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In part one, I took the position that a true growth stock strategy, especially a high growth stock strategy, would by definition outperform a dividend growth strategy. Then I cited three examples that illustrate just how powerful the long-term ownership of a true growth stock could be.

The main objective, however, was not to attempt to prove that growth stock investing was better than dividend growth stock investing. In truth, the concept of better is not necessarily dependent solely on total return. Because, as I also pointed out in part one, although growth stocks will outperform in the long run, the level of risk taken to get that performance can be extremely high.

There are many reasons why a true growth stock is riskier than a dividend paying growth stock. Some of the risk can be allocated to the extreme difficulty of being able to grow a business at a high rate over a sustained period of time. High growth stocks, which I defined as companies growing earnings at 25% a year or better, are very rare because of the difficulty of achieving that kind of growth. Since these stocks will often trade at a PEG ratio valuation, any slowdown in growth could prove disastrous to the company's stock price. If a company that has grown at 30% suddenly slows down to 15%, its PE ratio could easily be cut in half, and consequently its stock price along with it.

In addition to the risk of attaining a high rate of growth, since there are no dividends, your entire capital allocation remains at risk as long as you own the pure growth stock. This is an often overlooked benefit of a dividend paying company. When you own a dividend paying stock, each dividend in essence represents a return of your capital investment and not just a return on your capital investment. And as Will Rogers once so aptly put it: "I'm much more concerned with return of my capital than on my capital." Therefore, each time you get a dividend check, you now have precisely that much less capital at risk. In other words, the dividend paying stock in actuality becomes less risky the longer you own it.

Perhaps an even better benefit the investor receives from his dividend paying stock is that even though they have less capital at risk, the number of shares they originally bought remains the same. Therefore, they are not being forced to liquidate their assets like David Van Knapp berated in his article. Furthermore, the reader should keep in mind that each dividend received from a dividend paying stock represents your money, which you are free to do with as you please. This is no different than receiving a paycheck from a job. You could spend the dividend, reinvest it in a growth stock, or as many advocate, reinvest it back into the same company. You are free to choose which option serves you best.

Another way of looking at this is to recognize that the dividend from a dividend paying stock represents an additional economic benefit, something a non-dividend paying stock lacks. The following F.A.S.T. Graphs™ on Procter & Gamble (NYSE:PG) is offered to clarify this important point. Procter & Gamble (PG) was chosen because David Van Knapp featured this in one of his recent articles as the portrait of a beautiful growth and dividend company. Readers have often asked why we stack the light blue shaded dividend area above the green shaded earnings area; earnings is where the dividend comes from, but in addition to visual perspective there are two other important reasons we stack dividends on top.

The first reason is to illustrate that the dividend represents an additional economic benefit. The orange earnings justified valuation line represents the level of earnings that the market will capitalize, whether the company pays a dividend or not. In other words, the capital appreciation component for both a dividend paying stock and a non-dividend paying stock happens as a result of the market applying a value to earnings. Therefore, the light blue shaded area representing dividends is stacked on top which indicates the extra benefit of dividends.

The second reason helps explain why dividend growth stocks have traditionally (historically) been afforded a higher valuation than the orange earnings justified valuation line that applies to non-dividend paying stocks. The darker blue line, the normal PE ratio, illustrates the historical value that the market applies to any given company. With high growth stocks, the normal PE ratio (dark blue line) and the orange earnings justified valuation line will often coincide. However, with dividend paying stocks, it is not uncommon to see the normal PE ratio correlate very closely with the top of the light blue shaded dividend area. We believe this illustrates that the market recognizes the additional benefit of dividends and values a dividend payer accordingly.

Keep in mind that these relationships are typically not perfect, however, the close correlation appears to be more than mere coincidence. On the Procter & Gamble (PG) example below (click to enlarge), notice how, with the exception of high overvaluation in the early years, and low valuation currently, the market has otherwise priced Procter & Gamble stock in close correlation to its earnings growth plus dividend component. In other words, the market seems to include the dividend component in its valuation of the business. However, another way to look at this is to understand that dividend stocks can rarely be bought at True Worth™ value based on earnings alone.

Historical performance on select dividend growth stocks

In contrast to the three high growth stocks that were featured in part one, the following two examples, in addition to Procter & Gamble, were chosen to illustrate what an investor can expect from a good dividend growth stock. In the spirit of fairness, we selected two dividend growth companies--Wiley (NYSE:JW.A) and Church & Dwight (NYSE:CHD)--with above-average earnings growth as dividend growth stocks go. We did this so that we could provide the most competitive dividend growth stocks against the high growth stocks we previously featured. Notice, that these two examples (click on each to enlarge) provided more growth and a higher rate of return than the more moderately growing blue-chip Procter & Gamble above.

Reinvest the Dividend or Not?

When we produce performance results, as our F.A.S.T. Graphs™ automatically do, we do not reinvest dividends based on reasons that were articulated earlier in this article. However, for conservative investors that still see themselves in the accumulation phase of investing, but who are unwilling to take the risk of owning growth stocks, reinvesting dividends can provide an excellent source of growth.

Although, I continue to believe, and I feel the facts presented in these articles support this, dividend growth stocks, even when dividends are reinvested, will not outperform a true growth stock. On the other hand, attractive long-term returns can be achieved from reinvesting dividends into dividend growth stocks. Dividend growth stock returns are especially attractive when you consider the lower risk.

The reinvestment of dividends can be achieved utilizing different strategies. A primary advantage of a well executed dividend reinvesting strategy is the discipline that it brings to the investment process. True dividend growth investors tend to be rather market price agnostic and more focused on the rising dividend income stream that dividend growth stocks provide. Consequently, they are hungry to see that income stream grow, in addition to dividend increases alone.

David Fish, another recognized Seeking Alpha author and proponent of dividend growth investing, implements his dividend reinvesting strategy by participating in DRIPs (company dividend re-investment programs). In contrast, David Van Knapp, like yours truly, likes to collect his dividends and re-invest them (perhaps even in a different company), where he sees the best opportunities.

Both of these approaches are valid and each has advantages and disadvantages over the other. The DRIP program provides a disciplined approach that exploits the principle of dollar cost averaging. When stock prices are high the reinvested dividend buys fewer shares of expensive stock, and when stock prices are low the reinvested dividend buys more shares of cheap stock. Over time, this averages out to generally good pricing.

David Van Knapp--and I--prefer to be more proactive in how, where and when we reinvest our dividends. Although this approach does take more attention and work, it at least provides the opportunity to only invest in stocks when valuations are attractive. Importantly, both of these approaches take advantage of the principle of compounding your asset base over time. An intelligent and disciplined approach, regardless of what investing style is chosen, will usually be rewarding to the implementer, over the longer run. The key, is to stay the course and not let emotional responses instigated by hype and/or hysteria deter you from your stated goals.

There is one final consideration regarding the growth stock versus dividend growth stock debate that is worthy of consideration. An argument against growth stock investing that was discussed in the comments section of David's excellent article, was the perceived undesirable need to have to liquidate your portfolio and convert it into income-producing stocks when you reach retirement. In truth, this may actually not be necessary. Over time, and it can even be said eventually, the growth rate of a growth stock will slow down and the company can change from a growth stock to a dividend growth stock. There are a lot of technology stocks where this metamorphosis is occurring today.

Eventually, and as a general rule, the true growth stock will ultimately morph into, first a moderate grower, then typically into a moderate growth and income grower by instituting a dividend, and eventually into the slower growth and dividend income stock that David Van Knapp’s article was referencing.

This is important, because one of the arguments rejecting the pure growth investing strategy was the idea that you would need to liquidate your growth portfolio upon retirement and convert into a more conservative income-producing dividend paying strategy. My point is that an original pure growth strategy started early in your life, could in fact, naturally evolve into an income-producing portfolio when you reached the time where you needed to harvest your income (retirement).

Summary and Conclusions

In truth, there are valid reasons for investors to embrace these and other investing strategies beyond the consideration of the greatest total return. Other factors, such as risk tolerance, the size of your asset base, your age, knowledge base, investment objectives to include income needs and many other consideration can come into play. It's not only about where the best rate of returns can be found. That's why there are so many different types of investments and strategies that are available. Different strokes for different folks as they say.

My only objective is to evaluate each one based on accurate information. In other words, I object when someone tries to say that dividend growth stocks will outperform growth stocks, because they simply will not when the proper definition of a growth stock is used.

In closing, I believe that investors are more than capable of making good decisions when they have the appropriate facts to go on. I'm obviously not a big fan of studies and/or the concept of modern portfolio theory and all its statistical references. I certainly don't believe in the idea that the markets are always efficient, however, I do believe that the market will eventually seek efficient levels. In the last paragraph of his article that stimulated this series, David Van Knapp asked some excellent and I feel legitimate questions. I believe the answers lie in the way investing has, in modern times, become institutionalized with the advent of the academic concept called Modern Portfolio Theory (MPT).

When I first entered this business in 1970, investing strategies were based on meeting the specific needs, risk tolerances, goals and objectives of each investor. Back then it wasn't about asset allocation and the numerous so-called style boxes that investing has degenerated into. Back then it was about building portfolios for growth and/or income.

The old strategies talked about aggressive growth, moderate growth, or conservative growth and income. For income investors, portfolios were designed for conservative growth and income, moderate growth and income or aggressive growth and income. Investing strategies made sense to me back then, the modern strategies don't. I have coined what I was first taught as "Ancient Portfolio Reality™", because in the olden days strategies were based on the needs of individual investors and not fantasy. As I did in part one, I will quote David Van Knapp’s paragraph, the one that got me started. It is reproduced below:

The above represent my own beliefs, but they are hypotheses. I am not a professional in the field of retirement planning. I am seeking someone to shoot holes in my position. I know that there are financial planners and others in the retirement and investment industries who read Seeking Alpha. Why are the unique characteristics, benefits, and risks of dividend-growth portfolios ignored? Why are dividend-growth stocks never singled out as an investment category well suited to the needs of retirees, instead of being lumped in with all other stocks? Why are the rising-income-generating qualities of dividend-growth stocks never mentioned? Why is the dollar-for-dollar offset of dividend income against capital withdrawals never discussed?

Disclosure: I am long PG.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Source: The Great Growth Debate (Part 2): The Benefits of Dividend Growth Stock Investing

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