Keeping Your Dividend Growth Options Open

by: Eli Inkrot

Dividend Growth Investing. Perhaps I have lost some of you already, but let's press on anyway. When you think of this particular strategy, surely well-known within the Seeking Alpha community, what comes to mind? Personally, I think of a collection of companies like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), Colgate-Palmolive (NYSE:CL) and PepsiCo (NYSE:PEP). More specifically, I think of wonderful companies that have not only paid but also increased their dividend by a rate that consistently outpaces inflation. In fact with full disclosure in mind, this approach (mixed with a few personal nuances) is precisely the strategy that I happen to follow. While my reasoning is varied, perhaps my two favorite outcomes of this tactic is 1) My purchasing power increases each year even if I did absolutely nothing at all and 2) I don't have to rely on what others may or may not be willing to pay for my partnership stakes in the future. Granted, over the long-term the latter outcome is less of a concern for a wonderful company, dividend paying or not. However, given the option I would rather be exposed to the risk of a Coca-Cola or Wal-Mart (NYSE:WMT) making less money in the next couple of decades than the risk of say how much people might be willing to pay for Facebook (NASDAQ:FB).

Dividend growth investors love back-testing, and really it's hard to fault them. If you have Procter & Gamble increasing its dividend for 56 straight years or Kimberly-Clark (NYSE:KMB) increasing its payout for 40 years, it seems that there isn't much harm in extrapolating some reasonable dividend growth into the future. So let's see what all this hoopla is about and look into the results if you happened to pick up the recent dividend growth gem McDonald's (NYSE:MCD) in an earlier stage, say 2003.

McDonald's without Reinvestment
Invest Price Shares Dividend Payouts
Aug, 2003 $10,000 $23 434.7826 $0.40 $173.91
2004 $27 434.7826 $0.55 $239.13
2005 $32 434.7826 $0.67 $291.30
2006 $36 434.7826 $1.00 $434.78
2007 $49 434.7826 $1.50 $652.17
2008 $62 434.7826 $1.625 $706.52
2009 $56 434.7826 $2.05 $891.30
2010 $73 434.7826 $2.26 $982.61
2011 $90 434.7826 $2.53 $1,100.00
Aug, 2012 $89 434.7826 $2.80 $1,217.39
Value $38,695.65 Total Dividends $6,689.13
Click to enlarge

In August of 2003, one could pick up shares of McDonald's for around 23 bucks. It you invested $10,000 that would have bought you almost 435 shares. Fast forward to today and that $10,000 turned into almost $39,000, or a 9-year average yearly price appreciation of over 16%. Impressive by any market measure. Even better for the dividend growth investor was the fact that your dividend payout grew by about 24%, or from just $174 in the first year to over $1,200 based on today's forward rate. In total you would have collected about $6,700 in dividends, or more helpfully you would have a total gain of about $45,384, an 18.3% average yearly total return over the last 9 years. If you happened to reinvest your dividends, your results were even better:

McDonald's with Reinvestment
Invest Price Shares Dividend Payouts
Aug, 2003 $10,000 $23 434.7826 $0.40 $173.91
2004 $27 441.2238 $0.55 $242.67
2005 $32 448.8074 $0.67 $300.70
2006 $36 457.1602 $1.00 $457.16
2007 $49 466.49 $1.50 $699.73
2008 $62 477.776 $1.625 $776.39
2009 $56 491.6401 $2.05 $1,007.86
2010 $73 505.4464 $2.26 $1,142.31
2011 $90 518.1387 $2.53 $1,310.89
Aug, 2012 $89 532.8678 $2.80 $1,492.03
Value $47,425.24
Click to enlarge

Your total gain would be about $48,900 for a total average yearly return of about 19.2%. I can hear the dividend growth investor roar now! But let's grab a seat on the humble train for just a moment longer. Surely if you told an income investor in August of 2003 that they could have a price appreciation of 16% a year and dividend, currently yielding about 1.7%, that grows at a 24% clip for the next 9 years they would be ecstatic. And why shouldn't they be? Those are true wealth building numbers. But what else could you have bought in August of 2003 for $23 a share? I'll give you a clue: in just the last 9 years you would have earned about 58 times your money and if you can't figure it out try checking on your iPhone. That's right Apple (NASDAQ:AAPL). Let's see how your $10,000 investment would have fared in a $23 / share AAPL investment:

Invest Price Shares Dividend Payouts
Aug, 2003 $10,000 $23 434.7826 $0
2004 $0
2005 869.5652 $0
2006 $0
2007 $0
2008 $0
2009 $0
2010 $0
2011 $0
Aug, 2012 $670 869.5652 $10.60 $9,217.39
Value $582,608.70 Total Dividends $9,217.39
Click to enlarge

As described, the total value of your holdings would have been multiplied by no less than 58, moving from $10,000 to about $583,000. In 2005 you would have seen a 2-for-1 stock split to jump your total share count to about 870. Here's the impressive part to me: between August 2003 and the beginning of this year, Apple paid exactly $0.00 in dividends. Not that they didn't increase their dividend, but that they didn't pay one at all. Yet, take a look at the total dividends in the last column: $9,217.39. Now it should be noted that Apple has only paid one quarterly payout of $2.65 thus far. The $10.60 number that I quote is a yearly mark and in reality should be compared to McDonald's final payout of 2012 and the next two for 2013. But the impressive part remains: while McDonald's $6,700 of cumulative dividends from 2003 to 2012 is excessively impressive, Apple's single year $9,200 payout given the same investment is nothing short of extraordinary.

What strikes me about this is that there isn't a person out there that would have considered AAPL to be a dividend stock, much less a dividend growth stock in August of 2003. On the other hand, McDonald's was well on its way to increasing dividends with its 2002 to 2003 dividend increase jump of 70%, not to mention its record of increasing payouts for 25 years prior to that. On the other hand, Apple suspended its payout program in the end of 1995. Yet an investment in dividend-less Apple in 2003 would have yielded a much greater income bounty than a 2003 investment in a well-established dividend growth stock.

It occurs to me that the Apple investor in this scenario "had his cake and ate it too. Then he had a big dessert party, opened a cake factory and will continue to stuff his face for the foreseeable future. More succinctly, perhaps dividend growth investors can learn something from their non-dividend loving counterparts. Clearly a dividend growth investor would have ignored Apple in 2003. For that matter, a dividend growth investor might even have ignored McDonald's due to its perceived low 1.7% current yield; despite its recent 70% payout boost and storied record of increasing payments.

The dividend growth investor is usually bound by a strict set of criteria. For example a minimum threshold yield, say 2, 3 or 4%, a need for the company to have increased their dividend for a set number of years, say 15 or 25 straight or having a certain payout ratio, say under 65%. But just like the Apple example, perhaps we are missing something in limiting ourselves to just a handful of stocks. Now obviously, there are a great many of us out there that are perfectly content with filling our portfolios with the likes of McDonald's, Coca-Cola, PepsiCo, Procter & Gamble and Colgate-Palmolive. In fact to do otherwise would be mere speculation, right? As we all know the trick of back testing is far simpler than picking the next, or even the current, Apple.

However, I would like to indicate that one can move outside the realm of their restrictive criterion without jeopardizing their strategy. You're still looking for wonderful companies with the ability to raise their payouts by a rate that far outpaces inflation. But perhaps you open your eyes to an IBM (NYSE:IBM) even though it currently yields 1.7% (much like MCD back in 2003); or for that matter Target (NYSE:TGT) and Wal-Mart with their low 2% yields. Maybe you reconsider some of the most profitable banks again like JP Morgan (NYSE:JPM), US Bancorp (NYSE:USB) and Wells Fargo (NYSE:WFC) despite their scarring dividend slashes. Possibly you look into the stories of companies like General Electric (NYSE:GE), Hershey (NYSE:HSY) or BP (NYSE:BP); all of which would escape the dividend growth investor's screens. It seems reasonable that getting the companies right is likely to be both a more fundamental and worthwhile endeavor than getting your criterion correct.

Disclosure: I am long PG, IBM, KO, TGT, JNJ, MCD, PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.