An Introduction To Dividend Growth Investing

 |  Includes: JNJ, MCD
by: David Van Knapp

This article is inspired by two comments on Paulo Santos' Sunday article, "The Difficulties Of Dividend Investing And 2 Possible Solutions." Specifically, these are the comments (emphases added by me):

  • Why are obsessed with dividend "income"? The money you get paid is money that is removed from the company you still own. Which is why the value of a company drops in relation to its dividend payment. Dividends are merely transferring cash from one entity you own (a public company) to another (your bank account). To me, that is not what "income" is. Income is acquiring new cash that you didn't already have rights to.
  • Why all the articles about companies like [Johnson & Johnson] (NYSE:JNJ)and [McDonald's] (NYSE:MCD), which yield 4% or LESS when right now and into the foreseeable future, their [sic] are REITs and other companies…which generate 15% or more?...There are also companies such as GlaxoSmithKline (NYSE:GSK), which are high growth, plus have a yield close to 5%, yet all these articles seem to focus on companies that are relatively stagnant. If anyone can explain this head-in-the-sand lunacy I'd sure like to hear it, because it makes absolutely no sense to me.

Those of us who are dividend growth investors have seen many times the negative emotional reactions that our investment approach can generate. But those two comments raise legitimate questions, so I thought that I would take this opportunity to answer them for an audience of readers who may not understand dividend growth investing very well.

Let me start with a brief description of dividend growth investing. It is a strategy to accumulate dividend growth stocks that provide "organic" income from rising dividends. The dividends are reinvested during your accumulation years to speed up the accumulation process. Then when you retire, you stop reinvesting and simply take the dividends as income. Depending on how much you have accumulated and other sources of income (such as a pension or Social Security), you may not have to sell anything to create sufficient retirement income. The income is generated naturally by your investments. Studies show that in most years, the rising dividends grow faster than inflation.

When they first hear about this, a lot of investors and advisors dismiss it as a pipe dream or magical thinking by people looking for a free lunch. Some, as in the first comment above, believe that it represents an obsession with dividends. The strategy's practitioners have been labeled as cultists, zealots, and worse.

But dividend growth investing is actually just a strategy, and a relatively dispassionate one at that. In fact, when its best practices are followed, it is a coldly businesslike approach to investing, targeted at meeting specific articulated goals.

The idea behind dividend growth investing is that in retirement, you are going to want income. In the retirement literature, there does not seem to be much dispute about this. So the question becomes, What's the best way to generate the required income? An important follow-on question is, How do you make sure the income keeps up with inflation?

Under what I will call conventional retirement planning, one accumulates assets during his or her working years, then begins selling assets upon retirement to provide what I call "synthetic" income, meaning that it is not generated naturally by the investments themselves.

Under the conventional approach, such as the well-known 4% rule, you must sell assets. This approach to funding retirement is so common that "withdrawal years," "decumulation," and "retirement" are often used interchangeably, as if it is inevitable that one must liquidate assets to fund retirement. Your nest egg is reduced by those sales, and you must hope that market returns across the assets remaining in your portfolio are favorable enough to replenish the amount that you liquidated. If you have any experience with markets, you know that this is no sure bet. That is one of the reasons that Monte Carlo testing is required to project how long your money will last, because each scenario is different, and a certain percentage of them fail.

In dividend growth investing, on the other hand, ideally nothing is sold, because the income generated naturally by the assets is all that is removed from the account. All of the assets themselves remain intact. A bad market or economy pose no particular threat to most of this dividend income, because there is little correlation between dividends and stock prices. It is common for dividends from well-selected dividend growth companies to rise in a year when stock prices fall.

Most well-chosen dividend growth stocks have positive 5-year dividend growth rates, a time frame that includes the crash of 2008. There are over 400 stocks that have raised their dividends for 5 or more years in a row, meaning that they raised their dividends every year through the Great Recession. There are over 100 stocks that have raised their dividends for 25 consecutive years or more; some have passed the 50-year mark. They are called Dividend Champions. (S&P calls them Dividend Aristocrats, but their list is incomplete.) At the end of this article I will link you to a marvelous compilation of all of them, from the 5-year raisers to the 25-year raisers.

Thus we have an answer to the issue posed in the first comment. Income is not "acquiring cash that you didn't already have the rights to." (The proper word for that would be winnings or windfall or inheritance.) Rather, income is acquiring cash that you do have the rights to or at least the reasonable expectation of receiving. Common sources of income are bonds, a job, a pension, Social Security, an annuity, and, most pertinent here, dividend stocks. A central goal in dividend growth investing is to accumulate dividend rights.

The first comment posed another issue. The commenter stated, "The money you get paid is money that is removed from the company you still own. Which is why the value of a company drops in relation to its dividend payment. Dividends are merely transferring cash from one entity you own (a public company) to another (your bank account)." At the moment the transfer takes place, that observation is technically true. But it misses an important point that is extremely important in retirement: Compared to the conventional approach of selling assets to fund retirement, the receipt of a dividend requires the liquidation of no assets. That point is hugely important to a retiree, and it is simply overlooked by those who say, "Just sell a few shares."

Let's illustrate with an analogy. A landlord owns an important asset, namely the rental property. As long as he owns it, it produces income, which was its purpose. If he sells it, it would be technically true that the transaction merely transfers cash from one entity he owns (the property)] to another (his bank account). But to maintain that he is in identical positions with or without the transaction is ludicrous. After the sale, he has disposed of his income-producing asset. It ought to be abundantly clear that he is in an entirely different situation from before he sold the rental property. Admittedly, selling assets under a retirement liquidation scheme does not require disposing of all assets at once. But the underlying principle is similar. Once you sell an asset (or 4% of an asset), what you sold is gone. It cannot be sold again, and it cannot produce income for you.

Now let's turn to the question raised in the second comment. I'll paraphrase it: Why would anyone choose to own an asset yielding 4% or 5% when there are assets available that yield 15%? The answer is simple: Income growth.

Under the conventional approach, one increments the amount withdrawn each year to cover inflation. Under the common 4% rule, the retiree withdraws 4% of his or her nest egg in Year 1 of retirement, then increments that amount each year for inflation. Let's use a 3% annual increase for illustration, as this is a common number used in retirement planning. It's surprising how fast this annual increase bumps up the amount to withdraw. By Year 10, the original withdrawal has increased by 34%. By Year 30, the withdrawal amount is an astonishing 236% of the first withdrawal (or more than 9% of the original nest egg).

With dividend growth, on the other hand, the only withdrawals are of dividends received, and history suggests that those dividends rise faster than inflation, even during rough economic patches such as we experienced in the recessions of 2001 and 2008. The average 10-year DGR of the 100+ Dividend Champions that I mentioned earlier was 7.7% per year, far outpacing inflation during the "lost decade." So the reason that someone would rationally select a lower-yielding asset is because its payout is increasing faster than a higher-yielding asset. Dividend growth investing has two principle elements, the dividend and the growth. Both are important. A high value of one may overcome a lower value in the other. In my own dividend growth investing, I own a variety of higher and lower yielding, and faster and slower growing, investments as a form of diversification.

Which brings me to the last point that I want to make in this article. Prices of assets rise and fall constantly, and therefore even an expertly constructed MPT asset-allocation portfolio goes up and down in value. In contrast, portfolios of well-selected dividend growth stocks generate income streams that almost always rise, year after year. Even if a few stocks in such a portfolio suffer negative dividend actions (such as a cut or freeze), the vast majority of them increase their dividends enough to make the overall dividend stream rise. The asset liquidation model will inevitably require withdrawals in years when the overall portfolio's value declines. That means that more assets must be sold in such a year to generate the required amount of money. That increases the pressure on the remaining assets to overcome not only the market-caused decline in value, but also the value of the assets that were withdrawn. Staying even becomes harder and harder, which is why even "successful" portfolios under the withdrawal strategy often fail after 30 years, if they make it that far.

In conclusion, dividend growth investing is neither an obsession nor lunacy. It is a rational strategy for accumulating assets that, in retirement, will organically generate an income stream that is predictable, reliable, and grows faster than inflation.

I leave you now with a link to the Dividend Champions compilation that I referenced earlier. Go to the Dividend Champions document found at the DRiP Investing Resource Center. It is available in both Excel and pdf versions, and it is updated monthly. It is free. It is a marvelous source document, all but essential for the serious dividend growth investor.

Disclosure: I am long JNJ, MCD.