There are many reasons why an investor may elect to pursue an income-focused investing strategy, but I think that a primary one might be this: he might desire to allow business performance (and the dividend growth that reflects this) to define his success rather than the daily vicissitudes of Mr. Market. Of course, such a strategy lends itself to criticism from those who decide to take it to a more logical extreme, "Oh look at Poor Joe. He's happy that his dividend income rose from $3,000 to $3,200 even though his portfolio value fell from $100,000 to $40,000." Such thinking can obfuscate one of the greatest appeals of dividend growth investing with blue-chip stocks: with every dividend payment made, an investor is more likely to preserve principal in the event Mr. Market is a little bit harsher.
I'll use General Electric (NYSE:GE) to illustrate the point. GE pays a $0.17 quarterly dividend. To ground this example, we'll assume that GE's share price is $22 and the hypothetical investor owns 1,000 shares of the company. This investment is worth $22,000. Come dividend payment time, the investor receives $170 in quarterly income. Assuming a reinvestment is made at $22.00 per share, this will add 7.72 shares to the investor's account, bringing his total ownership of the firm up to 1,007.72.
From a protection of investment principal perspective, what is significant about this dividend payment? If the investor wants to see his $22,000 worth of investment principal maintained, Mr. Market can now knock the price down to $21.83 and the investor will maintain his $22,000 in principal. And that's just after one single dividend payment.
The principal preservation effect of a dividend-growth strategy becomes even more pronounced when you combine it with several other factors that are familiar to those who operate on the dividend-growth terrain. You get to have three big things working for you to protect your principal once you make your initial investment:
1. You have the fact that this happens every three months with most high-quality dividend-paying firms. Sure, there are some outliers like Disney (NYSE:DIS) and international blue-chips like Anheuser Busch (NYSE:BUD) that only pay a dividend annually, but the general rule is this: you receive four opportunities per year to receive organic income from your investment. Every three months, you are automatically taking steps that allow Mr. Market to value your investments lower while still maintaining your principal.
2. As you reinvest your dividends, you amplify the fact that it takes a stronger price decline from Mr. Market. Let's say that GE remains at the $22 mark for the period of two dividend payments. The first dividend reinvestment increased the investor's stake to 1007.72 shares, allowing the share price to fall $0.17 and maintain the $22,000 net worth. But as the share-count base slowly grows, it makes it harder for Mr. Market to take away the principal of the investment. When the second dividend payment at $22 rolls around, the investor will now receive $171.32 to plow back into more shares of GE stock. The share count is now up to 1015.51. In just two dividend payments reinvested over a six-month period, the dividend investor has effectively done this to protect his $22,000 principal: Mr. Market will now have to take the price of GE from $22 to below $21.66 if he wants to create a paper capital loss on the $22,000 investment.
3. And the third thing that dividend investing can often do to protect principal by making things harder for Mr. Market is this: grow the dividend. As General Electric has been recovering from the financial crisis, the dividend has grown from $0.10 quarterly in 2010 to $0.17 quarterly in 2012. It will likely increase annually over the coming years. For the examples above, I was showing what a $0.17 dividend does to slowly guarantee principal. The results will get amplified (and it will become harder for Mr. Market to take away the principal) when that $0.17 dividend turns into a $0.25 dividend a couple years from now.
Unfortunately, stocks that do not pay a dividend cannot do this. I love Berkshire Hathaway (NYSE:BRK.B). It has one of the greatest business models I have ever seen. But no matter what (unless the company starts returning cash to shareholders), I can do nothing to fight Mr. Market. If I pay $85 per share for a block of Berkshire stock, all Mr. Market has to do is take the price below $85 for me to lose money. There is nothing I can actively do to fight this effect on my initial investment (short of buying more shares to lower the cost basis).
It can be easy to get misled by statements about dividend-growth investing philosophies that effectively states, "I only focus on the dividend income, not the share price." That may be true, but it still does not prevent the strategy from gradually protecting the principal investment (provided the dividends and earnings of the company are maintained). Focusing on the dividend payouts does not create a tension with protecting one's principal. The dividend investor has three tricks in his bag to ensure that this is so: he gets four cash payments per year to make it harder for Mr. Market to take down the principal, the dividend may grow each year, and the election of dividend reinvestment amplifies the effects of the first two.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.