If You Build It, Capital Appreciation Will Come

by: Eli Inkrot

Recently there has been a reasonable amount of hoopla about how the Dividend Growth Investor defines success. Perhaps you have heard that DG investors "don't care about price fluctuations" and instead are solely focused on "creating an ever growing stream of purchasing power through consistent dividend increases." To be perfectly frank, I myself have suggested such a scenario:

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.

Obviously I still stand by those words, especially in the short term. But I would like to make a lasting clarification. It's not that the dividend growth investor doesn't care about capital appreciation. Whether they will admit it or not, no one likes to log-on to their brokerage account and see an electronic loss. Granted, the DGI won't care as much as someone that is bound by a capital appreciation strategy. But it remains, even if a dividend growth investor feels adamantly about ignoring stock prices, seeing higher capital appreciation necessitates a better buying decision: capital appreciation equals lower price equals higher yield equals more income. Everyone wants to be making better buying decisions.

So we have established that the dividend growth investor does care about capital appreciation, if only in minute proportion to the price-only or total return based investor. It follows that many DG opponents might exclaim: "Ah ha! We got you to admit it! Capital appreciation, if only slightly, is within your realm of investing thought after-all!" Not so fast. I would liken the dividend growth investor's mindset about capital appreciation to being the cutest girl at a high school party. In reality, the girl probably just came to the party to talk to her friends and show off that new outfit, but in all likelihood she's probably going to be asked out as well. Likewise, with dividend growth investing you just come to the market to find reliable streams of future income at reasonable prices. But in all likelihood, you're probably going to eventually get capital appreciation as well. You know that a growing stream of long-term income eventually demands long-term capital appreciation. You just don't happen to care that much if the market asks you to the prom.

Let's work through an example to better illustrate this point. Obviously the specific holdings of a dividend-growth portfolio vary markedly, but let's line up the regular suspects: Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), Colgate-Palmolive (NYSE:CL), Target (NYSE:TGT), Wal-Mart (NYSE:WMT), AT&T (NYSE:T), Walgreen (WAG), Clorox (NYSE:CLX), Kimberly-Clark (NYSE:KMB), plus say 10-30 more; all of which have increased their dividend for 25-plus years and look to do so in the future. In the event that one of your holdings cuts or freezes a dividend, you replace it with a company that has continued its increase streak. Now imagine that you have $100,000 to invest in a dividend growth portfolio. The actual number doesn't matter, but considering fees and 20-40 stocks, $100,000 is a nice round number. Additionally, allow us to assume that the aggregated initial yield of your portfolio is an even 3%, while your dividend growth rate for the next 30 years happens to average 6% annually; not unrealistic by any means.

So what happens in 30 years' time? In the first year, the $100,000 investment at a 3% dividend yield will return $3,000. Meanwhile, the value of the underlying holdings is a regular mystery. If we don't assume reinvestment, that $3,000 growing at 6% a year turns into $17,230 worth of annual income at the end of 30 years. This equates to just over $7,000 in today's purchasing power, but it is easy to see how that value is had. Furthermore, your initial yield on cost would be 17.2%; not bad. And while the underlying usefulness of a YOC measure can be debated, one cannot ignore what the implication of the yield on cost metric illustrates. In 30 years' time if the current yield of your portfolio is still 3%, then the value of your holdings is forced to be $574,349. ($17,230/.03) This translates to a long-term capital appreciation value of $474,349 and an apparent compound annual growth rate of 6% a year. More specifically, if the current yield on your portfolio remains constant, an organic increase in your dividend income forces the same growth in your capital appreciation. It's a package deal. Thus for the income oriented investor, you were likely only concerned with whether or not your dividend income was rising each year. It's not that you didn't care about capital appreciation; it's just that you knew it was coming along for the ride anyway.

An obvious fault of this logic comes in the form of knowing the current yield of your portfolio 30 years from now. To correct for this, scenario analysis seems like a pretty good bet. Historically, dating back to the 1950s, dividend yields have generally fluctuated between 1% and 5%; which seems reasonable moving forward. After-all it's pretty unlikely that either businesses will stop rewarding shareholders with dividends or that the market will be offering say Coca-Cola with a 9% dividend yield. Make sure to get a hold of me if either one of these things was to happen; I'm going to want to know. What does the scenario analysis look like?

Current Yield in 30 years
Div Growth 1% 2% 3% 4% 5%
4% $973,019 $486,510 $324,340 $243,255 $194,604
6% $1,723,047 $861,524 $574,349 $430,762 $344,609
8% $3,018,797 $1,509,399 $1,006,266 $754,699 $603,759
10% $5,234,821 $2,617,410 $1,744,940 $1,308,705 $1,046,964

Here we see dividend growth on the y-axis and the current yield in 30 years on the x-axis. The values represent a portfolio balance in 30 years' time. It should be noted that these numbers do not reflect today's purchasing power, compared with the original $100,000. However, making the wide simplification of constant 3% inflation, $100k worth of today's purchasing power would equate to about $243,000 in 30 years. In other words, every single scenario results in capital appreciation and every scenario but one increases not only your income purchasing power, but also your portfolio's value purchasing power. If we look to the 3% current yield and 6% growth cross-hair, we notice the previously quoted $574,000 number. As dividend growth increases and future current yield decreases, the balance of our portfolio increases. Here's a look at the relative capital appreciation in terms of compound annual growth rates:

Current Yield in 30 years
Div Growth 1% 2% 3% 4% 5%
4% 7.88% 5.42% 4.00% 3.01% 2.24%
6% 9.95% 7.44% 6.00% 4.99% 4.21%
8% 12.03% 9.47% 8.00% 6.97% 6.18%
10% 14.10% 11.50% 10.00% 8.95% 8.14%

We see the precise same story being told here as we did in the first table. Of course there are highly unrealistic scenarios that would force a negative capital appreciation, for example a current yield in 30 years that is higher than 17.2% with a 6% dividend growth rate, or a current yield over 9.7% with a 4% dividend grow rate. The more likely source of criticism is apt to be with regard to dividend growth. For example, if dividends grew at just 1% and the current yield went up to 4%, then one would just barely break even with regard to capital appreciation and surely fail in respect to building purchasing power. However, I believe that the two tables are justifiable in that they cover the majority of probable scenarios.

In reality short-term capital appreciation will likely fluctuate about the dividend growth rate through time. But over the long term, given consistent dividend growth and reasonable current yields, the correlation between capital gains and dividend growth is undeniable. Thus as a dividend growth investor it is true that we don't care about price fluctuations in the short term. But over a lengthy period of time it's not necessarily true that we don't care about capital appreciation. Rather, we simply realize that the math dictates that it will eventually materialize; and this happens whether we spend time rooting for certain prices or ignoring them altogether. More succinctly, if you build a solid dividend growth portfolio, monitor and balance it appropriately, then capital appreciation isn't so much an afterthought as it is a near certainty.

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