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Of all the justifiable arguments against a Dividend Growth strategy, perhaps the one I hear most often goes something like this:

"You DG investors sure do love back-testing, picking and choosing the most successful stocks within your strategy and blindly proclaiming the decades of triumphant results you would have. But if you were truly a dividend income investor before 2008, we all know that you would have held financials in your income portfolio. Thus the resulting financial crisis would have devastated your income strategy. What do you think about that, huh huh?"

To be frank, it's a perfectly logical point to make. After-all, during the last couple of decades before 2008, American bank stocks were widely recognized for their reasonable dividend yields and solid business models. We all know why banks make money. Unfortunately, we now all know how banks can lose money as well. But it remains that one that was focused on income before 2008 would not have shied away from bank stocks as much as they would have flocked to them. So I decided to work through an example of this reasonable criticism and post the results, whatever they might be.

Let's construct a portfolio. First, if we're going with individual stocks then it's likely that we're going to have more than 2 or 3 holdings for diversification purposes; we'll call it 30 stocks in total. The exact dollar amount doesn't matter, but we'll go with $30,000 or $1,000 each to make things simple. In reality, due to the transaction costs, you likely wouldn't want to invest as little as $1,000 at time; but it works fine for this example. Now we're sitting here at the beginning of 2008 and we have this goal of creating a growing stream of income over the long-term. In addition to the $30,000 we have to invest, we estimate that we will have say $5,000 more each year to contribute going forward. Which companies should we chose? Well of course the normal dividend growth stocks come to mind: Colgate-Palmolive (NYSE:CL), Kimberly-Clark (NYSE:KMB), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), PepsiCo (NYSE:PEP), 3M (NYSE:MMM), Wal-Mart (NYSE:WMT), etc. You get the idea. But now we need to add some financials to complete the example. Which ones should we go with? Let's see: JP Morgan (NYSE:JPM) hasn't cut its dividend since 1990 and is offering a 3.4% yield, Wells Fargo (NYSE:WFC) has increased its dividend every year since 1988 and sports a 4.3% yield and US Bancorp (NYSE:USB) has been boosting its payout every year since 1992 and has a very nice 5.3% current yield. Those look good, let's go with them.

Now an obvious criticism within the criticism would be creating an example with just 3 financial stocks in the portfolio. But I don't think 10% of my portfolio is an unreasonable assumption. With the possible exception of a potential heavy tilt towards consumer staples, I likely wouldn't be putting much more than 10% of my invest-able funds in say energy, telecommunications, healthcare, industrials, insurance or food either. There are a lot of different categories out there that offer compelling income growth prospects. So if the naysayer's suggest 3 financials out of a 30 stock portfolio is an unreasonable 2008 income growth assumption, I won't contest it, but it seems reasonable moving forward.

So now we have 27 of the "classic" dividend growth stocks and 3 financials: JPM, WFC and USB. In addition we'll assume that you take your dividend checks and pay your utility bill or take a few nights out on the town, rather than reinvest them. For the 27 DG stocks, we'll assume a 'cover-all' 3% current yield and an annual average dividend growth rate of 6%. Both of which might be drastically understated or slightly overstated, but still in line with practical assumptions. For the 3 bank stocks we will use the actual numbers. So let's quantify this thing:

 

 

 Initial Inv2008 Div2009 Div2010 Div2011 Div2012 Div
27 DG stocks$27,000$810.00$858.60$910.12$964.72$1,022.61
JPM$1,000$33.78$11.78$4.44$17.78$25.56
WFC$1,000$43.33$16.33$6.67$16.00$29.33
USB$1,000$53.13$17.97$6.25$13.28$22.19
 Income$940$905$927$1,012$1,100

It should be noted that I went ahead and assumed the last payout in 2012 would be paid accordingly. In the beginning of 2008 we start off with a $30,000 balance; $27,000 in our "classic" (i.e. didn't cut their payouts) dividend growth stocks and $3,000 in equal parts of JPM, WFC and USB. We see that the 27 DG stocks provide $810 in yearly income, or a 3% yield, while the 3 banks stocks throw off $130.24 in dividend income, or a juicy 4.3% current yield. In total we have received $940 in income from a $30,000 initial investment for a yield on cost of about 3.1%. It seems the strategy is working well. But then 2009 trots along and the bottom drops out. JPM slashes it's dividend from $0.38 a quarter to $0.05, Wells Fargo's $0.34 quarterly payout also drops to the mandated $0.05 and USB's huge $0.425 quarterly payment plummets to, you guessed it, $0.05 a quarter. Your annual income from the bank stocks drops from $130.24 in 2008 to $46.08 in 2009. Worse, the dividend cuts stick around for 2010 and your income from these three holdings drops further to just $17.36 in your third year of ownership. In both 2009 and 2010 you are making less total dividend income than in 2008; not exactly what you had in mind for a growing stream of income.

But hold on, what are those 4 digit income numbers in years 2011 and 2012? Yes indeed, those appear to be higher dividend income payouts. Granted, your 3 financial holdings are now only paying you $77.08 in 2012 as compared to $130.24 in 2008. But no worries, your other 27 holdings have been pulling the extra weight in the form of a consistent 6% annual payout growth rate. In fact, despite the magnificent dividend cuts that 10% of your portfolio faced, your income grew by an average rate of 4% a year over the 5 year period; for an ending yield on cost of about 3.67%. This hardly seems catastrophic given the enormity of the financial crisis.

Now let's add in that extra $5,000 that you are able to contribute each year. Perhaps you don't trust the financials anymore and decide to invest in your other 27 holdings:

 

 

 Initial Inv2008 Div2009 Div2010 Div2011 Div2012 Div
27 DG stocks$27,000$810.00$1,008.60$1,219.12$1,442.26$1,678.80
JPM$1,000$33.78$11.78$4.44$17.78$25.56
WFC$1,000$43.33$16.33$6.67$16.00$29.33
USB$1,000$53.13$17.97$6.25$13.28$22.19
 Income$940$1,055$1,236$1,489$1,756

Notice that the dividend payouts for the 3 bank stocks are precisely the same as the table as above. However, while the dividends for the other 27 dividend growth stocks are calculated in the same manner as our first table, I added an additional $150 to years 2009 through 2012. ($5,000 * .03) I kept the same 3% yield and 6% dividend growth assumptions for simplicity. In reality, one would likely have been able to find much higher collective yields for these stocks in the 2009 - 2012 timeframe. Here we see that the dividend income keeps increasing, regardless of the severe financial stock dividend cuts. This should be expected, as we move from an initial $30,000 investment to a much more substantial $50,000 investment. This precisely demonstrates the power of not only dividend growth but also the value of contributing just a little bit more as one is able. The beginning yield on cost is around 3.1%, as described, while the ending YOC is about 3.5%; again fueled by a large assortment of growing payouts.

A final example might be for the bold: taking the annual $5,000 and reinvesting in the aforementioned bank stocks:

 

 

 Initial Inv2008 Div2009 Div2010 Div2011 Div2012 Div
27 DG stocks$27,000.00$810.00$858.60$910.12$964.72$1,022.61
JPM$1,000.00$33.78$47.12$26.12$135.48$249.52
WFC$1,000.00$43.33$57.17$35.68$110.65$255.25
USB$1,000.00$53.13$71.22$39.27$109.68$225.51
 Income$940$1,034$1,011$1,321$1,753

Here you will notice that the dividend income provided by the 27 DG stocks is precisely similar to our first table. However, this time I used equal portions ($1,667) to invest in JPM, WFC and USB over the 4 year time period. It should be noted that I picked random prices in January of each year to determine how many shares a third of $5,000 bought. In total, I ended up with 217 shares of JPM, 290 shares of Wells Fargo and around 318 shares of USB; hence the $730 or so in annual income for these 3 stocks in 2012. In addition, as mentioned previously, I extrapolated the banks current dividend payout to include the 4th quarterly payment for 2012. Here we notice something somewhat off-putting. That is, while our income increases from 2008 to 2009, it actually declines from 2009 to 2010 despite an additional $5,000 contribution. Eventually, we end up with almost the exact same level of income in 2012 as we did with our second example. It's clear that moving forward the investment in the dividend growth stocks that didn't cut their dividend would provide more overall income. (Given that the three bank stocks grew their dividends at the same rate or a slower pass than the collective rates of the other 27) However, it's interesting to note that if the bank stocks increase their dividends more rapidly, say to 2008 levels and beyond, then reallocating capital to these stocks at a time when they were cutting their dividends could in fact lead to more eventual income.

Without question, there are a variety of simplifying assumptions provided in this example. Back-testing data, pin-pointing prices, using a short timeframe, not allowing for volatility, citing an imperfect 'yield on cost' measure and contenting that 10% would have been a reasonable financial income allocation comes to mind. However, even with these simple suppositions, I don't believe that this particular illustration is all that unreasonable for the average dividend growth investor. As far as the preliminary argument goes, I don't think "devastating" would be quite the right word to describe the financials impact on a dividend growth strategy. Perhaps a softer "momentarily impairing" would be more appropriate. In any event, the argument holds some weight but not overwhelmingly so. Perhaps I'm just embedded in my ways, but as a Dividend Growth investor I would take solace in the fact that 10% of my portfolio could melt down dividend-wise and just 3 years later I would still be making more income than I am today.

Source: Financials; Devastating Your Dividend Growth Portfolio Since 2009