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Jonathan Liss (JL): Let’s drill down into some of the nitty gritty of what you are proposing. How much portfolio turnover can the typical Div. Growth investor expect?

David Van Knapp (DVK): Typically, the dividend growth investor purchases stocks with the intention of holding them for a long time. That’s because he or she selects companies that are expected to succeed for long periods of time, and then focuses on the increasing income stream generated by those companies. So stock price movements have less impact than they probably do on the average investor. In fact, contrary to some behavioral finance theories about investor panic, a price increase may be more likely to induce a sale than a price decrease, while a price decrease may be more likely to induce a purchase.

So overall, turnover in a dividend growth portfolio tends to be pretty small, say well under 20% per year and sometimes as little as zero percent. That’s not to say that dividend growth investing is Buy-and-Forget. It’s more like Buy-and-Monitor or Buy-and-Watch. Most dividend growth investors have guidelines for when and why they will sell a stock, plus established procedures for watching over their flock.

JL: Along these lines, please offer an example of a dividend growth stock you've been able to hold for a long period of time and one you had to 'dump' as the circumstances surrounding that stock changed.

DVK: Here are two examples of sales from my own Dividend Growth Portfolio. An original holding in 2008 was Bank of America (NYSE:BAC). I did not hold it for long, though. When BAC acquired Merrill Lynch, I no longer understood their business model. That acquisition occurred not too long after the CEO had disbanded BAC’s own investment banking unit, saying that he didn’t need that business. Then a few months later, they acquired one of the largest investment banks in the world. I place great emphasis on understanding business models. I had no idea what BAC intended its business model to become, but it clearly was no longer the commercial bank that I had purchased. I sold BAC in October, 2008. I wrote an article about the sale and my reasons for it. Of course, we all know that since then, BAC slashed its dividend to almost nothing, its price has dropped more than 70%, and having accepted bailout money it remains in regulatory jail.

A more recent example is Sherwin Williams (NYSE:SHW). The company had a couple of years of anemic dividend increases, so I sold it in 2011 and reinvested the money in better opportunities. The Sherwin Williams deal illustrates the independence of market action from dividend cash flows. Even though the company’s dividend increases had slowed too much for my taste, I had a large capital profit. So when I used the proceeds to purchase other dividend growth stocks with more attractive characteristics, I immediately gained a significant cash flow increase as well as what I think are better prospects for dividend increases in the future. For anybody who is interested, I also wrote an article about the Portfolio Review that led to the Sherwin Williams sale.

There are lots of stocks that are “classic” dividend growth stocks that many people end up holding for years, enjoying the annual dividend increases. In my own portfolios, I own Johnson & Johnson (NYSE:JNJ), Chevron (NYSE:CVX), McDonald’s (NYSE:MCD), Kinder Morgan Energy Partners (NYSE:KMP), Realty Income (NYSE:O), AT&T (NYSE:T), and Procter & Gamble (NYSE:PG), all of which are in many dividend growth portfolios. A newer purchase that I expect to hold for a long time is Intel (NASDAQ:INTC), which seems to have successfully made the sometimes-awkward transition from hyper-growth company in the 1990s to mature dividend stalwart today.

I mentioned above that for a dividend growth investor, a price increase can lead to a decision to sell. McDonald’s has had a great price run-up, and many investors are sitting on significant capital gains. In my Dividend Growth Portfolio (DGP), I have a paper profit (on three purchases) of 59%. The price increase has driven the current yield down to 2.8%. I normally like at least a 3% minimum current yield. As part of regular portfolio maintenance, I will be investigating whether I should sell some of the MCD position and redeploy the proceeds into other stocks with higher current yields. That would give me an immediate jump in current cash flow.

A counter-argument against doing that would be McDonald’s strong history of dividend growth. It has a 3-year dividend growth rate of 16% and its increase last year was 12%. Not many stocks are increasing their dividends at that clip. So I’ll take a hard look at it and decide what to do, if anything.

JL: Can you elaborate on why you don't use payout ratio in evaluating dividend growth stocks? Wouldn't a high payout ratio be cause for concern about the long-term viability of dividend increases?

DVK: A high payout ratio might indicate dividend problems ahead, or it might not. It depends on the company’s business model. Telephone companies such as AT&T, for example, typically have high payout ratios, because their reported earnings are “reduced” so much each year by the depreciation of capital investments made in prior years. Master Limited Partnerships such as Kinder Morgan Energy Partners are required by tax laws to distribute a high percentage of their profits to unit-holders.

My belief is that there is a comfortable payout ratio for each company, but that it varies from company to company and may drift higher or lower in particular years. I’m dealing with companies that deliberately manage their dividend programs, and I count on them to look out several years and determine the payout ratio that is right for them over time. I examine the companies’ financials and business models to make sure that I understand where the money is going to come from to pay steadily increasing dividends. I haven’t found that the payout ratio adds much to my understanding.

That said, whenever I write an article about an individual dividend growth stock, I usually mention its payout ratio. Readers expect it, and I understand that I am off the beaten track in not using it in my own analysis.

JL: Any sense how such a portfolio would have fared in the great sell-off of 2008-2009? Also, how would it have fared in the ensuing bull market run?

DVK: Let’s define “fared” so that we don’t fall into the trap of thinking that “how stocks did” is defined only by total returns. I would imagine that most dividend growth portfolios lost capital value in 2008-09, but less than the market, because dividend growth stocks usually have lower betas than the market. In contrast, on the income side, most such portfolios experienced increasing cash flows in 2008, 2009 and thereafter.

My own public DGP is an incomplete example, because I began it in the middle of 2008. From its inception date on June 1, 2008 to the end of March 2009, it declined 32% in capital value. The S&P 500 declined 43% over the same time period.

On the income side though, my dividend stream increased 57% in 2009 over 2008, 15% in 2010, and 9% last year. (The 2009 increase is exaggerated by the fact that the portfolio only existed for seven months in 2008.) The DGP’s yield on cost has increased from 2.1% in 2008 to 4.5% now.

From the end of March 2009 to the end of January 2012, the S&P 500 gained 64%. The total value of my DGP gained 74%, and its total value is now +20% since its inception. As stated above, it is running at a 4.5% yield on cost currently.

For those who are interested, I track the DGP monthly on my web site. Here is a direct link to that page. I also write occasional articles about it here on Seeking Alpha.

JL: Does the emotional side of investing, i.e. the temptation to sell during a bear market, get trickier when you are holding mainly equities - even somewhat less volatile equities like dividend growth stocks - and you're in or near retirement?

DVK: Yes, no question. But what I’ve found interesting is that dividend growth investors seem to develop a layer of insulation from down-market panic. I don’t think that anyone enjoys seeing their total wealth go down. But if you are focused on income—rather than price—then you can enjoy watching your income go up even while the market is going down. Remember that the goal is to live off your income, not to liquidate assets to create income.

The psychological insulation layer goes back to what I mentioned before: Dividend flow is independent of market action. I think some people have a hard time seeing this, but it is right there in the statistics. More than 400 companies have raised their dividends for at least five years in a row. That means that in 2008—often cited as “proof” that dividend growth investing cannot work—all of those companies raised their dividends. Most of their prices dropped, but their dividend flows not only continued, they increased. So dividend-focused investors were not subject to as much panic or doubt even in a year like 2008. Their focus on dividend cash streams insulated them from panic about the price declines.

Interestingly, many dividend growth investors recognized that 2008 set up terrific buying opportunities. Valuations got better, and yields got better. At a given rate of dividend payout, a lower stock price equals a higher yield: Yield = Payout / Price. So the most skilled dividend growth investors loaded up on what may have been generational bargain-priced dividend-growth stocks in late 2008 and early 2009.

It’s not uncommon for the dividend growth community on Seeking Alpha to trade stories about particular stocks that they hope will pull back in price to provide better entry points. I was a net buyer of stocks in 2008 and in every year since. To be honest, selling in 2008 because of the falling prices never occurred to me. It was the same way during last year’s market correction. I was asked last year what I was selling. The question seemed odd, since I was focused on my growing income. When I had the money to do so, I was buying. Clearly the questioner thought that I was panicking and selling because of the market correction.

So I think that some of the behavioral finance “truisms” get stood on their heads a little when viewed through the lens of dividend growth investing. I imagine there was a fair amount of panic selling during last year’s correction. But I’ll bet that not many of the panic sellers were dividend growth investors. In fact, my guess would be that they were on the other side of some of those trades, scooping up bargain-priced stocks whose good fundamentals had not changed at all.

<< Return to Part 1

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).

Source: The Rational Case For Dividend Growth Investing (Part 2)