The Challenges Of Dividend Growth Investing

Includes: CSX, JNJ
by: Dividends For The Long Haul

Dividend growth investing is a strategy that I believe in and embrace. For me the idea of receiving a check, or as is the case now, a deposit in my brokerage, every three months from each of the companies I hold in my portfolio, and watching those deposits grow and grow each year, is exciting. This may not be the same excitement that some investors get by purchasing shares in an upstart technology company that doubles or triples its share price in a matter of weeks or months, but it is exciting enough for me. By purchasing share prices of high quality companies like Johnson and Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), and Wal-Mart (NYSE:WMT) investors will likely never see shares that double in the span of a year, but can rest assured that the company whose shares they own will not go bankrupt, and will continue to pay them to hold on to shares.

Dividend growth investing is simple in principle, but in practicing a dividend growth strategy investors are faced with a number of challenges. The idea behind dividend growth investing is to identify and invest in shares of high quality companies that will be able to pay and increase annual dividends, when they trade at favorable valuations. A more complete look into the world of dividend growth investing can be found here. Investors adopting this strategy face a number of challenges that they must overcome in order to be successful.

Challenge 1: Yield or Growth

When building a dividend growth portfolio, many investors become fixated on current yield. While many dividend growth stocks are considered to be high yield or high growth, there are the rare combination stocks that offer significant dividend yield along with substantial growth. For example Phillip Morris (NYSE:PM), which has a current yield of nearly 3.8%, has averaged a 39% annual dividend increase over the past 3 years. Others like Intel (NASDAQ:INTC), yielding just under 4%, has managed 14% increases over the past 5 years.

While it may be nice to purchase stocks currently paying out four and five percent annual yields, such as AT&T (NYSE:T), Verizon (NYSE:VZ), and Altria (NYSE:MO), investors must consider the timeline for their investment. If an investor is looking to maximize their immediate dividend income a strategy involving many high yielding equities may be an appropriate approach for them to take, but these equities often offer very low dividend growth, at or just above the rate of inflation. For investors with years ahead of them dividend growth may be more of a consideration, as over the long term a low yielding high dividend growth stock will surpass a high yielding low dividend growth stock in annual dividends. Stocks like Accenture (NYSE:ACN), CSX (NYSE:CSX), and Novo Nordisk (NYSE:NVO) have had dividend growth rates in excess of 20% over the past three years. Obviously, previous dividend growth does not guarantee continued dividend growth, but by examining a company's fundamentals, earnings growth, and dividend payout ratio investors can identify stocks which will likely have the flexibility to increase dividends rapidly in the years ahead.

Investors must look closely at their individual goals and the timeline they have identified to reach them to determine what strategy is appropriate. It is likely that a portfolio will not be exclusively high yield dividends stocks or high growth, but rather a combination of these which allows the investor to reap benefits of both high current yield and higher long term dividend growth. Find more information regarding yield versus growth here.

Challenge 2: Reinvesting Dividends or Cashing Out

There are several moving parts in this decision for the investor. First, is determining whether to take dividends as cash and use them to pay expenses, or to reinvest those dividends into additional shares of stock. The eventual goal of a dividend growth portfolio is to produce an income stream that allows the investor to collect their dividend payments, and use them to pay expenses. From that perspective it would seem that collecting dividends as cash and using them for expenses would seem appropriate, and for investors who are at a point where they are ready to begin living off dividends that may be the appropriate approach. However, collecting dividends as cash inhibits the long term growth of the portfolio and income stream. By reinvesting the dividends paid out, an investor not only gains from the increasing dividend payments, but also from the dividends paid by shares purchased with previous dividend payments. Albert Einstein described compounding as the most powerful force in the universe, and by reinvesting dividends in additional dividend paying shares, investors can harness that power.

The idea of reinvesting dividends again is not as simple as it may seem. Companies, and many brokerages, offer Dividend Reinvestment Plans (DRiPs) which allow investors to automatically reinvest dividend payments in additional shares of the same company. This is all well and good except that at times this company may be overvalued, and the shares being purchased with the dividend payments would be purchased at valuations that are not favorable to the investor. To counteract this, many DGI investors have adopted modified dividend reinvestment strategies that call for them to take their dividends as cash, and once accumulated to a certain level invest in a company they identify at that time as trading at a favorable valuation. Others chose to blend the two strategies together and reinvest dividends in stocks that appear to be at or below fair valuations, and collect dividends from overvalued companies in cash to be invested later.

Individual investors must determine what the best strategy is for them, and how much time they can devote to researching stocks and managing their portfolio. A consistent strategy of reinvesting dividends may be simplest and require the least time from investors, but may not allow them to fully maximize their long-term returns.

Challenge 3: Sell After a Run Up or Stay Invested

This is yet another challenge that dividend growth investors are often faced with. Over the course of their investments, many dividend growth investors experience holding a DGI stock which has a significant run up in share price. As the share price of a stock increases the percentage yield for that same holding decreases. For instance, an investor holds 100 shares of a stock trading at $50 (total value $5000) and yielding 3% would pay $150 in annual dividends. If that same stock then increases to $75, the investor now has a total investment value of $7500, with annual dividends of $150 (2% yield). If the investor were to sell their position in the stock and invest in a different company yielding 3%, they could immediately increase their dividend income to $250.

For these investors there is often a tough decision to make, whether to sell the stock, collect the capital gain, and reinvest that money into another higher yielding stock to increase the current dividend payments or to remain invested in the stock. Investors must consider a number of things when determining how to proceed in a situation like this. If an investor holds dividends in a taxable brokerage, the increased current dividend income will be offset at some level, by the taxes that must be paid on the capital gains. Obviously for investors holding dividend stocks in tax advantaged accounts, this is not an issue. Additionally, time and need for current income are worthy of consideration. If an investor is entering retirement they may have a need for the increased income obtained by investing in a higher yielding stock. Investors with longer time horizons must take into account the future potential for earnings growth (and dividend growth).

Again, the decision for investors to sell out of positions and re-enter in higher yielding securities is a personal one, and must be made by investors on determination of what aligns best to their individual strategy. Capital gains from increases in share price provide investors with the purchasing power to increase their dividend income; however, investors must take a number of factors into consideration when deciding how to proceed in these situations.

While this is not an exhaustive list of the challenges dividend growth investors face, the items discussed here are pertinent to all dividend growth investors. While building a portfolio with core positions in great dividend growth stocks like JNJ, Exxon Mobil (NYSE:XOM), and Dupont (NYSE:DD) provides investors with stability and predictability, dividend growth investing is not simply a "set it and forget it" strategy. When constructing their dividend growth portfolio, investors must determine how they will handle the challenges ahead of them.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JNJ, CSX over 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.