The Safety Valve Of Dividend Growth Investing

Includes: BAC, BP, GE, JNJ, KO, PG, T, WFC, XOM
by: Tim McAleenan Jr.

In the past five or so years, there have been five prominent dividend growth companies that experienced dividend cuts (or worse) which realistically could have been a part of a conservative dividend growth investor's portfolio.

(1) There was the collapse of Wachovia. What made this so unfortunate is that Wachovia had been a conservatively run bank with $40 per share in book value that drained its liquidity during the mid 2000s when business was booming, and did not have the cash and cash equivalent resources to weather the storm that erupted in 2008.

(2) There was the collapse at Bank of America (NYSE:BAC). The banking giant, which had spent most of the 20th century burnishing its reputation as a financial fortress (I'm referring here to the pre-merger California arm of the bank), overextended itself on leverage while conducting acquisitions, and caused permanent harm to shareholders through its excessive share count dilution and acquisition of Countrywide during the financial crisis. The quarterly dividend was cut from $0.64 per share to $0.01 per share.

(3) And then there was the dividend cut at Wells Fargo (NYSE:WFC). This was more a reflection of political reality (pressure from the Fed, as Warren Buffett explained in his 2010 Letter to Shareholders) than it was a reflection of the company's long-term earnings power. Nevertheless, the company's quarterly dividend was cut from $0.34 to $0.05 per share.

(4) And, of course, there was the granddaddy cut of them all: General Electric (NYSE:GE). GE had been the ultimate conservative retiree stock. It was an original member of the Dow. Alongside AT&T (NYSE:T), GE spent the 20th century living up to its reputation as the ultimate widow-and-orphan stock. Despite assurances from management that GE Capital posed no material threat to GE's dividend, a liquidity crisis drove the Board of Directors to conserve capital and cut the quarterly dividend from $0.31 per share to $0.10 per share.

(5) And lastly, we have BP (NYSE:BP) and its oil spill. BP had become the UK's version of Exxon Mobil (NYSE:XOM), becoming an inevitable member of pension funds, trust funds, and index funds throughout Britain. At its height, BP contributed over 10% of the total income to the British pension system. The weight on that company's shoulders (for retirees) was awesome in every sense of that word. Facing political pressure, BP cut its dividend from $0.84 to nothing for three straight quarters, at which point the company began paying a $0.42 quarterly dividend in the first quarter of 2011.

Even if you owned all five stocks in your conservative income portfolio, you still could have navigated those waters all right thanks to diversification and the dividend growth of other firms in your portfolio.

Here is how it could have played out. Let us say that you had ownership stakes in thirty different companies, each of which contributed $200 on average to your portfolio's total income. Together, they generated $6,000 in total income.

Let us say that before the crisis hit your portfolio, the five companies listed above contributed $1,000 total towards your portfolio's income (i.e. $1,000 worth of the $6,000 total). In the case of Wachovia, Bank of America, and BP, the income was effectively reduced to $0 (with the Wachovia reduction being basically permanent, the BP reduction being temporary, and with the Bank of America reduction being likely temporary). That is about $600 in lost income.

In the case of GE, the dividend became 32.25% of what it was before the cut. So the $200 in GE dividends was reduced to $64.50 in annual income. In the case of Wells Fargo, the dividend became 14.70% of what it was before the crisis. That means that $200 worth of Wells Fargo dividends became $29.41 in annual income.

So when you sum it up, you saw $1,000 worth of annual income turn into $93.91 worth of annual income.

Now, here is where things get interesting: You can still come out quite okay when you own a diversified portfolio of blue-chip stocks because the dividend growth rate of your other firms can offset some loss of income. The best kept secret among those executing a dividend growth strategy is the fact that it is relatively easy to get a 10% increase in annual income from a high-quality dividend growth stock if you choose to reinvest the dividends.

Let me use Johnson & Johnson (NYSE:JNJ) as an example. The Board of Directors gave shareholders an increase in the quarterly dividend from $0.61 to $0.66 per share. To most people keeping score at home, that may sound like just a 8.19% annual dividend increase. But if you are reinvesting your dividends along the way, your year-over-year income will increase at a faster rate than the declared dividend increase.

Let us look at a real world example with Johnson & Johnson over the past year. On June 13th, 2012, Johnson & Johnson shareholders received a $0.61 per share dividend that could have gotten reinvested at $64.26 per share. On September 12th, 2012, J&J shareholders received a $0.61 per share dividend that got reinvested at a price of $68.23 per share. On December 12th, 2012, J&J shareholders received a $0.61 per share dividend that got reinvested at a price of $71.27 per share. And on March 13th, 2013, investors received a $0.61 per share dividend that got reinvested at a price of $78.43.

Let's look at how that would have played out in reality for someone with 100 shares of Johnson & Johnson. During the first $61 payout, our investor would have 100.94 shares of J&J. The second payment would be for $61.57, which would increase the total to 101.84 total shares. The third $0.61 quarterly payment would generate $62.12 worth of income, which would bring the total share count to 102.71 shares. And during the last $0.61 quarterly payout, the J&J investor would have received $62.65, bringing his share count total to 103.50 shares. Those extra 3.5 shares are what add "the kick" to the next dividend increase.

When the Johnson & Johnson board raised the dividend to $0.66 per share, the share count base is 103.50 (instead of 100) if you chose to reinvest your dividends over the previous year. Instead of getting a $66 payout, you are getting a $68.31 payout. Converted into percentage terms, although it appears that Johnson & Johnson gave shareholders an increase of 8.19%, shareholders that elected to reinvest their dividends actually received an annual income increase of 11.98%.

This is why 10% annual increases in income are not rosy fantasyland projections for dividend growth investors. When you have companies like Coca-Cola (NYSE:KO), Johnson & Johnson, and Procter & Gamble (NYSE:PG) in your portfolio that are giving you regular dividend increases of around 8%, you can pick up that extra 2% and get to a 10% increase in annual income simply by clicking the "reinvest dividends" button on your brokerage website.

This is why a dividend investor can make some mistakes along the way and still do all right for himself. You could lose your dividend soldiers named General Electric, Wachovia, BP, Wells Fargo, and Bank of America and still win the war. If the other twenty-five stocks in your portfolio give you a year-over-year income increase of 10% (7.5-8% of that coming from an organic increase, and the other 2-2.5% coming from reinvested dividends), then you could see the $5,000 in your portfolio income grow to $5,500. It is a countervailing force against the stocks in your portfolio that did cut the dividend.

When you add it all up, look at what resulted from the carnage: you had five stocks turn $1,000 worth of income into $93.91. But if the rest of your portfolio was filled with the "usual suspects" of the dividend growth investor's universe, then you saw that $5,000 in income grow into $5,500. When you tally it all up, you saw $6,000 worth of annual income turn into $5,593 in annual income. In our worst case scenario, you are looking at a pay cut of 7%.

Now let's highlight the layers of conservatism that were used as inputs in our assumptions. First of all, we are assuming you owned each of the five companies listed above in your portfolio. Secondly, they were treated as if these cuts happened instantaneously to your portfolio, even though they occurred over a course of three years in reality. And thirdly, our assumptions basically treat BP as a "dead" stock, even though its dividend came back to life three quarters later. In the case of GE and Wells Fargo, the current quarterly dividends have since risen to $0.19 and $0.30, respectively. And Bank of America's dividend will likely show signs of life in the coming years as well.

This is what serves as the safety valve of a dividend growth investing strategy. The stocks that give you 7-8% annual dividend increases can bolster your income against dividend cuts, and if you choose to reinvest those dividends, you can realistically achieve 10% annual income gains from that portion of your portfolio's holdings. This allows you to tolerate failure in other areas of your portfolio without missing much of a beat. Even if you managed to own Bank of America, BP, Wachovia, General Electric, and Wells Fargo, you could have realistically limited your total annual income loss to 7% if you maintained a diversified portfolio and reinvested the dividends of your other holdings. Considering that we are talking about holding five burnout companies during the worst economic period since The Great Depression, that ain't bad.

Disclosure: I am long BAC, XOM, BP, PG, GE, JNJ. 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.