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Dividend growth investing, retirement
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Dividend growth investors come in all shapes and sizes. Some invest for total return, others are interested exclusively in the dividends, and many have their eyes on both. Some have a relatively short time frame (say 10-20 years), while others are looking for success over much longer time spans. An investor beginning in her 20s may think of her time frame as 70 years or more. Some want "high yield," but they define that in different ways. Some care more about the rate of the dividend's growth than they do about its yield. Some are interested in low payout ratios, but then debate about whether the ratio should be computed as a portion of earnings, cash flow, or free cash flow; others pay relatively little attention to the payout ratio.

Is there anything that practically all dividend growth investors agree about? I think that there is. Here is my list of the common elements in most dividend growth strategies.

Suitable Starting Yield

Not many dividend growth investors are blind to yield. Most have a minimum yield below which they will not purchase a stock. My own minimum is currently 3%, but I have used other thresholds in the past and I may change in the future. I know other investors who demand at least 4% or 5%. Some set minimums as high as 8%, 9%, or even higher. At the other end of the spectrum, some dividend growth investors will accept 2% or even lower if they like the prospects for fast dividend growth.

Here are some dividend growth stocks that meet various thresholds. The table shows not only current yield but also 5-year dividend growth rate (DGR) and the dividend's growth in 2011.

Yield Threshold

Stock

Stock's Actual Current Yield

5-Year Dividend Growth Rate

Dividend Growth 2011 over 2010

2% +

Illinois Tool Works (NYSE:ITW)

2.5%

14%

9%

3% +

Chevron (NYSE:CVX)

3.4%

9%

9%

4% +

Avista (NYSE:AVA)

4.4%

14%

10%

5% +

Altria (NYSE:MO)

5.1%

15%

9%

6% +

Alliance Resource Partners (NASDAQ:ARLP)

6.4%

14%

13%

7% +

Buckeye Partners (NYSE:BPL)

7.4%

6%

5%

[Source: Drip Investing, U.S. Dividend Champions, updated 4/30/2012, accessed 5/6/2012]

One interesting thing about the stocks shown here is that they mostly contradict the general notion that low-yield stocks have high DGRs and vice-versa. That is one of the many nuances to dividend growth investing: One must understand the importance of stock-by-stock examination rather than merely accepting common wisdom about how the strategy works or generalities about the characteristics of dividend stocks.

Suitable Growth Rate

I play golf with a former teaching pro who plays to maybe a 2-3 handicap. He's good. If he misses the green, he expects to get up and down from wherever he is, and he usually does it. (I almost always miss the green and almost never get up and down.) We got talking about the concept of "up and down" last week, and he pointed out one of his favorite golf thoughts: "There's two parts to an up and down. The 'up' and the 'down.'" In other words you need to execute two things well: First a good chip, and then that must be followed by a good putt. If either element is missing, you don't get up and down. If you're him, that means he gets a bogey. If you're me, that usually means I get a double bogey or worse.

Dividend growth investing also has two parts: The dividend and the growth. As we saw in the section above, most dividend growth investors require a suitable entry yield. While the definition of "suitable" can differ from investor to investor, there's a big difference from golf in that you can simply select your yield. Yields of all kinds are available, and you can usually find one that you like. There's not much problem executing the yield part of the two-part process.

But the growth part is harder. As with yield, investors will differ over what is a suitable rate of dividend growth. Many dividend growth investors demand a higher rate of growth if they select a lower starting yield, but they will accept a slower growth rate if they select a higher starting yield. For example, I own AT&T (NYSE:T). It's had an anemic DGR for the past four years (in the 2.4% range), but I am content with that because of its relatively high yield. My personal yield on cost is nearly 7% for the first shares that I bought in 2009.

Dividend growth is not locked in the way yield is. It's more like golf, where successful execution is involved. The golfer (theoretically) is in complete control of her stroke, whereas the investor is dependent on the execution of the company. It is impossible to predict the future, so dividend growth investors try to get a "read" on a company's likely future DGR. They look at metrics like how many years in a row the company has raised its dividend; what its 1-year, 3-year, and 5-year DGRs have been; the solidity of its balance sheet; its projected earnings; how well "covered" the dividend payout is by earnings or cash flow; and the like.

These metrics work fairly well looking out a few years, but no one can sensibly predict conditions 20-30 years from now. That's why dividend growth investors tend to practice buy-and-monitor portfolio management. (That's also a point often misunderstood by some who don't understand the strategy. They often presume that dividend growth investors are buy-and-forget types who doom themselves by not keeping up with their portfolio's performance.)

Dividend increases mean that the yield on your original investment (yield on cost) goes up over time. At an average annual increase of:

  • 6%, your dividend doubles about every 12 years
  • 10%, every seven years
  • 12%, every six years
  • 15%, every five years

Dividend Growth Investors Generally Care Less about Price

This is a loaded subject and the source of much misunderstanding of the strategy itself, as well as good-natured disagreements between practitioners of the strategy. It is also an area where hyperbolic statements can get you into trouble, as can statements that carry a double meaning, so I will try to choose my words carefully. The problem, as I see it, is that price, while having a precise mathematical meaning, not only plays varying roles in different investment strategies, but it also has different functions in the dividend growth strategy itself.

Here's a very common example of the way a statement about price can get be misunderstood, even by the speaker. A dividend growth investor says, "I don't care about price. In fact, I wish prices would fall so that I can buy the stocks I want at better prices."

First, the speaker has clearly misspoken. He does care about price, as shown in his own second sentence: He wishes prices would come down. If he didn't care about price, he wouldn't say that.

Second, his first sentence is true, in a limited context. He doesn't care about price in the sense that most investors care, which is: Up is good, down is bad (and something to fear). Our dividend growth investor is saying that daily noise in the market, even large downward price swings, do not affect him psychologically in the same way that they impact most investors. If anything market downturns have him looking for loose change in the couch so he can buy some shares on sale. He's not lying to himself when he says he doesn't care about price. He means that he is not primarily interested in the prices of his stocks, because he has different goals from the average investor. He may not even follow the market regularly, because he does not consider market movements (i.e., price movements) very important to his long-run goals.

Third, he may be replying to someone who has challenged the intelligence of actively rooting for lower prices. So he speaks hyperbolically in an effort to get across the idea that lower prices do not bother him, especially if he is in accumulation mode and would just as soon buy his stocks on sale and at better yields. (Price and yield are inversely correlated: Lower price = higher yield.) A positive psychological reaction to falling prices is pretty uncommon, and those who think about prices that way often find themselves in the position of needing to explain or even defend themselves.

Fourth, the speaker is talking about right now, when he is in accumulation mode. Twenty years from now, when he is retired, he may well change his tune and hope for the prices of his stocks to go up, just like everyone else. If he's not buying any more, then he no longer will care about stocks being on sale. Price drops won't do him any good, whereas price rises will increase his wealth without affecting his income stream.

So making generalizations about how dividend growth investors feel about prices is fraught with difficulty, because you may be talking about people with different goals and/or who are at different stages of their lives. When writing about dividend growth investing, I try to speak carefully about my own goals and tactics, recognizing that they don't apply to every dividend growth investor. In my approach to the strategy, I focus primarily on generating a reliable, ever-growing income stream. I mostly ignore the prices of my stocks unless I am looking for opportunities to buy more shares. Since I am in accumulation mode for dividend growth stocks, I am OK with price declines, as they usually represent better valuations and always represent higher entry yields. They don't affect my dividend income, and I don't care nearly as much about my total wealth as I do about my income.

If I were to generalize about dividend growth investors' attitude toward price, I would say that dividend growth investors care less about price, or don't primarily focus on price. I recognize that even that squishy statement is not always true.

Dividend Growth Investors Think in Long Time Frames

At the top of this article, I referred to 10-20 years as a "relatively short" time frame. I'll bet some readers paused there, maybe re-read the sentence. Wall Street's intense focus on price and price changes conditions all of us to telescope our time horizons back into shorter and shorter lengths, until "long term" can literally mean 6 months to some people.

We often read about the difference between traders and investors. The distinction can be fuzzy, but I will use "investors" here to mean this: They are people who hope to benefit from the long-term success of the company they own rather than from short-term changes in market prices. For most dividend growth investors, "long term" is measured in years or decades, not in months or a single year.

Dividend growth investors are interested in results over 10, 20, 30 or more years. The short-term charts shown on CNBC are of little interest, except as they present buying opportunities (when prices go down) or selling opportunities (when they go up).

Note how that last sentence differs from the behavioral economics concept of "panic selling," where investors become scared and sell when prices drop. Most dividend growth investors do not do that. Some, who are using the strategy with a goal of maximizing total returns, will sell because of a price drop, but my impression is that they are in a minority among people using the strategy, and that even most total-return investors ignore short-term price movements unless they are significantly large.

That does not mean that dividend investors never sell. But they are probably less likely to sell than investors focused mostly on capital appreciation, because dividend "disappointments" are pretty rare among well-selected dividend stocks. Dividend investors' reasons for selling may include a cut in the dividend; a slowing in its growth rate; or a chance to swap for a higher-yielding stock after a price run-up takes a stock they already own into "overvalued" territory as well as drops its current yield.

Dividend Investors See Stocks' "Secret Weapon": Dividends

With few exceptions, price charts are the only kinds of charts you can find. That is a pity, because dividend charts would tell a different story. While price charts go up and down, the dividends of portfolios of well-selected dividend growth stocks simply go up.

Investors in the best dividend growth stocks are doing just fine in 2012. Tens of millions of dollars have been distributed to dividend stockholders already this year, and they will continue to be paid every month and every quarter throughout 2012. Next year, it will happen again. Most likely, more will be paid in 2013 than in 2012.

But this cash reward from dividend stocks is ignored by most of Wall Street and the financial media, even after dividends enjoyed their 15 minutes of fame last year. There is no "Dividend Index" reported minute-by-minute the way the Dow, NASDAQ, and S&P 500 are reported. But those are all price indexes. They reflect price changes only and therefore give an incomplete picture of "how stocks are doing." Price declines (which represent yield increases) are denoted by alarming red arrows on CNBC. Many dividend growth investors mentally transpose those into green "opportunity" arrows, if they are watching CNBC at all.

Dividends are stocks' secret weapon. They operate in the background. They are not sexy enough to get much attention. If GE's price drops 14%, CNBC will light up the screen with "Breaking News" banners and quickly schedule interviews with GE officials, analysts, and pundits to investigate and explain what is going on. If GE announces a 14% increase in its dividend, it may get a tiny mention in the box at the bottom of the screen. Dividends are considered decidedly unsexy, even boring.

Dividend Growth Investors Want to Benefit from Ownership without Selling

If a stock pays no dividends, its total return comes from price changes. There is no other benefit from ownership. To profit, you must sell for more than you paid.

Dividend stocks, on the other hand, offer two components of total return: price changes and dividends. The price change part works exactly as just described. But the dividend part introduces an entirely new dynamic: The company sends you cash each quarter. In dividend growth investing, the idea is to own companies that regularly increase their dividend.

A charter member of my public Dividend Growth Portfolio, about which you can see much more here, is Chevron (CVX). I purchased 30 shares in September, 2007 (before the actual beginning of the portfolio) at $94.00/share and an approximate yield of 2.5%. Since the first purchase, here's what I have received back in cash:

Year

Amount

Cumulative Amount

Remainder of 2007

$17.40

$17.40

2008

$75.90

$93.30

2009

$79.80

$173.10

2010

$85.20

$258.30

2011

$92.70

$351.00

So far in 2012

$24.30

$375.30

At the moment, Chevron is selling for $103.31. So my total return on my 30 shares is $279.30 (price change) plus $375.30 (dividends) = $558.60. That's a total return of about 20%, more than half of which has been made up of dividends received.

But far more important to me are the dividend rights that came with that purchase. I use "dividend rights" to denote the rights that come "stapled" to each share of a dividend-paying stock. While obviously any company can cut or eliminate its dividend at any time, I like my chances with Chevron. It just announced its dividend increase for 2012, 11% effective with the next payment in June. The amounts in the table above for 2007 and 2012 represent one payment in each of those years. The 2012 payment ($24.30) is 40% higher than the one payment in 2007 ($17.40). That is a perfect illustration of my main focus in dividend growth investing: Reliable, rising dividend streams. I intend to live almost entirely off those streams (plus my pension and Social Security) one day. That's why they are way more important than the price changes. By the way, a purchase of Chevron today comes with a slick 3.5% yield.

If you build a strong portfolio of dividend-paying stocks that regularly increase their dividends, you can arrive at retirement with a significant income stream paying an enormous yield on your original investment. You may be able to make a transition from a salary paycheck to a "dividend paycheck" seamlessly. And you may be able to finance a comfortable retirement without needing to sell any of your assets.

Disclosure: I am long T, CVX.

Source: Why Dividend Growth Investors View Stocks Differently