SDS (Seductive ...'s  Instablog

When I was a child my parents told me a fairytale about a funny land over the horizon. In this land a fool plants small amounts of money into the soil and hopes that money trees grow producing big harvests of free money.
When I was young I was foolish enough to want to move to the funny land over the horizon where the money trees grew, naively believing that I could find these wonderful money trees and plant them in my own orchard.
Strangely, some aborigines of this land heard about money trees and a small fraction of them even tried to plant their money on these trees. But it seems that even the most enthusiastic planters did not fully trust the fairytale and lowered their expectations to only grow only 10% of their money on the wonderful money trees (see footnote 1).
Initially I thought that this made sense, and I joined the community of planters and attempted to seed the trees with small but growing money fruits.
Then recently I told my young four-year-old son the fairytale about a funny land over the horizon with free money on the trees. He asked me: "Dad - will I find such trees?" I said "Sure and I'll help you."
When I had excess money not needed for my sons "toys and candies" (see footnote 2) I started to invest my own money (mostly in mutual funds). However, it took me several years of intensive reading of finance literature and independent thinking (footnote 3) about stocks to prepare and become ready to help my son who is a bit older than 4 now. Now I am older and wiser as well and I feel it's time to suggest to my son that he not trust his hard-earned money to so-called certified financial pundits who I am convinced do not know any more about stocks and finance than I now do.
Let's quit fiction now and move on to the real world of finance and look at dividend paying stocks that I believe may be the closest thing to the fairy tale free money trees that exist in the real world. Here is a simple 7-step instruction how to plant real free money trees, better known as dividend growth stocks.
1) Diligently and methodically save a portion of your money (earnings)
2) Select solid companies with growing dividends and earnings
3) Plant a whole orchard, i.e. invest 3% or less of your money into any single company-in other words diversify (see footnote 4)
4) Hold until the price of any company's stock increases at least twofold (see footnote 5)
e) Sell half of any stock with 100% or higher gain
f) Enjoy the free money (dividends on zero cost) that grow on your free money trees (dividend growth stocks)
g) Always plant new trees in the spring (bear market) and harvest trees in the autumn (bull market)
Since I was wise enough to start young, some of my money trees (dividend growth stocks) are already bearing fruit (increasing dividends). Hopefully, my son will soon have his own orchard full of free money trees (dividend growth stocks) bearing succulent fruits (growing dividends). Hopefully, my little story of the free money trees will inspire some of you to plant your own money tree orchards. However, never forget that not all money trees bear fruit (sometimes you can lose your money), so be wise and diversify.

Acknowledgement
The author is grateful to Chuck Carnevale for proofreading.

Footnotes

1. These aborigines call the ripening fruit on the money trees growing dividends or yield on cost (YOC = increasing dividends/initial stock price) but some aborigines are so funny that they still endlessly debate current yield over yield on cost (see http://seekingalpha.com/article/383021-should-dividend-investors-care-about-entry-price#comment-2862141).
2. When I came to the funny land over the horizon (the zany world of finance) my knowledge about real world economics, finance and the stock market was the same as a newborn baby. I grew up quickly, studied hard, and after 4 years of my life in the funny land of finance,I applied my learned skills and started to invest.
3. Bertrand Russell, a famous British philosopher, logician, mathematician, historian, and social critic, might have been thinking about finance pundits when he wrote "Most people would rather die than think".
4. About 3% of Dividend growth stocks cut their dividends - see - see seekingalpha.com/instablog/725729-sds-se... so be prepared that some of your money trees maybe lemons.
5. I assume zero inflation and broker fees. For taxable accounts more than 2X price appreciation is needed.

As a small investor I can vote but I don't do it. Official company issues are voted based on capital weight, so my voice is almost zero to compare with institutional voices whose hold million times more shares than I have.
But in some aspects (in particular dividend policy) my and institutional voices are equal weighted but institutions talk with company management while individual investors are often silent.

IMO, we should and can influence companies with good dividend policies (e.g. company with positive DCR from David Fish CCC list) and communicate them our appreciation of their dividends.

It takes only couple minutes to send email like this to investor relations:

I really appreciate COMPANY dividend policy and think that your company did terrific job for shareholders. I hope that Board will be able to increase dividends in future. Please pass this message to your top management and Board as a voice of small but long-term ABCD investor.

I did it couple times after company announced dividend increase.

I believe that in difficult times than company need to decide about dividends CEO, CFO and Board will count your voice and message like one above as strong as other voices.

Many investors goal is "Maximum real total returns after tax" as it was defined by Sir John Templeton many years ago. My goal is slightly different and it is "As big as possible positive real total returns after tax during intermediate (~ 3-5 years) and long time periods"

Often financial advisers just split total stocks returns into 2 parts as shown in Credit Suisse (CS) picture below.

From this picture it is clear that capital appreciation part dominates during 1926-2006. Therefore many investors nowadays just ignore dividend contribution. In order to capture the capital appreciation a "regular" investor (without short positions) must sell stocks and I'll show elsewhere cons and pros of such decision. But if I go 1 step beyond this picture and try to understand causes of the capital appreciation I conclude that most probably the following factors are important in the long run:
a) growth of earnings (or another metric that investors in masse use to buy stocks, for example organic grow, revenue, etc..) due to better productivity and partially due to inflation;
b) growth of valuation due to increase of money inflow into stock market (in average life conditions on our planet improve with time and more and more people have some extra money they can invest. BTW, USA stock market still has good reputation and it is important for money inflow into it).

On long run earnings and divdends are correlated: both grow with time although at different spead in various time periods as shown below.

Although for many companies payout ratio fluctuates with time (mostly because of earnings fluctuations) for a big set of companies (e,g, all 500 stocks in S&P500) during some resonable long average period these fluctuations are zero out as shown above. Prof. R. Shiller demonstrated the same for inflation-adjusted numbers in his excellent book "Irrational Exuberance":

If we ignore fluctuations we can see that both stock prices (i.e. , capital appreciation) and dividends increase with time, so dividends might play a second role in total return.

Therefore total capital appreciation can be splited into growth of dividends (or earnings) and change of valuation as Societe Generale researches did in the following pictures (please note change in color codes).

In a long run (~10 years) about 94% of my goal can be achieved with Dividend Growth Investing (DGI) according to graphs below I took from a good James Montier book "Value Investing: Tools and Techniques for Intelligent Investment".

Prof. R. Shiller, Credit Suisse (CS) and Société Générale (SG) quants used all stocks traded in USA to build these graphs. A dividend investor by definition does NOT invest in stocks without dividends. So subset of abovementioned dataset should be used. I do not have such information and look on a simple task - to figure out how dividends and stock prices are correlated for seasoned dividend growth companies. I took 125 companies which increase dividends at least 20 years from today's David Fish list (dripinvesting.org/Tools/U.S.DividendCham...) and "verified" their dividends at Yahoo.com (please note that David Fish information is more precise but I wanted to do quick and dirty test). I trimmed out companies that have not enought Yahoo data or which dividends increased in more than 50 times (probably because of recent huge special dividends). As the result I got list of 100 companies. I compared dividends and prices grow numbers for these 100 companies for last 20 years and got the following graph:

Both factors are purely correlated. For most of companies dividends increase is below 20 /median ~ 4.6 /and for ALL companies price increase is below 5.5 /median ~ 1.88/. Nevertheless up trend is visible at the graph. Hence for last 20 years SG results are valid for companies with growing dividends. See also 25 March 2012 addition.

I mentioned that payout ratio (dividends/earnings) fluctuate due to significant earning noise. Indeed the following CS picture for dividends and earnings variations confirms this observation:

As probably any investor I dislike variations so smaller variations in dividends seems me atractive (well, as a nanotechnology researcher I do see a lot of noises and quantum fluctuations at work and even use them for banks dividend analysis in seekingalpha.com/instablog/725729-sds-se...). But I'd like to stress the big (in my opinion) difference: dividends can be only positive or zero while earnings can be positive, negative or zero and any "regular" investor hate negatives (behavior scientists found that a human hate losses about 3 times stronge than love gains). I calculated Geometric Average Dividend Payments Growth coefficient from R. Shiller data for 1871-2010 and it is 3.27%, so a dividend growth investor (DGI) can pressume such increase of dividends and hence real variations DGI faces even smaller than numbers calculated by CS quants. Also I calculated Geometric Average Earnings Growth coefficient from R. Shiller data for 1871-2010 and it is 3.86%. Therefore Dividend Payments Growth is equal to 84% of Earnings Growth now I know how SG quants got the number.

Do you still remember that Sir John Templeton and I wrote "returns after tax", so what is about taxes? In short I hate them (esp. in Silicon Valley, California there at the top of federal and huge state taxes we have ~ 10% sales taxes) but pay them. But I demand from all politicians that "represent" me at least to keep low taxes on dividends and I beleive any dividend zealot must do the same. And the max I think that double taxation of dividends in US should be stopped.

Of course there are other arguments in favour of dividend investing readers can find them in excellent books:
"The single best investment: creating wealth with dividend growth" by Lowell Miller (actually this 2006 book changed my investment philosophy);

"Dividends don't lie: finding value in blue-chip stocks" by Geraldine Weiss (substitutes are "The Dividend Connection: How Dividends Create Value In The Stock Market" by Geraldine Weiss & Gregory Weiss and "Dividends Still Don't Lie: The Truth About Investing in Blue Chip Stocks and Winning in the Stock Market" byKelley Wright);

"The Strategic Dividend Investor" by Daniel Peris - see seekingalpha.com/instablog/725729-sds-se...;

TOP 40 DIVIDEND STOCKS FOR 2012: How to Create and Maintain a ividend Growth Portfolio by David Van Knapp (DVK published such book each year so previous editions can be used, he also publish good articles at SA - seekingalpha.com/author/david-van-knapp - I sometimes try to challenge).

"The High Dividend Yield Return Advantage" downloadable from www.tweedy.com/resources/library_docs/pa....pdf

I'd recommend to read these books for any stock investor.

Of course there are other and probably even better styles of investment but I prefer to be eclectic dividend investor.

ADDITION 20 Feb. 2012
Graphs like figs. 7.2 and 15.6 of SG shown above for US stocks can be constructed for any country. Indeed famous trio from London Business School / the authors of excellent book "Triumph of the Optimists" (2002)/ analyzed long-term stocks return in 19 countries.
They wrote "Unlike fixed-income investments, equities offer the prospect of dividend growth. Historically, dividends have grown in nominal terms in every country. But what matters is real, inflation- adjusted growth. Figure 4 shows the <analyzed> countries and world index ranked by their annualized real dividend growth over 1900-2010 (the gray bars). Real dividend growth has been lower than is often assumed. Figure 4 shows that 10 out of 19 countries recorded negative real dividend growth since 1900, and only four enjoyed real dividend growth above 1% per year.

Dividends, and probably earnings, have barely outpaced inflation. Dividend growth was lower in the turbulent first half of the last century.... But from 1950 to 2010, real dividends grew everywhere except New Zealand, and the world index enjoyed far healthier real growth of 2.3% per year. Figure 4 also shows how dividend yields have changed over the long run. The red bars show the annualized change in the price/dividend ratio (the reciprocal of the yield) from 1900 to 2010. Over the last 111 years, price/dividend ratios have risen (dividend yields have fallen) in 16 of the 19 countries. The price/dividend ratio of the world index grew by 0.48% per year. Finally, the blue bars in Figure 4 show the mean dividend yield in each country from 1900 to 2010. By definition, the real annualized equity return in each country is equal to the sum of the three bars shown for that country, i.e. the mean dividend yield plus the real growth rate in dividends plus the annualized change in the price/dividend ratio. Dividends have invariably been the largest component of real returns. "
I'd like to compare this recent picture with similar graph published by the "Triumph of the Optimists" authors (Elroy Dimson, Paul Marsh and Mike Staunton) 10 years early:

It seems interesting that USA moved from #4 to # position while Sweden maintained #1 position. I think this difference reflects importance of dividends in "lost decade" of US stock market.

25 March 2012 addition:

Research Affiliates LLC compared stock prices earnings and dividends after inflation based on the same Robert Shiller's data - see picture below

All 3 have almost the same uptrend that again confirms SG results that about 90% of total return is due to dividends and their growth. Let me just remind that dividends come from earnings at least in the long (> 100 years) run.

March 14, 2013

There are few research that shows that dividend indexes outperform S&P500, here is an example:

(click to enlarge)