For Seeking Alpha readers the idea of Dividend Growth Investing (DGI) is nothing new. Countless authors post articles on a daily basis trumpeting the value of a creating a growing dividend stream. Dividend growth investing doesn't offer the opportunity for capital appreciation that some other stocks do, and in fact it is highly unlikely that shares of Johnson and Johnson (NYSE:JNJ) or Exxon Mobil (NYSE:XOM) will ever double in 12 months like some stocks aggressive growth investors may find. At the same time it's equally unlikely that shares of these enormous international companies will ever decline by 50-or 100%, which often times is the case with the high risk high reward stocks pursued by aggressive growth seeking investors. Purchasing stocks with long histories of annually raising dividends faster than the rate of inflation, at or below fair value allows investors to build a dividend stream that can hopefully provide the monetary support for their desired lifestyle. I am yet another one of these authors, but my focus is more on the value of a DGI strategy in uncertain economic times like what we are currently faced with. In fact when the economy is unpredictable, there may be no better time to rely on dividend growth investing.
For all investors, but dividend growth investors in particular, purchasing stocks at or below fair value is a primary concern. No matter how great the company is if you overpay for the stock you are greatly reducing or eliminating any possible returns. ( I learned that one the hard way) An unpredictable market with dropping and stagnant share prices offers more opportunities to purchase stocks at or below fair value. When the share price of a stock drops, the effective yield of the stock goes up. For example a stock trading at $100 dollars and paying $3 in annual dividends has a yield of 3%. However, if that stock price were to drop 10% to $90, the yield would increase to 3.33%. By purchasing stocks on price declines investors can obtain a better yield on cost (YOC), which is one of my favorite metrics for measuring the performance of a DGI portfolio. Additionally, by focusing purchases on stocks with long histories of annual dividend increases like Procter & Gamble (NYSE:PG) and Wal-Mart (NYSE:WMT) each successive dividend increase will drive YOC ever higher.
For a dividend growth investor, price declines can serve as a gold mine, allowing them to grow their dividend stream faster than could be accomplished during a time of continuous economic and share price growth. With the reinvestment of dividends during down economic times a dividend growth investor can supercharge the income stream thanks to the power of compounding. With the increased dividends being purchased through reinvestment and the annual dividend increases from high-quality dividend stocks an investor's income stream can grow significantly faster than inflation. Additionally, the longer an investor can hold those dividend stocks, the more the dividend stream will grow.
To demonstrate I have back-tested a basic dividend growth portfolio versus the broader market since January 2, 2008. The dividend growth portfolio consists of 100 shares each of JNJ, XOM, WMT, PG, and KO (KO prices and dividends adjusted to reflect 100 shares post stock split) stock. A portfolio with this make up would have been valued at $30,918; through closing on September 12, 2012, this same portfolio would have a value of $34248, representing a 10.7% gain, not great given a period of nearly 4.5 years. However, over that same time period those stocks paid an additional $3761.12 in dividends, which when combined with 10% stock price appreciation adds a total investment gain of ~23%, with an annual dividend stream approaching $900 annually.
A portfolio with the same initial value invested evenly in SPY, DJIA, and the NASDAQ would have returned 9% over the same time period. Over the past 4.5 years a portfolio of high quality dividend stocks has outperformed the broader market, and with the inclusion of dividends has nearly provided double the return to the investor. This does not even include the possibility of reinvesting the dividends, which could grow the income stream quicker, and with continued share price growth, increase the capital appreciation of the portfolio even further.
The coming years will likely offer a number of economic headwinds (European debt crisis, economic slow down in China, growing U.S. debt), which will slow or limit market growth. Due to the uncertain and unpredictable nature of the markets in years to come DGI is a strategy that could handsomely reward patient investors. This strategy will not bring an investor great wealth over time, but with the steady return of dividends and the stability of companies like Johnson and Johnson, Exxon Mobil, Colgate-Palmolive (NYSE:CL), and Coca-Cola (NYSE:KO) I know I can sleep better at night and feel secure that my money will continue to grow while the economy stabilizes.
Disclosure: I am long JNJ. 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.