Accelerate Dividend Growth With Capital Gains

Includes: CVX, JNJ, KO, MCD, TPR
by: Canadian Dividend Growth Investor

My core strategy is buying companies for their dividend growth. Companies like Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD), Chevron (NYSE:CVX), and Johnson & Johnson (NYSE:JNJ) come to mind. However, that doesn't mean I won't stray away from that strategy. Sometimes, I take opportunities in buying shares of companies that I believe have been penalized overboard in their stock price. For example, after an earnings report that is perceived badly, or the announcement of the gloomy forecast of a company, there could be a huge sell-off in a company's shares.

I believe some of these sell-offs will recover within a year if not less. The sole reason for me to take these opportunities is to build more capital for my core -- my dividend growth portfolio. The plan is to get a substantial appreciation in the values of these holdings which aren't for the yield or dividend growth. (Though having some dividend is nice while I wait for the price to appreciate and sell for a gain at my targeted price.)

The idea is to have "quick" capital gains to create more wealth in the short term when the stock recovers. (I generally expect to sell these holdings within six months to a year.) I go through a similar research routine before buying these "side" holdings. That is, I will buy the company at a reasonable (if not low) valuation, check that the company is not burdened with debt.

In the long term, my dividend growth companies (the core) provides more stability and cushion in an unstable environment.

I aim for ~20% capital gain on these "side" holdings, and I'll reap whatever dividends that I manage to get. This helps me build more capital for my core strategy of dividend-growth investing. However, I am flexible with this approach. If there's a really enticing dividend growth company that I really want, that is at my desired price, I would probably sell some "side" holdings for capital gain even if it does not reach the 20% capital gain mark.

In fact, I acted on such an opportunity today (February 4). I just scooped up some Coach (COH), and I'm planning to sell it within next six months to a year for ~20% gain. The ~2.5% yield is a bonus while I'm waiting. The main goal is to get the capital gain, and then use the results for other opportunities in either getting more capital gain, or for getting a dividend growth company with stable earnings at a good valuation.

With the capital gain I get from my side holdings, along with the principal, I would have more cash to initiate or add to solid companies for many years of dividend growth.

Assume I had $100,000 for investing and I were in my 30s. I might allocate 90% to core dividend growth holdings and 10% to "side" holdings for capital gains.

With that 10% of side holdings, having a return of 20% per year (excluding any dividends that might have been received), over five years, the $10,000 would have become $24,883.2.

The alternative might be to use a pure dividend growth strategy. Thus, that 10% ($10,000) of side holdings would instead be the core dividend growth companies. Assuming an initial yield of 3% with 10% dividend growth per year, the end result after five years would be $11,970.04. (Now, that's excluding the unrealized capital gains or possible DRIP that could have occurred; as in using a dividend growth strategy in the accumulation phase, I'm assuming we won't be selling any shares unless the company's fundamentals are broken or the company becomes substantially overvalued.)

The difference is greater than seven-fold! However, enticing this may be, I only plan to use this strategy to build my cash position to enhance my dividend growth, since I plan to live off of my dividends someday. With any strategy, of course, there are pros and cons.

Pros of this Strategy
Build cash faster in the short term (six months to one year) for ~20% capital gain. (Imagine that most of my core dividend growth companies have a ~3% yield, this ~20% capital gain is big!)

Cons of this Strategy

  1. Since it's possible that the "side" holding might go further down in price, I might have to wait awhile to get that cash back. And in the meantime, I could be missing out on opportunities to enter at a compelling price for a desired dividend growth company.
  2. Opportunities for this "side" holding strategy for capital gains don't come all the time. So you might be holding cash on hand and waiting and waiting...

Do you employ a similar strategy to build capital or do you purely focus on a dividend-growth investing strategy?

Disclosure: I am long COH, CVX, KO, MCD. 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.