5 Myths About Dividend Growth Investing

by: David Van Knapp

A pretty cool community has emerged on SA over the past couple of years. It's the community of dividend growth investors. Through articles and comments, sharing ideas, and talking about "what's up," an active cohort of investors who use this strategy has formed. New participants are always welcomed. It's a friendly place, as no one seems to see dividend growth investing as a zero-sum game. Tips and suggestions are freely shared. There are no secret handshakes, no hazing.

With so many participants and contributions, it is inevitable that some misconceptions about dividend growth investing have sprung up. Here are five prominent "myths" about dividend growth investing, along with my point of view about each one.

Disclaimer: Not all dividend growth investors define or utilize the strategy in exactly the same way, so some of my perspectives may be different from theirs, even though we are all following a generally similar strategy. That's fine. There are lots of flavors to dividend growth investing.

Myth #1: The only sensible goal in investing is total return

Some investors and investment advisors do not believe that the pursuit of dividends is a worthwhile goal. Rather, they have stated, the only valid goal of investing is total return. A corollary to the myth is that because dividends are not one of the "three factors" that explain total returns, they are essentially irrelevant.

I think that the main source of the myth of total return exclusivity is that many investors and advisors presume that the way everyone will fund retirement is through withdrawals. In this context, "withdrawals" is synonymous with liquidations. You sell assets to create synthetic income. This concept is so embedded that the phrases "withdrawal years" and "retirement years" are used interchangeably, as if the phrases were synonymous. If you fund retirement through withdrawals, then what difference does it make whether you get your hands on the money by selling capital assets or as dividends? It's all just money.

The perspective of dividend growth investing is different. Creating growing dividend income is a valid goal by itself. Dividends are important in their own right, not only as a component of total return.

This perspective is a genuine paradigm shift. It allows one to foresee the possibility of funding retirement exclusively or primarily through organic income rather than through the repeated sale of assets. Rising dividends can be seen as a significant source of retirement income. This income perspective creates a sharp contrast with the withdrawal presumption, because if you receive money in the form of dividends, you do not have to sell your stocks to receive it.

I think that the total-returns myth also creates differing views about what kind of assets to acquire during your accumulation years. Dividend growth investors who intend to use rising dividend income throughout retirement can begin accumulating income-generating assets fairly early in life. The rising dividends are positive returns that can be reinvested every year to compound prior to retirement. Since the eventual goal is to fund retirement as much as possible from the dividends themselves, they see accumulation driven not so much by a goal of maximum total wealth as by maximizing the dividend rights that one owns by the time they retire.

Those dividend rights will extend far beyond the day they retire. Indeed, in contrast to withdrawal plans, dividend growth investors can switch over to retirement mode simply by stopping the reinvestment of dividends, and instead, taking them as rising retirement income.

Myth #2: Dividend growth investors don't care about total return

Dividend growth investors have sometimes said that they don't care about total return. I think they usually overstate the case when they say that. Often what they really mean is that they understand that the safety, predictability, and growth of rising dividends are largely disconnected from market prices. They make statements like that, for example, when someone uses 2008 as an example why dividend growth investing won't work. That is a view held by many who mistakenly equate market crashes with dividend crashes.

Personally, I think that it is just naturally human to like to see that you have wealth, and more wealth feels better than less. But that said, here again we see a difference between the withdrawal method for funding retirement and the income method. With the withdrawal approach, maximizing wealth is crucial, and a year like 2008 is rightly seen as a disaster. If one follows a typical "4% rule" for retirement withdrawals, then the amount of retirement income one can draw from their assets is a direct function of the total wealth that they have. If bad market events destroy a significant portion of one's assets, as happened in 2008, someone on the cusp of retirement can see their withdrawal plans eviscerated.

In contrast, if the pre-retiree has been accumulating stocks that generate growing income by their very nature, the prices of those stocks in the market don't matter very much. What matters is the dividend stream that they generate. So in making the point that market price is not correlated with dividend stream, it is easy to overstate the relative lack of importance of market price by saying that you don't care about total return or about wealth. (In saying this, I recognize that a few dividend growth investors have so completely made the paradigm shift from wealth to income that they truly don't care about total return.)

My own public Dividend Growth Portfolio declined in value in 2008. It holds stocks such as Chevron (NYSE:CVX), McDonald's (NYSE:MCD), and PepsiCo (NYSE:PEP). But price declines and the awful economy in 2008 did not stop the companies from raising their dividends that year. In fact, Chevron has raised its dividends for 24 straight years, McDonald's for 35, and PepsiCo for 39. I did not particularly enjoy seeing the value of my portfolio decline in 2008, but that did not stop me from holding onto the stocks. That's because the long-range goal of the portfolio is to hit a target income amount, not a target total value. None of the stocks mentioned cut their dividends, so there was no reason to sell them. (A couple of other stocks did, and I did sell those.)

Myth #3: Income from "selling a few shares" is the same as dividends

This myth is related to Myth #1 in that it is based on the view that it does not matter in what form you receive money, as dividends or as the proceeds from the sale of assets. The flaw here is so obvious that it is easy to miss: If you sell assets to fund retirement, you have fewer assets left. They are gone. In contrast, if you can fund retirement from the income that your assets generate, you still own all your assets.

The difference is profound. In the withdrawal method, assets are liquidated. While they provide money at the time of sale, they are gone forever after the sale. In a 30-year retirement scenario, someone on a withdrawal plan must hope that the assets remaining after each sale expand in value enough so that they literally do not run out before one dies.

I have seen "success" in a withdrawal plan defined as assets running out exactly at the end of 30 years. You can imagine what the last few years of such a scheme look like: The assets are plunging toward zero as the withdrawals (incremented each year for inflation) overtake the remaining assets' ability to grow enough to make up for each year's withdrawals. It is sort of a morbid race to the bottom.

Again, we see the sharp contrast with an income-based retirement funding plan. In an income plan, ideally nothing is sold. The natural or organic income from the assets rises each year enough to keep up with inflation. So the money in hand goes up each year, just as in a withdrawal plan. But no assets are sold. Therefore, all assets remain to generate income next year and each year in retirement.

Myth #4: Dividend growth investors think they have found a free lunch

I have seen this myth stated in various ways:

  • Dividend growth investors do not understand risk
  • Dividend growth investors cannot and should not pick individual stocks, because stocks are too risky
  • If you lose as much money in price as you received in dividends, you've gained nothing

Once again, this myth spotlights the difference between focusing on price and focusing on income. Numerous studies --many of them academic and peer-reviewed-- have been published on the risk of various categories of stocks. But the risk studied and quantified in various ways is usually the risk to price. It is true that because of the fact that stocks are traded on the market, their prices are always at risk. If one possesses long-term databases of stock prices, historical price risk can be quantified in various ways, such as standard deviation, maximum drawdowns, and the like.

However, the dividend growth investor is focused on a different risk: Risk to the dividend. Academic studies about this risk are rare or non-existent. But we can use our eyes and experience to see that many companies have raised their dividends every year for decades. Most dividend growth investors would say that the risk to dividends is nowhere near the price risk studied academically. More than 400 companies have raised their dividends for more than 5 years; more than 100 have done it for more than 25 years. These are annual gains; nothing remotely similar exists in the records of stock prices.

Long dividend-increase streaks are remarkable accomplishments. Every company with an increase streak of five years or more raised its dividends right through the Great Recession of 2008. Companies with longer streaks raised their dividends annually straight through every recession during their streaks, some of which go back more than 50 years to the Eisenhower administration.

While certainly some companies cut or suspend their dividends during recessions, or when individual companies suffer misfortune, the sheer number of companies with long dividend-growth streaks suggests that if one chooses carefully, he or she can construct a portfolio of dividend growth stocks with a decent current yield (say 3%-4%) and decent diversification (dividend stocks can be found in practically every sector of the economy). Most importantly, in contrast with periodic bear markets that decimate prices across the board, there is an extremely low risk of a similar income-stream disaster. Many dividend growth investors report that their portfolios' income streams have never dropped year-over-year since they began using the strategy.

Is this a free lunch? No, of course not. There is, of course, the risk common to all stocks that prices will decline. But as we have seen, price declines do not correlate much with dividend cuts. In the dividend growth strategy, price declines do not matter much. For an evisceration of a portfolio's dividend stream, it would require many dividend growth stocks to slash their dividends simultaneously. I don't know if that has ever happened, but the risk of it-- the risk of a widespread dividend melt-down among the most sound dividend-growth companies-- seems pretty small.

Myth #5: Each dividend growth stock must maintain its performance for 30 years

This rather surprising myth turned up recently in comments by someone who believes strongly that investors should never choose individual stocks. The misconception behind the myth seems to be that, once purchased, dividend growth investors are passive observers. Buy your stocks, sit back, collect your dividends, and never lift a finger. So if a stock slashes its dividend, or if its dividend comes under severe pressure, under this myth the investor would continue to hold it anyway, never selling.

Thus, in order for dividend growth investing to work, each stock's continued strong dividend performance must be projected for decades, which-- of course-- is fraught with uncertainty to the point of being impossible. In fact, however, dividend growth investing is an active strategy. The investor must establish goals, research individual stocks, decide what to purchase, decide how to reinvest dividends during the accumulation years, and (perhaps most important) monitor the portfolio and react to events as they occur. This includes selling stocks when their dividend performance fails, and sometimes even when their price performance surprises to the upside. The latter provides unexpected money that can sometimes be redeployed at better yields. No decision is automatic, and the investor is actively engaged at every step of the process. None of it is outsourced.

This is in sharp contrast to most asset allocation strategies, in which the stock-picking is left to ETF providers, investments are allocated on a percentage basis across asset classes, and the only activity is occasional rebalancing or allocation adjustments. In other words, the proponents of this myth are projecting their own passive investment theories onto the dividend growth investing strategy. To criticize dividend growth investing on this basis is to create a straw man and then knock it down. It was never true in the first place.

That's today's rundown of five myths about dividend growth investing. There are others, but this article is long enough. Some of the other myths are these.

  • Dividend growth investors don't care about current yield, they only care about yield on cost
  • Dividend growth stocks are all large-cap U.S. stocks, therefore a dividend growth portfolio lacks diversification
  • The S&P 500 is a good proxy for a dividend growth stock portfolio
  • Dividend growth investors select stocks based only on yield; dividend growth investing = high-yield investing

Perhaps we can discuss those at another time.

Disclosure: I am long PEP, CVX, MCD.

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