Dividend Growth Investing Is Capital Appreciation Investing

 |  Includes: AFL, PG
by: Eli Inkrot


Often there’s a strict line drawn between investments with an income component and a capital appreciation (“growth”) element.

Yet in both instances, you’re simply partnering with a business and assigning a value based on your expectations of a future value.

This article demonstrates that a focus on a growing stream of income doesn’t so much preclude capital appreciation as it demands it.

Perhaps my article title isn't technically accurate, but the underlying point will soon become apparent: over a long enough time horizon, a growing dividend is accompanied by capital appreciation. Of course, a company also has to grow earnings in order to sustain a growing payout. Yet the takeaway will be that dividend growth and share price growth are two peas in the same pod.

So why do I bring this up? When thinking about investment opportunities, many try to divide the opportunities into sets of income and capital appreciation. Some think in these terms: "I could partner with this company for dividend growth or that one for capital appreciation." And to a degree, this has merit. Those primarily focused on income happen to favor companies that routinely reward shareholders via cash payouts. On the other hand, others prefer the company to build upon itself and reinvest all of the business proceeds.

Yet it's all just investing. In each instance, you're partnering with a business with a value based on the company's future profitability.

This commentary would like to create a singular construct: with dividend growth investing, it's not as if you're automatically tossing aside the opportunity for capital appreciation. In fact, quite the contrary is true. Whether you focus on it or not, it's highly probable that it will come along for the ride anyway.

To better illustrate this point, I'll use a "real world" example.

At the end of 1994, Procter & Gamble (NYSE:PG) was paying a quarterly dividend of $0.0875 per share, or 35 cents on an annual basis. Further, the company's shares closed at $15.50 (both of which are split-adjusted). In other words, Procter & Gamble traded with a 2.26% "current" dividend yield.

Up until this time, Procter & Gamble had not only paid, but also increased its dividend for 38 consecutive years. Moreover, in the years leading up to 1994, the company was increasing its dividend at a double-digit rate. So it'd be fair to suggest an investor of 1994 might have expected more of the same. In doing so, they may very well have been focused on the income component. However, this is certainly not to suggest that capital appreciation would be absent.

Today shares of Procter & Gamble trade with a yield around 3.1%. Yet that's not very revealing. Suggesting that the yield went from 2.26% to 3.1% in two decades doesn't tell you much. What's more useful to know is the current dividend: $0.6436 per quarter, or just over $2.57 on an "annualized" basis. Stated differently, the dividend is now over 7 times higher than it was in 1994 for a dividend growth rate around 10%.

Here's where the capital appreciation component comes in. In order for shares to trade at the same price as they did in 1994, PG would have to sport a 16.6% "current" yield (if only). Instead, as mentioned, shares trade with a yield of just 3.1%. As such, it follows that capital appreciation must result. And it most certainly did, as shares of Procter & Gamble have been increasing by a compound rate in the eight and a half percent range over the past 20 years. Indeed, the returns generated by capital appreciation have greatly outpaced the dividend income.

So back then or today, you can say things like, "I bought Procter & Gamble for the dividend growth," or "I don't care about the share price of PG, as long as the dividend goes up." Those are perfectly reasonable statements. Yet keep in mind that you should then add: "and in thinking this way, it follows that capital appreciation will likely happen anyway -- whether I focus on it or not -- and in fact could very well be a larger part of my overall return."

A lot of people like to discount the "yield-on-cost" metric, but it serves as an important reminder. If you don't expect companies like Procter & Gamble or Coca-Cola (NYSE:KO) to have 10% or 15% "current" yields, it follows that a growing dividend is accompanied by a growing share price.

Of course, there are timeframe exceptions to this ideology. For instance, Aflac (NYSE:AFL) provides a seemingly reasonable counterpoint. In the middle of 1998, shares of AFL were changing hands around $16. Meanwhile, the company had an annual dividend payment of about 13 cents for a 0.8% "current" dividend yield.

If you fast-forward to the depths of the 2009 recession, Aflac was paying an annual dividend of $1.12 -- a compound dividend growth rate of over 16% per annum. In a similar manner to the Procter & Gamble example, in order for shares to trade at the same price as they did in 1998, this would require Aflac to have a "current" yield of 7%. Guess what? This actually happened. In March of 2009, shares of Alfac hit $16 once again for a 7% yield, and then got as low as $11 a share for a yield of 10%.

So it's not as if dividend growth -- even 16% annually for close to a decade and half -- guarantees capital appreciation. However, I would contend that it gives you a great shot. Shares of Aflac did not trade with a 10% or even 7% yield for long. In a matter of months shares shot back up into the mid-$30's. The liquidity of shares had changed, the cash flow had not.

In the last 12 months, Aflac has paid a dividend of $1.48, corresponding to a trailing yield around 2.4%. More pertinent to this article, the investor of 1998 would have capital appreciation on the order of about 10% per annum. Unless you believe Aflac, or any company that has the propensity to continuously reward shareholders through increased payouts will trade with double digit current yields for sustained periods, it follows that capital appreciation will eventually result. Perhaps not exactly when you want it to or expect it might, but ultimately.

We'll finish with a generic idea. If you have a collection of companies with an aggregate yield around 3% and an expectation of say 6% yearly dividend growth, this comes with anticipation about capital appreciation as well. You could say that you're "buying for the dividend growth," or that you "ignore stock prices, as you have no intentions on selling." Those are perfectly reasonable statements. Yet unless you believe your group of holdings will trade with 5%, 9% or 17% yields in the future, you're also making an assumption about capital appreciation.

A lot of people get caught up in the everyday stock price movement, but just consider the math. If an aggregate yield of 3% is able to grow by 6% annually, this represents a 5.4% yield in 10 years time. In 20 years that jumps to 9.6% and 30 years results in 17.2%. 40 years? Well that's 30.9%. Now, the possibility of holding a group of Aflac's during the recession is always out there. Yet consider the likelihood of Johnson & Johnson (NYSE:JNJ) or Colgate-Palmolive (NYSE:CL) trading with a 9% or 17% yield for any sustained period of time (or any amount of time, for that matter).

As such, whether you pay attention to it or not, capital appreciation is part of your investment. In fact, it's sensible to assume that this could be a greater portion of your overall return. If you have an expectation about intermediate- to long-term dividend growth, you simultaneously have an expectation with regard to capital appreciation. You might not track it or give it credence in your everyday investing decisions, but it's there nonetheless. Dividend growth investing is capital appreciation investing.

Disclosure: The author is long PG, KO, JNJ.

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.