All the market volatility we've seen since the start of the year prompted me to make a case study of what you can achieve by making systematic purchases of dividend growth stocks. For my original example I focused on Johnson & Johnson (NYSE:JNJ) because it's such a commonly held stock among new dividend growth investors.
Many dividend growth investors focus primarily on large blue chip stocks with long dividend histories, so new investors naturally stumble upon stocks like Johnson & Johnson, Coca Cola (NYSE:KO), PepsiCo (NYSE:PEP), P&G (NYSE:PG), Exxon Mobil (NYSE:XOM), 3M (NYSE:MMM), Philip Morris (NYSE:PM), Wal-Mart (NYSE:WMT), AT&T (NYSE:T), etc.
Now, hindsight is 20/20 and we all know Johnson & Johnson did pretty well over the last couple of decades, so some readers criticized the article for cherry picking a best-of-breed DGI stock. This time I'm taking a different approach by redoing the case study with General Electric (NYSE:GE), a stock with a much poorer track record than Johnson & Johnson.
Image source: General Electric
As I mentioned in my previous article, most dividend growth investors, including myself, focus on building a diversified portfolio filled with high-quality companies that have a good chance of increasing dividends for many decades to come.
If you're a great market timer this article isn't for you, but for my own dividend portfolio, I believe time in the market will ultimately be a much greater force than trying to time the market. But unfortunately, we can't foresee what stock prices will do over the next couple of years or decades, and sometimes companies carry risk that is not easily identified or significantly underrated.
Systematic investments in a less-than-ideal stock
In my Johnson & Johnson article, a fictitious young man named James joined JNJ in the early 1990s and was so impressed by the company's execution that he decided to start making monthly investments in the company's stock in 1996 when he was 30 years old. By buying $1,000 worth of shares for the next 20 years, James ended up with a portfolio value of $607,497 and his shares are now pumping out a dividend income of $18,664 a year.
But what would have happened if James went to work for General Electric instead and got enamored by Jack Welch? If we pull up a 20-year chart of General Electric, the chart looks far from impressive. General Electric hit an all-time high of close to $60 near the peak of the Dot Com bubble and collapsed to a low of $5.87 at the height of the financial crisis. Even today, the stock is still trading far below its 2000 peak; in fact, it's not even close to the range it traded in between 2004 and early 2008. But fortunately, a chart doesn't always tell the whole tale of an investment.
GE data by YCharts
A General Electric dividend investing case study
In reality, most dividend growth investors have a widely diversified portfolio but for these case studies I single out a single stock to see how it performed. I believe these case studies are valuable as they more closely reflect how real dividend growth investors invest money, by making regular contributions, versus checking out a stock chart or a total return calculator.
The premise of this case study is the same as for the previous Johnson & Johnson case study. James gained an interest in investing towards the mid-1990s and decided to set up a systematic investment scheme centered around General Electric.
We'll assume James started his portfolio with a $1,000 investment in late 1995 before the ex-dividend date. He saved $1,000 a month for the next 20 years, and invested this money together with the received dividends on General Electric's quarterly dividend payout dates. To keep things simple, I leave out transactions costs and taxes, and use fractional shares.
|GE dividend growth portfolio case study (split-adjusted)|
|Stock price||Shares||Quarterly investment||Dividend per share||Forward quarterly dividend income||Market value||Total invested|
Over the course of 20 years, James managed to accumulate 13,600 shares of General Electric. Based on Friday's closing price, the GE investment is now worth $383,949.80. Additionally, a dividend payment is hitting the account on Monday so adding up an extra $3,128.18 results in a total value of $387,077.98.
Would it have been easy for James to stick to his investing strategy for 20 years? Absolutely not, with the total value of the portfolio sinking below the total investment several times over the last 20 years it would have been a nerve-racking ordeal. It would have required great confidence in economic recovery in general and during the financial crisis it would also have required iron clad confidence in the future of GE.
The chart below tracks the portfolio value [blue] of James and compares it with his total investment [red], excluding dividend reinvestment. The investment in GE was off to a good start until 2001; it dropped into the red in 2003, but recovered nicely until 2008. Due to the use of quarterly data, the chart lacks a lot of data points, but when General Electric reached an 18-year low of $5.87, the portfolio was worth a mere $46,725 versus a total investment of $163,000.
The next couple of years were a wild ride but on the bright side, the low valuation enabled investors to grow their share count at an accelerated pace. A lot of patience was required as the portfolio value didn't comfortably exceed the sum of the monthly inlays until mid-2012.
Fortunately, long-term holders were rewarded with significant share price appreciation as the company recovered from the financial crisis. The initial investment of $1,000 and the quarterly inlays of $3,000 plus dividends resulted in a total portfolio value of $387,077.98. To match this performance, you would have needed a savings account or a CD with an interest rate of around 4.50 percent.
It was not a super investment, but given what GE has been through over the last 15 years, it's better than one might expect. For comparison, the Johnson & Johnson case study performed quite a bit better; that stock would have compounded your money at a rate of close to 8.2 percent.
There wasn't a lot of solace in the dividend either; General Electric investors still lament about the massive 2009 dividend cut. The financial crisis forced the conglomerate to cut its quarterly dividend from 31 cents per share to a mere 10 cents per share -- and even today, the dividend is still only 23 cents per share.
The following chart tracks the yearly dividend James received from 1996 to 2015. Up until early 2009, the dividend progressed nicely, hitting a figure of over $7,850 for 2008. Dividend income more than halved after the dividend cut but continued reinvestment at low valuations pushed the dividend income to a new high in 2013 despite a quarterly dividend of just 19 cents per share. That's still a far cry from the 31 cents per share distributions from before the financial crisis.
In 2015, the shares generated a dividend income in excess of $12,000, a yield on cost of 5.07 percent versus the total inlays. General Electric has frozen its dividend through 2016, so without further reinvestment the figure will stay level this year. For comparison, the Johnson & Johnson portfolio from my previous case study distributed a dividend of slightly over $18,000 in 2015.
Could a dividend growth investor have done better?
Ultimately, GE was faced by enormous but fixable problems in a very poor macroeconomic environment. I think this case study highlights the importance of having a diversified portfolio. You may end up with a couple of poor-performing stocks, but if they are offset by many more with average performance and a couple with outstanding performance, you can still attain more-than-satisfactory returns.
Pulling up a long-term chart of GE's earnings per share, we can see that the re-basing of the company's earnings after the financial crisis is the biggest reason why the stock underperformed. Earnings per share dropped from $2.20 in 2007 to $1.03 in 2009; with hindsight we all know why this happened, but 10 years ago the average investor would not have been able to anticipate the massive hit GE would take to its earnings. Since the crisis, GE has focused on becoming a classic industrial and has shed most of its risky assets.
GE P/E Ratio (TTM) data by YCharts
One thing you do have control over is how much you pay for a stock. Pulling up a long-term P/E chart of both Johnson & Johnson and General Electric, it becomes clear that both stocks suffered from significant P/E compression since the turn of the millennium. For several years, General Electric traded at a P/E of over 30, and two times, the P/E even spiked above the 55 mark.
One other way to think about this is by using the inverse of the P/E ratio, more commonly known as the earnings yield. A stock trading at a P/E of 50 has an earnings yield of 2 percent. This basically means that all things being equal, for every $100 you invest in a company, the business generates just $2 that can be distributed as dividends, used to buy back shares or reinvested into the business. In rare cases this can be a good deal if a company is growing its earnings at an astronomic rate, but for established blue chips, this is usually not the case.
While General Electric grew its earnings per share by 15 percent in 1999 and 18.7 percent in 2000, annualized earnings growth for the period 1997-2002 came in at just 12.6 percent. While that's a very healthy growth rate, it did not justify the extreme valuations the stock was trading at.
JNJ P/E Ratio (TTM) data by YCharts
This is also one of the reasons why I don't blindly use automatic dividend reinvestment, I prefer to pool my dividends with fresh cash to buy shares of businesses I find attractively valued. This way, I will not be reinvesting dividends into businesses that are trading at very high valuations versus expected growth, but putting the money into stocks that offer a more attractive risk/return ratio.
One of the big takeaways from this case study is the importance of diversification. I don't want to keep all my eggs in one basket so I focus on building a broad, well diversified portfolio by adding attractively valued high-quality companies on a regular basis. I like to compare my dividend growth portfolio to a low-cost index fund -- the main difference is I pick each component by hand and have no ongoing costs.
Another important lesson here is that even if you make terrible investing choices, given enough time you can still get halfway decent performance if you stick to your strategy (and focus on quality companies) through thick and thin. The General Electric shares in my case study compounded at a rate close to 4.50 percent. It's nothing to brag about at cocktail parties but given the issues the company experienced last decade, it's better than you might expect.
If you enjoyed this case study, please click the "Follow" button and read some of my previous dividend-centered articles:
Disclosure: I am/we are long GE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.