times.

It was not easy to navigate through the Great Recession and stay away from stocks that had their dividends cut, eliminated or frozen. Dividend surprises were everywhere, even the Dividend Aristocrats and larger Dividend Champions list had many companies who disappeared (from the list that is).

And what's to say that consumer staple stalwarts won't drop as much as the broader market? We don't know. Dividend growth investors might have been loading up on companies at higher and higher valuations as investors have been seeking the safety of dividends and have bid up those prices.

Now certainly, if you are very confident of your risk tolerance level assessment and you are investing on a regular schedule with new monies to deploy, carry on. If you have any doubts, you might want to lower the volatility level of your portfolio by the way of bonds. If one is already holding a lower beta stock portfolio and they add some bonds, they might be able to create a very manageable volatility (and maximum drawdown) level.

Here's VDIGX with the broad based bond index (NYSEARCA:AGG) and long-term Treasuries (NYSEARCA:TLT) through the last recession, from 2007.

The asset mix for the above is 2/3 stock to 1/3 bonds split evenly between AGG and TLT. The above portfolio's total return was 69.6%, outperforming the SPDR S&P 500 ETF's total return of 59.4%. And of course, the portfolio price drop was well below the 20% level compared to over 50% for the market. An investor who also rebalanced that portfolio would have experienced even greater gains. From 2014, an investor might be in the position to lower the risk and boost the returns, if we experience another major correction or two.

As I have written, there's likely No Money To Be Made From Here at these valuation levels. If we go back to 2004-2008 when the CAPE price to earnings model predicted very low returns -- we have real annualized returns in the area of (negative) -.17 to 2.36% to 2012. That's assuming of course that 2013 is a period of irrational exuberance and some form of pricing normalcy will return.

There's no way of knowing, but there's the probability that you could lower your risk and boost your returns. Benjamin Graham suggested that the defensive investor always hold at least 25% bonds. I find it surprising that this suggestion from the greatest investor is largely ignored. I would guess that given the valuations and low yields from good bonds, Mr. Graham would suggest a 50/50 allocation in these times. Perhaps nothing looks enticing these days, but the money has to flow somewhere.

By the way, a 50% stock to 50% bond portfolio would have handily beat the market from 2007 to present. Once again, rebalancing would have boosted those returns.

For the defensive investor, they might consider a combination of bonds and cash. For those in the retirement phase, they might consider holding enough cash to get them through any difficult period. If a retiree is harvesting dividends and shares to fund retirement, they might consider holding 2 or 3 years of total spending in cash. See articles on "bucketing" for retirement.

Investing is simple stuff. Nothing should be easier in life. But it all starts with knowing your risk tolerance level. Most of the money lost or unrealized in the land of investing comes down to a mismatch of investments to risk tolerance level. That's why and how investors as a group are able to turn long-term 9%-10% market gains into 2%-3% annualized returns.

The market has given you a gift and opportunity over the last 2-3 years. It's time to reassess your risk tolerance level, and also it's time to consider if the additional risk of an all-stock or stock-heavy portfolio (from 2014) holds the probability of outperforming a balanced portfolio over the next several years.

Happy investing, and be careful out there.


Disclosure: The author is long VIG, SPY, EFA, EWC, THI, AAPL, ENB, TRP.

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.

Additional disclosure: Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.