The Rational Case For Dividend Growth Investing (Part 1)

by: David Van Knapp

David Van Knapp is anything but an entrenched financial professional. Starting in 2007, his affinity for value investing gradually gave way to developing his own unique approach to dividend growth investing. The author of five annual eBooks on the subject, Van Knapp has allowed individual investors approaching retirement to take their financial destinies into their own hands by carefully constructing and managing a portfolio of dividend growth stocks. Dave has been analyzing and writing about stocks since 2001, both on his own site and here at Seeking Alpha.

Seeking Alpha’s Jonathan Liss recently caught up with Van Knapp to discuss the rapid growth in popularity of dividend growth investing. His most recent e-book, Top 40 Dividend Growth Stocks For 2012: How to Create and Maintain a Dividend Growth Portfolio provides the basis for the interview that follows.

Jonathan Liss (JL): In general, I find the entire dividend growth concept and community that has sprung up around it to be a fascinating phenomenon. Despite fairly limited academic research conducted to date (as is often the case with new ideas), this concept and community have taken the investing world by storm. Do you think dividend growth investing is here for the long term, or is this phenomenon 'low-rate' environment specific? If yields on 10-year Treasuries were back above 4% for instance, and the average S&P 500 stock was paying just half that, would this theory still hold its current widespread appeal?

David Van Knapp (DVK): The emergence of the dividend growth community on Seeking Alpha has fascinated me too. It turns out that a lot of self-directed individual investors have discovered this approach and want to share their stories and methods with other investors. Seeking Alpha provided a place for us to meet and coalesce into a community, particularly after the “Investing for Income” section (now called “Dividends and Income”) was created a couple of years ago. We don’t generally see this as a zero-sum game so we are willing to share information. The extensive discussions have been the catalyst for the community.

I don’t think that dividend growth investing is a new strategy. Stock dividends have attracted a lot of attention in the past few months, because in the current low interest rate environment, it appears that some investors have turned to dividend stocks for higher yields. But stock investing based upon receiving and reinvesting dividends is an approach that has been around forever. In many families it is multi-generational.

The arrival of newcomers seeking higher yields does not necessarily mean that they are following a dividend growth strategy. They may just be seeking better yields temporarily and not really feel comfortable investing in stocks for income at all. It may go against their instincts, but they feel forced into it by low interest rates.

The dividend growth strategy is about a lot more than high yields. It involves careful stock picking based on a variety of criteria. Some of the qualities of the best dividend growth stocks are great companies with superior business models and moats; managed dividend policies that lead to higher dividend payouts annually; yields that are “high enough”; and good valuations. It is hard to overstate the importance of reliable dividend growth as a component in the strategy.

I have little doubt that when Treasury rates go back above 4% or 5%, some investors will abandon dividend stocks for better yields elsewhere. But long-term investors who are truly executing a dividend growth strategy will mostly stick around. That is because the ‘growth’ part of the strategy is as important as (or more important than) the ‘yield’ part. Dividend growth investors are looking for rising income, not fixed income, and the payoff from that develops over the long term as income streams compound and rise to significant levels.

JL: I found the Ben Graham quote from page 26 - "The prime purpose of a business corporation is to pay dividends to its owners" - very instructive. Can you elaborate on this notion that without regular payouts, something can't properly be classified as an investment.

DVK: I take the same view as Warren Buffett that investing involves laying out money today to make more money later. There are a multitude of approaches that fit that broader definition, so I would not say that if dividends aren’t involved, you are not “investing.” There are lots of ways to invest that do not involve dividends.

That said, I do distinguish dividend growth investing from short-term trading, if the purpose of the trading is to make quick profits on market movements that may have little to do with the real-world business results of the stocks being traded.

Graham’s quote was made decades ago, when the payment of dividends was far more prominent than it is today. But the underlying idea is still sound. It’s that the investor regards himself or herself a part owner of the business rather than the owner of a lottery ticket. The owner expects to succeed right along with the business. One way to participate in a business’s success is through dividends, which are direct distributions of earnings to the owners.

An important point is that the distribution of dividends is independent of the stock market. Frankly, I think that the investment industry—Wall Street if you will—has placed so much emphasis on price return that the income portion of total return has been moved to the background. This causes most investors and the media to focus almost exclusively on market action. Meanwhile, the dividend part of the equation keeps chugging along in the background, almost unnoticed. Dividends account on average for about 40% of total stock returns, and they are generally unaffected by market swings. The market is not involved in dividend payouts; they are direct transfers of money from companies to their shareholders.

JL: Does it concern you at all that as you yourself say on page 17, "high-dividend companies—which have typically had P/E ratios about 20 percent lower than non-dividend-paying shares over the past three decades—saw their P/E ratios catch up with non-dividend stocks for the first time since the 1970s"?

DVK: It concerns me to the extent that higher valuation ratios make good investments harder to find. But that statement was a general one, illustrating a trend. Dividend growth investing is a stock-picking endeavor, meaning that you evaluate stocks one at a time. No matter what the averages or trends are, I’ve always been able to find a few great companies that offer decent yields and valuations at the times I was looking to invest.

JL: Are you recommending in essence holding just a single asset class - dividend paying equities?

DVK: No, not at all. My recommendation is that each investor figure out his or her own goals. Once you have your goals figured out, then you can work on strategies and game plans to attain your goals.

One goal that most investors have is to achieve a financially secure retirement. Overwhelmingly, the advice industry emphasizes the “accumulate-decumulate” or “withdrawal” model for funding retirement. In this model, one accumulates assets during their working years, trying to attain “The Number”—how much you need to have the retirement you want. Then during retirement, one withdraws from those assets to convert retirement capital into retirement income. This model has become so embedded that the phrase “retirement years” is used synonymously with “withdrawal years” in the investing community. It is not uncommon for an investment advisor to begin a sentence, “During your withdrawal years,…” as if liquidating assets in retirement is inevitable and happens to everyone.

But there is another model that gets far less attention: the income model. In the income model, one accumulates income-generating assets during their accumulation years, then lives off the “organic” income during their retirement years. The target number is not total wealth, it is total income. There is no liquidation of assets to provide “synthetic” income. Or if one’s organic income doesn’t meet one’s needs, then there is a dollar-for-dollar reduction in the amount that must be withdrawn each year to make up the difference.

But I would never recommend that someone put all their assets into dividend growth stocks. How to allocate your assets is about a 4th-level question. You get to that only after you have defined your goals, selected a strategy or model to reach your goals, and so on. If you choose the income model for some or all of your investing, then dividend growth investing, I believe, has many attractive attributes.

One other point. Much of the advice industry puts forth absolutes: You need this much money. You can’t succeed by buying individual stocks. You need to allocate your assets in this particular way. The only sensible investment goal is total return. You need to diversify widely within asset classes. And so on.

As soon as I see absolutes, I recoil, because everyone is different and has different goals and aspirations, not to mention time, inclination, and knowledge. I like to think things out for myself and to understand them. There are a lot of individuals who are like that. So I consider myself to be a self-directed individual investor talking to other self-directed individual investors. It is clear that dividend growth investing has much more traction among individual investors than it does in the advice industry, where the principal emphasis is placed on Modern Portfolio Theory, averages, indexes, asset-class results, and passivity.

Continue to Part 2 >>

Disclosure: Dave Van Knapp is long JNJ, CVX, MCD, KMP, O, T, INTC, and PG.

Jonathan Liss doesn’t hold any individual stocks. However, he holds several dividend paying ETFs and CEFs including Vanguard High Dividend Yield ETF (NYSEARCA:VYM).