When I write articles discussing the advantages of a dividend growth strategy, one of the frequent responses I hear is a variation of this: "Financials prove this strategy comes with some pretty nasty warts. Banks had a reputation for paying growing dividends before the financial crisis hit, and it's very conceivable that 20% of a dividend growth portfolio consisted of Lehman Brothers, Bank of America (BAC), Wachovia, JPMorgan (JPM), Citigroup (C), US Bancorp (USB), and Wells Fargo (WFC). Doesn't the failure of these once widely respected dividend-paying companies cast a dark shadow over the strategy as a whole?"
Here is how I would answer this question step-by-step:
First of all, dividend growth stocking is a strategy that demands the picking of individual stocks. There's no dividend growth button to press that locks you into a certain return. Whatever income you receive from a stock is tied to the success of that company's products. The appeal of the strategy is that it doesn't take uncommon insight to predict that people will still be drinking Coke, buying potato chips, and using tissue ten years from now. If you realized this in 2002, you could have enjoyed the 10.0% annual dividend growth of The Coca-Cola Company (KO), the 13.0% annual dividend growth of PepsiCo Inc. (PEP), and the 9.0% annual dividend growth of Kimberly-Clark Corporation (KMB) between then and now.
Likewise, when you look at the history of various sectors in 20th century America, you can pick up on certain patterns. Brand-name consumer staple companies tend to stick with us or get bought out. Tech companies are particularly susceptible to the "creative destruction" elements of a capitalist system, and they can quickly rise and fall. Banks have a tendency to explode into crisis every generation or so. The knowledge of this historical pattern could have reasonably led a dividend investor to underweight the tech and financial holdings in his dividend portfolio, and overweight his proportion of consumer staple companies.
But still, this brings us back to the question at hand. What if you are retired and 20% of your dividend income came from financial stocks right before the crisis hit? Doesn't this mean that a common man's approach to dividend growth investing doesn't work?
Well, let's assume that every single financial company in this investor's portfolio stopped paying a dividend for good. This overstates the wreckage of the financial crisis because companies like Wells Fargo, JPMorgan, and US Bancorp reduced their dividends during the crisis, and now appear to offer dividends on the mend for the investor that remained steadfast.
But let's take a look at how this would have played out. Let's pretend our retired investor generated $50,000 in dividend income before the financial crisis hit. A complete wipeout of every single financial company in the portfolio would have taken $10,000 off the total income. But here's the thing: the Exxon Mobils, Cokes, and Colgate-Palmolives of the portfolio continued to raise their dividends throughout this time period. If the rest of the portfolio grew its dividend by 7% during this time period (and the bluebloods of the dividend growth universe did this or better), that represents $40,000 worth of dividend income growing to $42,800. What does this tell you about the strategy? During the worst financial crisis that this country had ever seen since the Great Depression, investors who had a dividend-paying portfolio that consisted of the financials in the eye of the storm only suffered an immediate income loss of less than 15%.
If the investor swore off banks after that and added companies like Johnson & Johnson (JNJ) and Procter & Gamble (PG) to the portfolio to achieve safer and more reliable dividend growth, the portfolio could have gotten back on track fairly quickly. Here's what would happen if the investor could compile a dividend growth portfolio that has a total dividend growth rate of 7%. The $50,000 in dividend income in 2008 would have fallen to $42,800 in 2009. In 2010, that would have become $45,796. In 2011, it would have turned into $49,001.72. And by 2012, this investor's total portfolio income $52,431.84. Within four years, our investor could have been made whole again.
I don't make any promises that a dividend growth portfolio will work best for everyone out there. But I do think it can produce the results necessary to meet one's lifetime income goals. The fact that a portfolio generating 20% of its income from financials during the worst financial crisis most of us have seen in our lifetimes might only lead to a 15% total loss of income catches my attention. If you make the judgment call that you can construct a portfolio that will generally grow its income by 7% each year after getting caught in the wrong place during the financial crisis, it would only take four years to become whole after the worst collapse in modern American history. A dividend growth strategy can withstand some abuse along the way. When you have the Exxons and the Cokes of the portfolio doing the heavy lifting during times of economic crisis, the dividend flame-outs in the portfolio can be repaired quicker than you might think.
Disclosure: I am long BAC.