Dividend Growth Investing: Five Thoughts for 2011

| About: SPDR S&P (SPY)

I recently completed the 2011 (fourth) edition of my Top 40 Dividend-Growth Stocks series of annual special studies. This endeavor, which is concentrated on October through January each year, always causes me to revisit and re-question the basic principles of the strategy, and also to reflect on what I learned in the intervening year. This year was no exception. Here are five thoughts that I have coming out of the process this year.

1. The strategy has held up under severe questioning. For me, 2010 was a watershed year in terms of examining dividend-growth investing, testing its hypotheses, and determining if it is a viable and sensible strategy. In February, I wrote a post on Seeking Alpha entitled “Why I Love Dividends” in response to four anti-dividend articles and Instablogs that had trashed dividend investing, deemed it irrelevant, or brushed it off as a crutch for unsophisticated investors.
I expected some response, but the commentary blew me away. To date, there have been 138 comments, many of them article-length themselves. I have read through those comments several times. In the end, my conclusion is that the strategy holds up against the strongest arguments against it. Since that time, several other authors have come forth with articles supporting the strategy, and of course well before I wrote that article, there were many articles that regularly reported on ongoing applications of the strategy. I certainly did not invent it; I just wanted to give it a spirited defense.
The commentary on dozens of articles has focused the basic arguments for and against. Many participants have concluded that the individuals on the opposing side simply cannot be convinced and have stopped trying. Some buy into it, some don’t.
As a side note, in 2010, Seeking Alpha took a big step by creating the Investing for Income category, which now sports its own tab at the top of every page. David Jackson, SA’s founder, tells me that SA has further plans for beefing up its income content. (David was one of the four authors against whom I was arguing in my February article. His genuine open-mindedness is a pleasure.)
2. The S&P 500 is no proxy for dividend-growth investing. David Fish just covered this very well in an article the other day, so I’ll be brief. The S&P 500 is often used as a proxy for “the market.” I have no problem with that; I do it myself. But it is a long leap from that to using it as a proxy for any particular investing strategy that the S&P 500 does not well represent.
At any given time, about 370 stocks in the index pay dividends, meaning that 130 (about 35%) do not. Further, those stocks that pay dividends are not selected for their dividend prowess. When talking about dividend-growth investing, I often refer to “a portfolio of well-selected dividend-growth stocks” as a requirement for the strategy. Not every dividend stock will do; they need to have certain characteristics. The dividend stocks in the S&P 500 do not fit this definition as a group, although some do individually.
Total dividends paid by the S&P 500’s stocks declined 20% in 2009, then they rose 5% in 2010, leaving the total 17% behind the amount paid in 2008. Thus, in December 2010, Howard Silverblatt of S&P stated that “…even with [the S&P 500’s] expected [dividend] increases [over the next few years], investors will not get back to where they were in 2008 until 2013.”
That statement is simply not true. It is based on the S&P 500’s dividend stocks, not on “a portfolio of well-selected dividend-growth stocks.” The latter did not suffer large declines in dividends in 2009. Banks, of course, did, but many of those cuts were foreseeable and attentive investors could remove them from their portfolios and watch lists either before or immediately after their cuts, moving their money to other qualifying stocks.
On the contrary, dividend-growth stalwarts continued to increase their dividends in 2009 and 2010. (My demonstration Dividend Growth Portfolio’s dividend income increased 19% in 2009 over 2008.) The true stalwarts never fell behind 2008. They will not take until 2013 to surpass 2008; they’ve already surpassed it.
3. 2011 will be a better year for dividends than 2010. I do believe that the S&P 500 can provide insight into broad trends. Just as its total dividends increased in 2010 and are generally predicted to increase again in 2011, I think that the same will be true for well-selected dividend-growth stocks. There are several reasons:
  • By the end of 2010, many companies had returned to “normal mode” with regard to their dividend policies. Banks are still a notable exception.
  • The improving global economy, combined with the rapid and effective response of many companies to the recession, has led to many companies with higher earnings, stronger balance sheets, less debt, and more cash than before the recession. Cash is the source of dividends.
  • If the economy keeps improving, corporate outlooks will improve. Confident managements and boards declare growing dividends.
  • The tax resolution at the end of 2010 — preserving the 15 percent rate on most dividends for two more years — delays one reason for companies to direct funds to share repurchases rather than dividends.
  • The changing demographics of stockholders — with more approaching retirement age —may influence some companies to tilt towards dividends. As they seek yield, it is quite possible that as they retire, baby boomers will put more pressure on companies to pay dividends.
4. Reinvesting dividends accelerates the growth of dividend-growth portfolios. This may seem obvious, but I think it is underappreciated. I wrote an article about this a couple of months ago, using a simple example to illustrate that (under the premises of that example), reinvesting dividends increased the dividends received from a single stock by 43% in the tenth year of a dividend-growth strategy. Reinvesting dividends causes DRYOC (dividend-reinvested yield on cost) to start pulling away from YOC (yield on cost) from the moment of the first reinvestment. The longer you keep at it, the more the results accelerate.
I realize that many retired dividend investors cannot reinvest dividends, because they need them for immediate income. But for younger investors who don’t need the cash immediately, reinvesting dividends will build your wealth and your income stream considerably faster than the growth in dividends alone.
Note that there are various ways to reinvest dividends. Some use DRIP plans that reinvest the dividends immediately in the stock that issued them (purchasing fractions of shares). Others (including myself) allow dividends to accumulate to a certain amount, then make a single larger purchase of an existing portfolio stock or of a new stock. This allows targeted purchases of stocks with, say, a higher current yield or one that improves portfolio diversification, to give two examples of goals that might be advanced via reinvestment.
5. Should there be a dividend-growth Hall of Fame? Maybe. Several stocks (including familiar names such as Johnson and Johnson (NYSE:JNJ) and McDonald's (NYSE:MCD), as well as a couple of surprising names) have made my Top 40 list every year. David Fish’s Dividend Champions (Excel) document includes around 100 stocks that have increased dividends for 25 or more years consecutively.
The reason that I hesitate to create a Hall of Fame is because valuations change over time. Some dividend-growth stalwarts over the past four years were total-return disappointments over the past 10 years. That fact is sometimes trotted out as an objection to dividend-growth investing itself.
But the reason that happened is not that those stocks lack stellar 10-year records of dividend growth. Rather, the reason is that 10 years ago, they were swept up in the general stock-market bubble, had ridiculous valuations, high prices, and low yields. It happened once; it could happen again.
My Top 40 is meant as a guide to stocks that are good buys currently. Some multi-year winners could reach a point of overvaluation and low yields (those two things go together) again. So I’ve decided against a Hall of Fame. The Dividend Champions document is a sort of Hall of Fame in its recognition of continual dividend-raisers. A stock’s appearance there does not require a low valuation to constitute a good buy every year. It reflects ongoing dividend-growth proficiency.
Good luck in 2011 to all investors on this site, no matter what your investment strategy.
Disclosure: I am long JNJ, MCD.