A Constructive Critique Of Dividend Growth Investing

Includes: DVY, SDY, VIG
by: Adam Aloisi

I'm not a dedicated proponent of the dividend growth strategy. However, I am fond of the dependability of income-producing equities and own them as part of an actively managed, diversified investment portfolio. The emotion and controversy that has erupted on SA over the veracity of this seemingly benign portfolio methodology has been educational and, at times, entertaining to me. I thought it might be helpful to offer a balanced, constructive discussion of the approach.

While its ardent detractors find DG foolhardy, I find DG to be a disciplined, thoughtful strategy of generating a stream of increasing, inflation-beating, forward income. Some have painted an ugly picture of its adherents. I find those critics, by and large, closed-minded and argumentative.

Despite the fact DG may not show up in textbooks and may not be utilized by a gigantic entourage, it's tenants are simple, straight-forward, and effective. David Van Knapp, et. al., have done a good job spelling out the strategy, its purpose, and practicality, and defending it against some of the more voracious attacks.

Van Knapp, in particular, spells out a cogent, more actively managed strategy which embraces the tenets of total return. While maintaining strict dividend buy-criteria, he attempts to maximize income stream and capital by selling into price strength and yield weakness and vice versa. Thus, while mainly focused on income generation, there is an awareness of equity valuation and capital preservation as well, which plays, as it should, prominently into the buy/sell decision.

The demographic here is diverse. The strategy seems to appeal primarily to conservative investors who need or desire income, typically older individuals nearing or in retirement. But, it also has appeal for new investors as they initiate or develop their trading acumen with dividend paying stocks that tend to possess lower volatility than non-paying brethren. For those with a multi-pronged total return strategy, like me, the strategy plays a partial role, but may play a more dominant one in the years ahead.

While there's much to like here, a strict dividend growth strategy has a few drawbacks or flaws in my mind. First, you eliminate much of the investing universe, typically small-, and mid-cap stocks. If it hasn't ever paid a dividend, hasn't increased its dividend for five years, stops increasing its dividend for whatever reason, or doesn't yield X percent, it typically doesn't merit consideration. Even the recent talk of the town, Apple (AAPL), which recently declared its first ever dividend, won't fit the mold for many more years. I think portfolio flexibility is important for investors of all ages, and this strategy provides little in the way of that.

Second, and this is not a blanket statement on supporters, but I sense pockets of unfathomable apathy toward capital preservation or the risks of equity investment. While income generation is paramount here, it should not come without awareness of capital. In this low rate environment where equity dividends outpace investment grade fixed-income interest payments, investors are understandably scrutinizing the risk/reward comparison. However, I believe some are shifting too much allocation towards equities without adequately comprehending the increased capital risk.

I also consider it odd that some DG investors seemingly root for a stock they already own to drop in price to a yield they would want to buy it at, with little consideration to fundamental analysis or lost capital. I want my stocks to go up, not to go down. This again indicates to me too much emphasis on the income component and too little awareness of the investment.

On a similar capital preservation note, while I don't think bonds, especially long-term ones, are a great value here, I continue to think fixed-income, much like an emergency cash stockpile, has a place in most DG investors' portfolios, even though many seem opposed to the idea. While bonds may not keep up with inflation, near-term investment grade paper can provide better yield than cash, with negligible capital risk compared to equity. High-yield and International bonds, while more risky, but arguably less risky than equity, offer total return potential, with higher current income than DG equity yield.

To conclude, dividend growth investing is a strategy with considerable appeal to buy and hold, more passively inclined investors looking to develop a stream of increasing income. However, I think because of the style limitation that it presents, it is a strategy best utilized in conjunction with other income and equity investment strategies. Utilizing dividend growth alone seems imprudent, leaving too much else untouched and perhaps too much else to chance.

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