Dividend Growth Or Closed-End Funds: What's Your Time Horizon?

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Includes: CEFL, DGRO, DGRW, DIVC, FOF, GCE, JTD, LEAD, NOBL, PCEF, PFM, RDVY, REGL, SDY, SPE, VIG, YYY
by: Faithful Steward Investing

Summary

I've been invested in Closed-End Funds for a long time and love them.

The Dividend Growth Investing strategy has been brought up over and over, so I decided to look into it.

A comparison of CEF and DGI portfolio strategies has been very eye-opening.

I have been trying to grapple with this debate for several months now.

When I first heard about the dividend-growth investing strategy, I saw how small the initial yields of the stocks were, and dismissed the idea entirely. After all, I have been invested in closed-end funds for about eight years and have averaged about 9.5% in dividends. I love those juicy yields!

But the dividend growth concept kept coming up in my reading and discussions, so I decided to look into it more closely. What I discovered is that the long-term results can be absolutely astounding!

For instance, using an Excel spreadsheet to calculate dividends quarterly and compounding for 30 years, I found that a stock with an initial yield of only 2% and an annual dividend growth rate of 10% can turn $10,000 into $250,326 without investing any more money. Impressive! Bump it up to a 3% yield going in, and you end up with $1,191,856. Wow! Who wouldn't go for that?

But wait.

Far too many of us don't have 30 years to enjoy the fruit of our investing labors. What if you'll need the income from your investments in 10 or 15 years? Or sooner?

That's when the wheels really started to turn. So I began crunching numbers---a LOT of numbers---trying to anticipate various scenarios. I had to test my long-held assumptions that I was better off in closed-end funds; I also wanted to know which strategy would be best for my children, who are in their teens and twenties.

Looking at various stocks that fit the "10% per annum dividend growth" criteria, and weeding out any yielding below 2%, I calculated an average yield of 3.4% at current prices (July 2016).

Then I calculated the current yield on my own CEF portfolio (excluding the few REITs and BDCs I own). It came to 9.7% at today's prices.

After taking a good look at my initial results, I decided to dig a bit further and see if the 10-percent-per-year-dividend-growth was, in fact, to what DGI proponents are usually referring. Reading several articles by fellow authors here on SA, I discovered that I had been investigating a more unique or rarely-used version of the DGI strategy. (I would recommend Marc Lichtenfeld's book Get Rich With Dividends if you'd like to learn more about it.)

It would appear that a more easily attainable and broadly sought-after DGI strategy is to invest in stocks paying around 5% in dividends, and growing those dividends by about 5% per year. I added this more typical DGI approach to my comparison.

The dividend stocks pay quarterly, so I calculated reinvestment on a quarterly basis. The CEFs pay monthly, so reinvestment entered into play 3 times more often. To keep it simple, I assumed an average price that stayed the same upon reinvestment. The following table shows only the year-end figures for income and value, compounded at a constant rate.

As you can see, it took 16 years for the Hi-DGI portfolio to outpace the CEF portfolio in income, and just over 20 years for it to catch up in value.

In playing with the numbers, I discovered that with a 2-to-1 difference between the initial yields, the Hi-DGI strategy always by-passed the CEF strategy in year 11 for income and year 15 for value. For any 5:2 comparison, it took 14 years for income and a full 18 years for value; and in a very reasonable 8:3 difference (i.e. 8% CEF yield vs 3% Hi-DGI yield), it would take 19 years for a dividend growth portfolio to surpass a CEF portfolio's value and 14 years to earn more income. In any 3:1 comparison (very close to my comparison above), it always took a little more than 16 years to pass it in income and over 20 years to pass it in value.

The more typical DGI investment (5% yield with 5% dividend growth) took 21 years to surpass the CEF portfolio in income, and 26 years in value. By the end of our 30-year comparison, the value is 45% larger than the ending value for the CEFs.

**It is worth noting that reinvesting dividends in real life does not happen so flawlessly. Prices fluctuate; sometimes you'll pick up fewer shares because the prices have increased, and sometimes you'll gain more shares as prices decrease. In the long run, I believe it all tends to average out, so using a constant rate of growth is a fair way to approach the calculations for compounding. Blue-chips typically don't make large market moves, nor would a diversified basket of CEFs, especially if positions are rebalanced on a regular basis.**

(If you would like a copy of the spreadsheet I created for this comparison, please message me with your email address so I can send it to you. I do not keep email addresses and will not use it for any other purpose. The spreadsheet is formatted so that you can change the initial investment and yield numbers and do your own comparisons.)

CONCLUSION #1:

Dividend Growth is for kids! A Dividend Growth strategy is the clear winner for those young enough and patient enough to stick with it for at least 20 years. The longer, the better.

I believe that either DGI strategy is the better long-term track for my children. But there aren't many teens or twenty-somethings that have $10,000 to invest. Mine sure don't --- not even close!

In light of the topic and the results of my research, my thoughts turned to "what stock should my 17 year old daughter put her $250 into?" After all these recent conclusions, the answer was not as forthcoming as you might think. I discovered a weakness in this investing strategy.

But I'll save my explanation for another article.

CONCLUSION #2:

For those with a time horizon under 20 years, especially under 15 years, my findings say you're better off compounding as much as you can in a CEF portfolio until you need to take the income.

Here are those numbers again, in bar chart form for a better visual representation of the income comparisons. Note how long the income generated by the CEF portfolio stays ahead of the other two strategies (15 and 20 years).

Click to enlarge

Click to enlarge

I, for one, believe we can create our own "annuity" upon retirement by moving our investments out of our 401(k)s and into a well-diversified CEF portfolio that we'll never have to deplete. A lofty goal for some, perhaps, but attainable. (What makes it better than a traditional annuity is that you have access to your principal, should you need it. But that's a subject for another time.)

It's pretty obvious that beginning an income portfolio with the Dividend Growth Strategy at retirement wouldn't even compare!

What about risk?

Many investors would argue that a closed-end fund strategy is much riskier than a dividend-growth strategy. However, long-time CEF investors agree that risk can mitigated by: choosing your entry points (only buying at a discount to NAV), sticking to funds with a proven track record, diversifying across asset classes and sectors, position-sizing, and periodically rebalancing between funds.

It's always a good idea, no matter what strategy you use, to stay abreast of what's happening with your investments, and to be ready to move out of a position that's no longer working and into a new one. This is just as true for your blue-chip dividend-growers as it is for any other type of investment. (I find Seeking Alpha to be one of the best resources to keep tabs on my closed-end funds and to find new ones to put on my watch list.)

With either strategy, the point here is to have your portfolio generate enough income so that you never have to withdraw any principal. That in itself is a massive risk reducer in my book.

So a Closed-End Fund Portfolio for retirement, it is!

Now before anyone gets their knickers in a knot about not considering the price growth of these blue-chip stocks versus potential flat prices for a CEF portfolio, understand that I'm only comparing these on the basis of the income they would generate for retirement. This is an Income Machine, not a Growth Machine. If it's mainly growth you're looking for, then I would suggest looking elsewhere.

For the record, though, the following charts show those same growth figures from the table above. Even without factoring in potential price appreciation (and its subsequent effects on the number of shares picked up upon reinvestment), the Hi-DGI strategy knocks it out of the park!

Happy Dividend Investing!

DISCLAIMER: I am not a professional financial advisor. All commentary in this article is for the express purpose of sharing ideas and generating discussion among my fellow investors. Please do your own due diligence before investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.