Dividend Investors: Avoid Living In The Past

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Includes: BAC, JNJ, KO, MAS, PG, WB
by: Dividend Growth Investor

Summary

Dividend investing is part art and part science. You look for companies that have a track record of raising dividends,but do your own due diligence in evaluating their prospects.

I would encourage investors to study past successes of dividend kings and dividend champions as case studies to identify factors behind their success to learn from.

While I am a buy and hold forever type of an investor, I realize that I would have turnover in my portfolio. As a result, I have several fail-safe mechanisms.

Their goal is to protect me from getting too emotionally attached to a single stock, and failing to see that its business is never going to recover.

One of the reasons why some have ventured towards the world of dividend growth investing, is due to the marvelous success stories of the past. If you or someone in your family had put a mere $1000 in Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG) or a Johnson & Johnson (NYSE:JNJ) thirty years ago, your stake would be worth a lot, and you would likely be earning double digit yields on cost.

Such examples illustrate the true power of dividend growth investing as a strategy that can provide investors with a rising stream of passive income that is directly tied to the fundamental success of the businesses you are investing in. These examples are very inspiring, and show that a patient dividend investor can do pretty well for themselves if they select companies with the following characteristics:

  1. A company with competitive advantages, pricing power and a growing market for its products/services
  2. A company that generates so much extra cash, and has such a high return on equity, that it ends up increasing dividends for at least a decade
  3. A company that is attractively valued at the time of purchase

If you are a serious dividend investor, I would strongly encourage you to study the history of all the greatest dividend growth stocks. This is in order to learn about the factors that had made these companies successful enough, so that they could afford to increase dividends for 40-50 years in a row. The knowledge should accumulate over time, and hopefully help you to spot those existing champions that can keep rewarding you with higher dividends or those emerging dividend achievers that can afford to raise distributions for several decades in the future.

However, there are no guarantees that the past performance will continue. The thing is that the world changes, and evolves over time. The destructive forces of capitalism continuously attack any moat out there, in pursuit of gaining market share and more profits. Technological innovations, changes in competitive nature and consumer habits can alter the business model of the company with the best defended moat of today. As a result, dividend investors should not be blinded and emotionally attached to each individual stock in their portfolio.

A few fallen angels from the list of dividend kings include Winn-Dixie and Masco (NYSE:MAS). Other fallen dividend growth stocks include Bank of America (NYSE:BAC) and Wachovia (NASDAQ:WB).

While I am a buy and hold forever type of an investor, I realize that I would have turnover in my portfolio. As a result, I have several fail-safe mechanisms, whose goal is to protect me from getting too emotionally attached to a single stock, and failing to see that its business is never going to recover.

My fail safe mechanisms are:

  1. Maintaining a diversified dividend portfolio, consisting of at least 40 - 50 individual companies
  2. Focus on companies that have raised dividends for at least 10 years in a row
  3. Selling a dividend stock after it cuts dividends
  4. Reinvesting dividends selectively in other quality companies at fair prices
  5. Purchasing companies that have increased earnings and which are not overvalued

In addition, next time you analyze a great company like Coca-Cola , it is important to try and look past the dividend growth history. In other words, do not simply look at the dividend history, and assume the good times would continue indefinitely, without doing any additional research on the company. If the company manages to increase dividends for another 50 years, that is great. However, try to be realistic, and determine if there are growth catalysts that can allow it to keep earning more and paying more in dividends to you. Merely projecting past dividend growth, without doing any due diligence about where future raises could potentially come from, could prove to be costly for your dividend retirement.

In the case of Coca-Cola, the company has hundreds of brands that it sells around the world. In addition, it has a very strong distribution network, and pricing power on its strong brands. The increasing in number of people around the world who can afford the refreshing products the company is offering, will most likely bode well for sales and profits over the next 15-20 years.

That being said, even for a great company like Coca-Cola, you should avoid paying more than 20 times earnings at a time. Even for an outstanding company, you need to have a margin of safety by purchasing only when prices are fairly valued. If you overpay for a quality company, and something changes dramatically in a few years, you would lose far more compared to a scenario where you bought at lower prices.

On the other hand however, you should also avoid focusing too much on minutiae, and losing focus on the big picture as well. The worst mistakes I have made involved selling companies because they got a little overvalued, getting impatient because growth slowed down temporarily, and usually purchasing something inferior in the process. There are always reasons not to buy a stock, but unfortunately it would take many years, before you can realistically determine their validity. If you do start with companies that have a proven track record of growing dividends, but then study each company in detail for growth catalysts and fair entry valuations before you buy, you should do well in a diversified portfolio held patiently for the long run.

This is why dividend investing is more art than science. You essentially look for companies that have grown dividends in the past, but need to do your own due diligence in evaluating whether the good times can continue for a couple of decade.

The ultimate goal for you is to generate more dividends from your portfolio every year for the next 20-30 years after you retire. In order to achieve your goal, you need to avoid being emotionally attached to the stocks you hold, and be realistic about their position. History doesn't repeat, but it rhymes.

Disclosure: I am/we are long KO, PG, JNJ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.