Dividend Growth Investing; Give Us Your Tired, Poor And Unguided

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Includes: CL, EMR, FB, JNJ, KO, MCD, MMM, PEP, PG, TGT, WBA, WMT
by: Eli Inkrot

When prompting the average person for investing knowledge, you're likely to hear the old adage: "buy low, sell high". Even if you happen to encounter a novice or unaware investor the underlying logic probably wouldn't be that difficult to discover on your own. If you buy something at one price, you need to sell it at a higher price in the future to make money. Now admittedly this axiom is overwhelmingly simplistic. For example, one need not just make money, but enough money to compensate them for the gratification that they are delaying today. But in theory "buy low, sell high" works great; after-all this saying isn't the oldest advice in the investment book without reason. Unfortunately, it doesn't exactly transfer to the real world. It's what I like to call the "coolest, but most useless strategy I know." You might as well being advising people to "make money."

Let's allow our imaginations to run wild for a moment and implement the "buy low, sell high" strategy. Say it's the beginning of June (2012) and you're looking to take $10,000 to "invest" in the stock market. Maybe you're an avid Facebook (NASDAQ:FB) user and happen to think that your funds would be best placed into a company with hundreds of millions of users just like you. But you've done a little bit of research and feel that the IPO price is much too high. Turns out you're spot on and now you have the opportunity to "invest" at say $26 a share on June 6. Twenty days later the shares are trading at $33. Buy low and sell high, boom you take the proceeds. A little more than a month goes by and the market is offering $20 a share on Thursday August 2, which you swiftly take advantage of. You take the weekend off and wake up to a $22 price on Monday August 6, easy breezy. Take another month off and you happen to notice that FB is trading at $18 a share on September 4. Just eight days later $21 runs across the bottom ticker on CNBC and you decide to cash out. Here's a table summing up your moves over the past 3 plus months:

Date Price Action Shares New Total
6/1/2012 Sit on Hands $10,000
6/6/2012 $26 Buy 384.61
6/26/2012 $33 Sell 384.61 $12,692.31
8/2/2012 $20 Buy 634.61
8/6/2012 $22 Sell 634.61 $13,961.54
9/4/2012 $18 Buy 775.64
9/12/2012 $21 Sell 775.64 $16,288.46
Click to enlarge

Now there are a variety of qualifications that need to be explored within this exercise. First and foremost, I would like to indicate that this isn't a necessarily fictional example. True, I made it up for illustrative purposes; but it holds that someone could have actually made these trades. In fact given that these prices occurred, by definition, someone did make these exact trades. Perhaps not all of the trades, on the same sides or even in the same order; but it's not an absurd case. Next, there would be frictional expenses involved. If you take say $7 trades and not being able to reinvest a slightly smaller amount this would translate to slightly over $50; not a big difference. What would be a big difference is accounting for taxes. Call it 30% and our new total goes to about $14,400. But given those qualifications, think about what just happened: You were able to find a 44% return on $10,000 in just over 3 months. All you did to achieve this was place 3 different buy/sell orders following the logic "buy low, sell high." You could take the next 9 months off and have a perfectly brilliant year at that pace. In fact, if you could return 44% on $10,000 for 17 straight years you would end up with about $4.9 million; or closer to three million in today's purchasing power. From there, retire and find your beach; this investing stuff is easy.

Of course the underlying reason that the majority of us are not drinking margaritas on the sand and touring Europe in a helicopter, aside from the fact that we would collectively stop producing more stuff, is that there's no way of determining when the highs and lows come. Even if you could establish a criterion, it's all relative; perhaps you noticed that the beginning $26 low is a great deal higher than the corresponding $22 and $21 highs. Incidentally, if you happened to switch the trade actions, starting with June 26, you would turn that same $10,000 into about $5,000. Granted a more likely scenario would be buying at $26 and holding your shares today at a paper loss. The point is that predicting stock prices is excessively difficult in the long term, but purely impossible over the short term.

Thus we need an investment strategy other than the "buy low, sell high" ideology. To be candid, I'm not knocking a value strategy whereby one evaluates a current investment opportunity based on a variety of essential elements and then determines how much the market ought to pay for it over the long term. If you find opportunities with enough priced-in wiggle room, i.e. Ben Graham's "margin of safety," you'll likely do quite well over the long haul. However I am simply suggesting that, personally, I claim no insight into future market prices. Even if I happen upon situations where I believe the prices are lower than they should be, I stay humble in my assumptions. After all, assuming any efficiency whatsoever in the market leads one to the realization that there are literally thousands of people out there who are apt to be both more intelligent than you and have a greater ability to influence where a larger chunk of capital is deployed.

So here we are. We know that competing with prices, especially in the short term, is an irrational man's game. On the other hand we know that over the long term, equity investments have proven to be one of the most efficient ways to guarantee future financial fulfillment. That is, we need to be invested. So the follow up would be: "Is there a way to invest without having to concern one's self with price fluctuations?" And of course I wouldn't lead you on without providing a concrete answer.

My answer, as is the answer for many fellow SeekingAlpha.com authors, is Dividend Growth Investing. The precise definition can be debated, but a collection of brief universalities would be as follows: "Dividend Growth Investing is an income strategy whereby one owns a collection of wide economic moat companies that have not only the propensity to but also the storied track record of increasing dividends by a rate that far outpaces inflation." The specific companies can also be debated, but generally this means investing in companies like: Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), McDonald's (NYSE:MCD), PepsiCo (NYSE:PEP), Target (NYSE:TGT), Wal-Mart (NYSE:WMT), Walgreen (WAG), 3M (NYSE:MMM), Emerson Electric (NYSE:EMR) and Colgate-Palmolive (NYSE:CL). All of which have increased their dividend payouts for decades.

Now I want to be perfectly clear that this strategy doesn't necessarily suggest that one should go out and buy a portion of these companies tomorrow. In fact, this is a rather common misconceived criticism of the dividend growth strategy. Eventually, once you own a sufficient level of holdings, it is true that you don't really care what the price of your ownership stakes happens to be in the future. But the critics often mistake this way of thinking as "not caring about prices ever." Of course the DGI crowd cares about prices when they are going to partner with one of these wonderful companies. A lower price implies a greater yield and thus more income moving forward. In fact, it wouldn't be a far stretch to call a DG investor a value investor, with the qualification of needing a growing dividend to boot.

So how do we get to the point of not caring about prices? More precisely, what are some basic DG principles that you can take from this article and apply to the investing world? That's a good question and I'm glad you asked:

Develop a shopping list

I've already mentioned a few companies, but really there are hundreds of applicable options. A great place to start this search is David Fish's CCC lists, found here. Do the same thing as you would if you were going to the grocery store on a tight budget: write down all of the companies that you would like to own, then go to the market and see whether or not they are on sale. When you do happen to find a sale, only buy companies that you would be happy to own in 10 years' time. These partnerships are meant to be around for a long time. And while there might be some situations that would effectively "make you sell" by and large a solid dividend growth portfolio shouldn't have very much turnover.

Be Patient

The unfortunate thing is that wonderful companies likely don't go on sale as often as we would like. And this makes sense. Keeping with the grocery store example, we rarely see the prices of the highest quality items cut to compete with mere store brands. But when such opportunities do come along, make sure to fill up your shopping cart.

Think of Yourself as an Owner

Imagine that you own a popular and profitable shop in your local town. Everybody knows the store and people are willing to pay a premium for the first-class shopping experience that you provide. As the owner, you decide to reward yourself with a raise each year in the 5-10% range; hey, you earned it. Furthermore, you intend on retiring and hiring a general manager in a couple years to run things for you. Per your agreement, you'll not only keep your salary but you'll also keep enjoying those nifty pay raises. Now consider if all of your customers and even some people walking past the storefront decided to offer you a price to buy the business from you. Each day you hear hundreds of prices thrown out there, some insultingly low, others almost unreasonably high. But to each of them you simply shake your head and politely decline their offers. You know that the true worth of your ownership is value that it will continue to provide you for many years to come. The same goes for a DG portfolio. Once you partner with a wonderful company, you don't really care whether or not people are shouting prices at you.

Focus On Planning

The neat thing about DGI is that the income that comes in is rather predictable. On the other hand, it is overwhelmingly difficult to predict capital appreciation. Thus while there is definitely value in price increases, it is unknowable. Let's say that this year I am going to make $1,000 in dividend income. Next year, I know that it is reasonably likely that my dividend income will be in the $1,040 to $1,100 range; without me having to do anything at all. More than that, I know that if I continue contributing my income will almost certainly keep climbing. Even in the scenario of the financials cutting their dividends in 2009, I previously demonstrated that the momentary income impairment wouldn't have lasted that long. The bottom line is that I can focus on a goal of say making $1,300 in dividends next year. But I have no idea how to plan around what stock prices will do in the next couple of years.

Achieve Your Goal

Perhaps you think I've missed some intermediate steps in going from around $1,000 in yearly dividend income to say $50,000 in yearly payouts to cover your living expenses. To this point I would suggest Tim McAleenan's "wash, rinse, repeat" motto would suffice. In reality, there's no secret behind the dividend growth investing strategy. It takes a long time and a lot of effort. But once you've reached your goal, perhaps it took $1 million worth of contributions to get there, you can stop monitoring prices and do whatever it is that you might like to do instead. You know that your dividends will likely outpace inflation going forward to boot, so you're actually becoming richer as you do whatever it is that you're doing. If someone goes around and offers you $500,000 or even $250,000 for your holdings, you tell them to kindly be on their way. If they offer you $10 million, then perhaps you think about it a little more, but really you'd just put the money back into what you're already doing.

Granted, this strategy is not for everyone. Many people do just fine without it. But I would like to bring up two points. First, mentioning capital appreciation with regard to dividend growth investing suggests that one has missed the logic quite completely. Incidentally capital appreciation and dividend growth stocks are highly associated, just as any profitable endeavor would be over the long term. However, the DGI crowd just so happens to be fortunate enough to be concerned with a more prediction-friendly growing income stream rather than relying on what other people may or may not be willing to pay. Second the "buy low, sell high" phrase, while concise and easy to remember, sounds like a get rich quick mantra. Investing, no matter your primary strategy, is neither quick nor perfect. Perhaps the expression could be changed to "buy low, invest regularly, collect dividends, strategically redeploy payouts, be patient, remain with fundamental companies as long as they remain fundamental and eventually live off of your wonderful partnerships that you have accumulated." I suppose that it doesn't quite have that same 4-word ring to it, but it's just a fist cut. Perhaps you have something a bit catchier; I'm all ears.

Disclosure: I am long KO, PG, MCD, TGT, WAG, JNJ, 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.