5 More Myths About Dividend Growth Investing

by: David Van Knapp

This past weekend's article on myths about dividend growth investing proved very popular, so here is another installment.

As with the first article, these are my personal views. Not everyone goes about dividend growth investing in exactly the same way, nor do all of us have exactly the same goals. But within the "big tent," there is general agreement on core principles. The purpose of these two articles is to foster more understanding about the dividend growth strategy and to encourage useful discussions about it.

Myth #6: You need more money to live off of income than withdrawals in retirement.

I'm not sure why this myth is so widespread, because it defies simple math. The fact is, your required accumulations before retirement are the same either way for a given amount of income in Year 1 of retirement.

Both withdrawal and dividend growth schemes converge on 4%. In typical withdrawal schemes, a 4% withdrawal in Year 1 is the standard recommendation. In a typical dividend growth scheme, 4% is a common current yield across the portfolio. (The most recent brokerage statement on my wife's and my "Perpetual Dividends" portfolio from E-Trade lists our "estimated annual yield" as 3.98%.)

So the takeout in Year 1 is the same under either scheme. It's 4% of what you accumulated.

After Year 1, annual withdrawals or incomes may diverge.

  • For example, under a withdrawal scheme, the retiree may increment each year's withdrawal by a fixed amount (like 3%) to cover inflation, or s/he may adjust each year's takeout to actual inflation or to the portfolio's performance.
  • In a dividend growth scenario, the retiree may take more income each year based on the dividend increases across the portfolio (which will typically be in the 5%-10% range), or s/he may increment by a fixed amount for inflation and leave some of the "extra" income behind for reinvestment.

But in Year 1, either plan commonly places in hand 4% of the accumulated assets.

Myth #7: Dividend growth investors don't care about current yield, they only care about yield on cost.

Yield on cost (YOC) causes way too much confusion. It's a simple concept, but it seems to set people's teeth on edge. For me, it's a useful motivational tool to look forward and set goals, as well as a metric to track progress towards those goals. But it does not drive all decisions.

I think that's where some of the confusion originates. Because YOC can become quite large (greater than 10% after 10 years or so), some dividend growth investors "fall in love" with the high number. Others don't.

There is room in dividend growth investing to consider other metrics in making decisions. Many of us do so. The McDonald's (NYSE:MCD) example that I discussed in a recent article is a good illustration. Because of a large price run-up, I now own MCD stock with a high YOC, a low current yield, and a sizable capital gain. The question is, what (if anything) should I do?

If I'm simply in love with the fast-growing YOC, I do nothing. If I want to capture some of the capital gain and place it into a different stock with a higher current yield, I may sell the position and use proceeds from the sale to buy something else. If I like the capital gain in its own right, I might sell the position, reap the profits, and use them to outfit a man cave. I might do a combo meal: Sell some and keep some.

Putting the man cave option aside, most dividend growth investors use the strategy to build an income stream for retirement. The common denominator then becomes the dividend stream itself-stated in dollars, not in percent. Percents (current yield, projected yield, YOC, and dividend growth rates) muddy the waters because they are calculated on different base amounts, but sometimes people forget that and make straight-line comparisons that are invalid.

But if you reduce everything to dollars, then direct comparisons are valid. Here, we can see that I can increase my current dividend stream by selling some or all of the MCD position and replacing it with a stock that has a higher current yield. But there are reasons that I might not want to do that:

  • I might see MCD as a "once in a lifetime" great company and wish to keep it both for its dividend prowess and also further capital gains
  • I might realize that MCD's dividend growth rate has been much higher than most stocks' and wish to keep it, reasoning that I won't find a better one elsewhere.

Frankly, I have not decided what to do yet. If you look in the comments of the earlier article, you will see various scenarios and opinions laid out and supported with sound reasons. Reasonable minds can certainly differ in a situation like this. But the point here is, not all dividend growth investors use YOC as some sort of exclusive metric that controls all decisions. That's a myth.

Myth #8: Dividend growth stocks are all large-cap U.S. stocks concentrated in a few industries, therefore a dividend growth portfolio lacks diversification.

This myth comes from outside the dividend growth community, as most people using the strategy never mention it and are not taken in by it.

First off, it is true that many well-known dividend growth stocks are large-cap U.S. stocks. Names such as AT&T (NYSE:T), Chevron (NYSE:CVX), Coca-Cola (NYSE:KO), Intel (NASDAQ:INTC), McDonald's, 3M (NYSE:MMM), and Wal-Mart (NYSE:WMT) all fit that description. It is also true that many good dividend growth stocks frequently appear in such industries as energy, healthcare, and consumer goods.

But not all terrific dividend growth stocks are large-cap, based in the United States, nor in just a few industries. In this year's Top 40 Dividend Growth Stocks For 2012, 11 industries or sectors are represented (using my classification scheme). At least one common dividend growth industry (real estate) is often considered a separate asset class by asset allocation fans. Of this year's Top 40, seven are mid-cap and three are small-cap. Six are headquartered outside the U.S. I see little truth in the proposition that a dividend growth portfolio is, by definition, undiversified.

Myth # 9: The S&P 500 is a good proxy for a dividend growth stock portfolio.

This myth seems to be fading, as more and more investors understand that the S&P 500 does not represent dividend growth stocks very well. First off, more than 100 stocks in the index do not even pay dividends. Second, most dividend growth investors require a minimum yield; a stock paying a 0.5% dividend would not qualify. Many of the dividend stocks in the S&P 500 fall short of common minimum required yields (say 2.5% to 4.0%). Indeed, the projected yield across the S&P 500 has hovered around 2% for the last few years, which is much lower than the typical yield of a dividend growth portfolio (which, as stated earlier, is often about 4%). Third, most dividend growth investors drop stocks that cut their dividends; the S&P 500 does not. Fourth, it is not apparent that dividend practices have any bearing on whether a stock is included in the S&P 500.

I find that the S&P 500 is sometimes useful for illustrating broad dividend trends. When dividends rise throughout the index, they are usually rising across the best dividend growth stocks too. Other than that, membership in the S&P 500 is irrelevant in selecting the best dividend growth stocks. Membership is no imprimatur of any significant characteristic for dividend growth investors.

Myth #10: Dividend growth investors select stocks based only on yield; dividend growth investing = high-yield investing.

This is another myth with origins outside the dividend growth community. I have seen it stated that dividend growth investors look "only at yield" in selecting stocks. I have also seen the term "dividend growth investing" morph into "high yield investing" when it is being discussed by someone who does not use (and apparently does not grasp) the strategy.

Both of these mistakes suggest a basic misunderstanding of what most dividend growth investors actually do. Most dividend growth investors I know use a variety of factors to select the stocks they want in their portfolios. Yield is certainly one of them, but other common factors include:

  • Dividend growth rate
  • Length of dividend increase streak
  • Fundamental factors such as ROE, debt, earnings, earnings growth, soundness of balance sheet, moats, and the company's business model
  • Valuation factors such as intrinsic value, over-valuation and under-valuation, P/E, P/B, P/S, PEG, and comparisons to typical valuations within the industry or for the company over time

In other words, the dividend growth strategy is a species of value investing, with emphasis on stocks with rising dividends.

As to the high-yield factor, there is not agreement on what "high yield" even means. Some writers equate it with any yield higher than the S&P 500's yield, which may mean as low as 1.8% at times. Few dividend growth investors would consider 1.8% to be "high yield." Within the dividend growth investing community, high yield can mean 5%+, 9%+, or the truly highest-yielding stocks with yields in double digits. Many dividend growth investors eschew the highest-yielding stocks as inherently risky (the high yields being seen as unsustainable), and instead shoot for "sweet spot" stocks with yields between 3% and 5% or so.

That completes this week's round-up of misconceptions about dividend growth investing. As usual, other perspectives are welcome in the comments.

Disclosure: I am long T, CVX, INTC, MCD, MMM.