Why Dividend Growth Investing Can Make You A Better Investor

Includes: CME, MCD, NVS, V
by: Integrator

I first started investing in my early 20s. Frankly, those initial years were filled with trial and error. The latest biotech tech stock, the fastest growing "small company" stock and the hottest thing in smart cards all made their way into my portfolio at one point or another. And after a 6 month period, they were all gone. Liquidated. Bankrupt.

Fortunately at that stage my investment size was very small, and my losses were minimal. But I was determined to find a better away. That was when I stumbled onto Roxanne Klugman's Dividend Growth Investment Strategy. The book promised a lot, and while its focus was on keeping retirement income doubling, I figured that it wouldn't hurt to keep my own current income doubling pre retirement so I could spend it now as well.

So I started implementing dividend growth investing in my mid 20s, and I have stuck to this approach for the last 10 years. I feel dividend growth investing has certainly helped instill a more rigorous discipline for me in how to select, buy and monitor stocks, and frankly, helped me become a better investor. The following are the reasons why I believe the method has helped me, and why it can help anyone become a better investor:

1) Forces a focus on solid businesses with defensible barriers to entry and wide moats. To find a dividend growth stock that is capable of growing its earnings, cash flow and dividends for years, you need to have stocks in your portfolio that have significant sustainable advantages that can last for years or decades.

Whether it's a unique brand, intellectual property or significant network effects, McDonald's (NYSE:MCD), Novartis (NYSE:NVS), Visa (NYSE:V) and Chicago Mercantile Exchange (NASDAQ:CME) are all examples of stocks that I now hold with sustainable advantages that I believe can endure for years to come.

2) Preservation of your capital. Dividend stocks actually help you with the most important rule in investing which in my book is to preserve your capital. Obviously investment in companies that wipe out your capital due to bankruptcy hurt the overall performance of your portfolio (as I discovered to my disappointment in with some of my more speculative stocks).

A focus on dividend growth stocks forces you to find stocks that are focused on growing earnings, cash flow and dividends. This focus allows you to avoid the speculative stocks with no earnings, poor business models and poor cash generation that can lead to bankruptcy and wipe out your capital

3) Creates a mindset to buy and hold...and hold. Dividend investing instills in you a discipline to find investments that you will hold for years, decades even. In my view, this has really helped me become less of a trader churning my portfolio to chase performance and become much more disciplined about trying to find stocks that I can hold onto for the long term. Many of my core holdings have been unchanged for years. Buying and holding onto a stock gives you the best chance of significantly increasing your dividend income over many years through the effects of compounded earnings growth progressively increasing your dividend income over time.

4) Encourages regular monitoring and review. A focus on growing my dividend income has made me particularly sensitive to reductions in the rate of dividend growth. It motivates me to understand why a company that has grown its dividends previously at a much faster rate is unable to so anymore. I'm alert to what changes are taking place in the business that have contributed to the growth rate reductions, whether its slowing earnings growth or expense increases. I then want to understand what the implications are on the longer term growth prospects and earnings for the company, and in turn what that means for my dividends.

Dividend growth investing forces me to buy, hold and monitor as opposed to just buy and hold. In doing so, I become more immersed in the business rather than just a passive onlooker.

Performance Metrics

It's hard to make a case that dividend investing can make you a better investor without some actual evidence to back it up. In my case, the key things that I can point to are the lack of any total loss of capital for any of my stocks since I started dividend investing. In addition, I can point to a consistently increasing dividend stream each year.

Given my dividend paying stocks are cash generating machines, I'm yet to have any of the dividend growth companies that I have invested in go bankrupt. My portfolio overall has generally recorded consistent increases in the amount of dividends paid out (typically averaging an effective dividend growth rate of about 7% p.a - 2009 being an exception). This increase in my dividend stream typically correlates with an increase in the stock price of my dividend stocks, something which I previously outlined.

However in an attempt to better validate my own belief that dividend investing should help improve your total returns, I searched out research data to help validate this thesis. In the process, I came across some analysis by Ned Davis Research that suggests that investment in dividend growth stocks leads to better total returns.

Ned Davis Research looked at the average total returns for dividend growth stocks, dividend paying stocks and non dividend paying stocks in the S&P 500 from 1980 to 2011.

Dividend paying stocks were defined as stocks that paid out a cash dividend any time in the last 12 months, with dividend growth stocks being any stocks which increases their dividends in a given 12 month period. Non dividend paying stocks were stocks that did not pay out any dividend at all.

The research concluded the following:

- Dividend growth stocks had an average annual return of 9.4% p.a over the measurement period

- Dividend paying stocks had an average annual return of 8.61% p.a over the measurement period

- Non dividend paying stocks grew an average of 1.35% p.a over the measurement period

The inference here is that dividend payment is a sign of corporate health, and cash generation. Companies that can pay a dividend are generating surplus cash, some of which they are reinvesting into the business to accelerate future earnings growth.

Dividend growth stocks likely generated a superior return to dividend paying stocks due to progressively increasing earnings and cash flow which enabled them to pay out more to shareholders over time. It's likely stock prices increased consistent with the initial dividend yield plus dividend growth over this period of time.

Non dividend paying stocks were the laggards in the sample set, growing a mere 1.35% p.a.

Wrap Up

A focus on dividend growth investing should help instill a focus on earnings growth and cash generation in an investor. These are two key elements that speak to the health of a business in my view. Dividend growth investing should also help avoid investments with speculative business models, inconsistent earnings and poor competitive advantages which are most likely to contribute to a total loss of capital.

Research also seems to support that a dividend growth focus can contribute to superior total return over an extended period of time.

Disclosure: I am long CME, MCD, V, NVS. 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.

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