Dave Van Knapp Positions For 2014: The Best Dividend Growth Stocks Will Pay Out More This Year

by: David Van Knapp

This is the 13th piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.

David Van Knapp may be a self-directed individual investor, but his impact extends to many members of the Seeking Alpha community and beyond. Starting in 2006-2007, his affinity for value investing gradually gave way to developing his own unique approach to dividend growth investing. The author of six annual eBooks on the subject, Dave assists individual investors who want to take their financial destinies into their own hands by carefully constructing and managing a portfolio of dividend growth stocks.

Dave has been analyzing and writing about stocks since 2001, both on his own site SensibleStocks.com, here at Seeking Alpha, and elsewhere. He maintains a public demonstration Dividend Growth Portfolio. His next eBook, "Top 40 Dividend Growth Stocks for 2014: A Sensible Guide to Dividend Growth Investing," will be released in mid-January.

Seeking Alpha's Abby Carmel and Jonathan Liss recently spoke with Dave to better understand why dividend growth investing continues to appeal to him more than other investing styles, and how he plans to put this strategy into practice in 2014.

SA Editors (SA): The continued growth in popularity of dividend growth investing continues to astound the so-called modern portfolio theory experts - how do you explain this?

David Van Knapp (DVK): I don't know if I would say they are "astounded," but it does seem to disturb many classically trained experts. Several have spoken out forcefully against it.

I think that the reasons for their concerns lie in their training, their genuine beliefs, and sometimes in their business interests.

My perception - and I could be wrong, because I am not classically trained in either economics or investing - is that conventional financial education downplays the importance of dividends. In fact, in the CFA Level 1 course as presented on Investopedia, we find these statements:

The dividend-irrelevance theory…assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price….As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decisions since they can simulate their own dividend policy….[A]n investor can sell some of the company's stock to replicate the cash flow the investor expected.

My perception is that training such as this leads many in the profession to genuinely believe that dividends have no significant meaning. If they agree that "investors care little about a company's dividend policy," it also may lead them to misunderstand some of their clients.

So when they encounter an investor that is interested in dividends, they try to talk them out of it, pointing out that if the investor wishes to create income from his stock holdings, they can "Just sell a few shares," as it is usually framed. They truly believe that an investor shouldn't be interested in dividends.

Most academic papers on stock returns ignore or even criticize dividends. Under MPT's growing body of research into the factors that explain returns, dividends are not one of the factors. The generally accepted factors are beta (market movements), size (small caps outperform large caps), momentum (the direction of price change tends to persist), and value (undervalued stocks outperform overvalued stocks).

Recently, profitability has been added as a generally accepted factor, and a combination of other factors combined into a category called "quality" is currently under investigation.

With these factors, using regression analysis, the academics can "explain" over 90% of stock returns. So again, dividends come across as irrelevant.

Reinforcing the theory, or maybe because of it, stock exchanges artificially reach in and lower the prices of stocks by the amount of an upcoming dividend while the market is closed. So an expert can say correctly that you can either have a $100 stock share, or a $99 share plus $1 dividend. The result is the same, and you, as an investor, should not care which condition it is. You have $100 either way.

I don't see things that way.

My view is that what we have is a difference in taxonomies. If your starting point is to assume that dividends are not relevant, then your collection of factors that affect returns will obviously not include dividends. The academic conclusion that dividends explain nothing is preordained by their starting assumption that dividends are irrelevant.

I don't make that assumption, as it seems unjustified. The simple return equation is:

Total return = Price change + Dividends

So if a stock's price changed +7% in a year and it delivered a dividend of 4%, your total return was 11% that year. If its price changed -3% and delivered the same 4% dividend, its total return was 1%, and the fact that the return is positive at all is entirely courtesy of the dividend. Dividends are always positive, they are cash sent to shareholders, and therefore they are relevant.

Dividends don't explain total returns as a theoretical factor, they are returns. The dividend component of total returns has averaged about 40% across many years. (That ignores reinvestment of dividends. The impact of dividends is much higher when reinvestment is accounted for.)

So I find it impossible to believe the dividend irrelevance theory, and I am baffled that it has so completely been accepted in academia. It's not as if dividends are obscure. The companies send you the money.

As to the factors that MPT academics have settled on (beta, size, momentum, profitability, and quality), I don't have much problem with them. I just look at them as helping to explain the price return component of total return. It does strike me as odd that something so apparent as profitability is one of MPT's late-arriving factors.

(SA): But if the exchanges lower prices by the amount of upcoming dividends, doesn't that in effect render dividends irrelevant?

(DVK): I think it is unfortunate that the exchanges reach in and artificially alter the prices of stocks by subtracting out dividends due to be paid. You would think that with all the free-market sentiment around stock exchanges, most participants should be abhorred that the exchanges interfere with the market's price discovery process. If market participants think that prices should be lowered by dividends paid out, let them do it.

So far as I know, the markets only interfere in this fashion when it comes to dividends. When JPMorgan (NYSE:JPM) made its $13B settlement with the Justice Department a few weeks ago, the NYSE did not subtract a proportional amount from each share of JPM's stock, even though that money will never be seen by shareholders. When BP's (NYSE:BP) oil spill a few years ago made it obvious that BP was going to pay out billions in reparations, no one suggested that the stock exchanges lower the price of BP's stock. In fact, it is ironic: Because BP was forced to cut its dividend, they sidestepped an artificial lowering of their price.

I have seen no evidence or study that the market's price adjustment for dividends has any permanence. I have examined lots of price charts, and it is impossible to see any lasting effect from the exchanges' price reductions. I have never seen an academic study of the matter. Of course, you would not expect one, since academics generally believe that the stock's price should be lowered by the amount of the dividend. But since they also believe that the markets are efficient, you would think they would be in favor of leaving things alone and letting market participants do the subtraction. In any event, it is pretty obvious to anyone who has looked at price discovery in actual market charts that the exchanges' price adjustments are soon lost in the noise of trading. There is no permanent effect.

(SA): Why does this investing style appeal to you above all others?

(DVK): Because it directly produces the result that I want out of investing, which is reliable growing income.

I believe that it is a best practice in investing to start with goals. Many times, goals are taken for granted, in the sense that the primary goal for all investors is presumed to be "make the most money." Well, in fact, that's not my goal. And what I have discovered in writing for SA and interacting with many readers is that it is not their primary goal either.

The "aha" moment for me was when I explicitly separated the two components of total return: price changes and dividends. I realized that the dividend component could be pursued as an end in itself. That appealed to me, because I wanted to produce income organically instead of by selling things off each quarter.

What I found is that once I clarified my primary goal as generating reliable growing income, I looked at investing differently. I became far more attracted to dividend growth investing, because it matches my goal. I don't need to translate or convert the outcome of my investing into the income that I really want. The outcome is already there, in the form of the dividends that I receive.

In retirement, income is of primary importance. Stated more accurately, purchasing power is of primary importance. Dividend growth investing builds and maintains purchasing power that keeps pace with inflation. So it strikes me as a natural way to accomplish my primary goal in retirement, which is to have enough cash in my wallet.

Dividend growth investing also has a psychological appeal. Managing the emotions of investing is a huge part of success no matter what your strategy is. I have found that focusing on the dividend side of the equation pretty much insulates me from worrying about fluctuations in the market. So long as my income generation is safe - which I help insure by monitoring it - I find that I don't worry about market prices.

So when I buy dividend growth stocks, I believe that what I am primarily purchasing are the rights to receive future income that will rise over time. The fact that I also receive price-trading slips is of secondary importance. I generally expect the organic income from the stocks to remain intact and to grow no matter what Mr. Market does to prices. And for the most part, that's the way things have worked out.

(SA): As we approach 2014, are you bullish or bearish on global markets?

(DVK): I am really the wrong person to ask this question. I no longer study the markets, so I honestly have no strong opinion on them, other than that they will go up and down. I don't try to predict which way they will go or when they will do so.

When I transitioned to being a dividend growth investor, I found that my desire to follow the markets dropped all the way from needing a daily fix down to not caring very much. I am still interested a bit, but mostly as a matter of keeping up with current events. Looking back, it took about a year or two for that paradigm shift to take place. It is now pretty much complete.

I view the market as just a store. I go there to buy stuff and occasionally to sell stuff. So when I am there, I am looking at individual products and their particular prices. Whether prices as a whole are "high" or "low" does not matter very much.

(SA): OK, then are you bullish or bearish on stock dividends for 2014?

(DVK): I feel good about most dividend outlooks for 2014. I think that most companies have regained their footing since the Great Recession. It took some of them a few years to get there, but I think that most of them are there now.

So I anticipate that 2014 will be more or less like 2013 on the dividend front.

  • Most of the best dividend growth stocks will continue their managed dividend policies in 2014 and will pay out more in 2014 than they paid in 2013.

  • A few new businesses will "join the club" of stocks that have raised their dividends for 5, 10, or 20 years or more. And a few others will drop out for various reasons.

  • Typical dividend increases for the best dividend growth stocks will be in the 5% to 10% range, with some lower and some higher. Across a well-constructed dividend growth portfolio, the income stream will probably increase faster than inflation. That's what it usually does.

(SA): In what ways does your approach to selecting dividend-growth stocks change based on the current market environment and outlook? In what ways does your approach remain constant, regardless of current market conditions?

(DVK): As I look back on my 6-7 years as a dividend growth investor, I would have to say that market environment and outlook have played almost no role in how I have adjusted my approach to stock selection.

When I began laying out my selection guidelines in 2006-07, I pretty much took a blank-paper approach. Keeping my eye on the goal (reliable increasing income) led me to search for companies with particular characteristics - namely business quality and records of regularly increasing their dividends. I prized growing revenues and earnings, business efficiencies, and sustainable business models that looked like they would work for a long time.

I knew from previous experience that I prefer grading systems to screens, because one outlying data point can fail to pass a screen, whereas in real life it may be an aberration or even a data error. So I developed a system that starts with just a few screens to narrow down the universe, then switches over to a grading system for the rest of the metrics I examine. A stock may pull a low grade on one or two data points without failing entirely.

Each year, I tinker with the system. This year, for example, I lowered my minimum required yield from 2.7% to 2.0%. But I did not do this because of market conditions. Rather, I did it because of feedback from readers, especially younger ones, who said that they are interested in high-quality companies that may have lower yields but high DGRs (dividend growth rates). Their thinking is that they look forward to decades of compounding and do not care if the initial yield is relatively low.

(SA): How do you respond to those that continue to claim that dividend-paying stocks are in a bubble, based on historical value metrics like P/E ratios and the Dividend Discount Model?

(DVK): To me, the aggregate valuation of groups of stocks - such as "all" dividend growth stocks - is not very important. I buy them one at a time, so what is more relevant is the valuation of each one individually.

Say you already own a stock, like Chevron (NYSE:CVX) for example. If it becomes significantly undervalued, that does not affect the income that it generates, so usually your response to the undervaluation is to do nothing except keep collecting the income. Indeed, if you are in the market to make a purchase, you might want to buy more CVX at a bargain price.

If a stock that you own becomes significantly overvalued, you are presented with an interesting choice: Do you sell and collect what are probably large capital gains, or do you just continue to hold and collect the dividends? This is a legitimate question. The available profits might equal several years' worth of dividends, which you can get all at once by selling. Here is an example, Automatic Data Processing (NASDAQ:ADP).

Personally, I have done both: I have sold and collected immediate profits, while at other times I have just held, since the stock was accomplishing what I bought it for: Delivering reliable growing income. My default choice is to hold, but I do study these situations when they arise. The price run-up in an overvalued stock may have caused it to exceed my maximum position size guidelines, so I may trim it for that reason. The proceeds from selling are redirected into another dividend growth stock with a better valuation and probably with a higher current yield. That causes my income stream to jump immediately.

Say you are considering buying a stock that upon investigation, turns out to be overvalued like ADP above. The answer is simple: Don't buy it.

I have not yet encountered a situation where every stock that I was interested in buying was overvalued when cash was available. So I just turn my attention to other stocks. I am indifferent as to when or in what order I purchase stocks. Assuming I have done my due diligence on the companies, I let valuations lead me to the best stocks for investment at the moment.

Dividend growth investing is a long-term enterprise. You can wait for good valuations. Whether the entire category is overvalued in some broad sense really doesn't come into play in making individual buy and sell decisions.

(SA): What is your ideal allocation heading into 2014 in terms of U.S. vs. foreign-based dividend growth companies?

(DVK): I do not have an ideal or target allocation. Over the years, I have come to prefer U.S. companies, because their dividend practices tend to be more regular and they do not have the annoyance factors of some foreign stocks. But I have owned foreign companies. Presently my wife and I own BHP Billiton (NYSE:BBL), Shaw Communications (NYSE:SJR), GlaxoSmithKline (NYSE:GSK), National Grid (NYSE:NGG), and Rogers Communications (NYSE:RCI). We also own Philip Morris (NYSE:PM) which, while based in the U.S., does all of its business overseas.

That last point is important. Many of the top dividend growth companies, such as Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), and McDonald's (NYSE:MCD), are multinational operations that get over 50% of their revenues from overseas anyway. So even though the companies may be headquartered domestically, they participate in growth in foreign markets by the very nature of their businesses. So, for investors concerned about international exposure, you can get quite a bit of it from U.S. based companies.

I may be naïve, but international exposure has never seemed like an important consideration to me. I have lived most of my life near the Canadian border, and over the years, the U.S.-Canadian exchange rates have crisscrossed several times. Sometimes they work in your favor and sometimes they do not. The fact is that I do most of my spending in the United States, and I expect that to remain true for the rest of my life.

To me, it is far more important to protect my purchasing power against inflation within this country than to protect it against the exchange rate of some foreign country where I am never going to go.

(SA): How have changes to the tax code affected your assessment of dividend-paying investments?

(DVK): They haven't. Most dividends have been "qualified" for as long as I have been doing this. That means that their taxation is the same as that of long-term capital gains. Some dividends are not "qualified" under the tax code, but that hasn't changed either.

If the taxation of dividends does change, I may rethink this issue. But I treat taxes as expenses in our household budget, so if taxes go up or down, that means we need more or less income. Compared to our entire budget, any tax changes to dividends are on the margin.

(SA): Do you feel dividend growth ETFs like SDY and VIG are a decent alternative for investors that buy into the principle of DGI but don't have the time to conduct the due diligence necessary to hand-pick a portfolio of individual of stocks? Or is it better for these investors to simply avoid DGI altogether?

(DVK): In 2012, I studied a fair number of dividend ETFs, including SDY and VIG (articles here and here). My conclusions were that while they often held many of the same stocks that a dividend growth investor might hold, their yields are surprisingly low, even when the ETF claims to be "high yield." For example, per Morningstar, at the moment SDY's yield is 2.4% and VIG's is 2.0%. By comparison, it is not uncommon for a dividend growth investor's portfolio to have a current yield of 3.5% to 4% or more. (My demonstration Dividend Growth Portfolio's current yield is about 4% right now.) I also found that their dividend growth records were spotty. All of the ETFs I examined skim their fees and expenses off the distributions, and I think that mostly accounts for their disappointing yield rates to investors.

I know that some investors look for ETF vehicles to achieve and enhance total returns, and indeed some of the dividend ETFs (as well as others) have matched or outpaced the total returns of some dividend growth investors, especially in the bull market that began in March 2009. This is to be expected, as both value and dividend growth strategies tend to do best relative to the market during flat or declining markets, not during strong bull runs. Overall, there is copious research that dividend growth investing delivers strong total returns over time. Of course, that is not the main focus of most dividend growth investors, who rather are looking for income that is sufficient, reliable, and grows faster than inflation.

So, I guess I feel that the ETFs I looked at were disappointing from the standpoint of my goals as a dividend growth investor. If I get hit by a bus tomorrow, I would probably leave instructions for my wife to engage one of the investment advisors who understands dividend growth investing (they exist, but they are a small minority of advisors overall) rather than purchase one of the available dividend ETFs.

That said, the ETFs do provide some of the characteristics of dividend growth investing as I understand and practice it. I would not purport to give advice to anyone other than my wife.

(SA): At what point do you feel Apple (NASDAQ:AAPL) will enter your radar?

(DVK): On a personal level, AAPL has already entered not only our radar but our portfolio. My wife and I purchased some shares during 2013. While our personal "Perpetual Dividend Portfolio" is mostly a clone of my public portfolio, we do take a little leeway from time to time to make a fun purchase. (I don't do that in the demonstration portfolio, where I stick to the guidelines in my eBooks in order to be perfectly straight with readers.) My wife and I both own iPads and iPhones, and I own several iPods, so when AAPL's price crashed, we decided to buy some.

I have had a tentative article title in mind for a long time: "A Dividend Growth Investor Looks at Apple." I do read some of the avalanche of Apple articles, and the thesis that came to mind was this: Let's assume that Apple cannot reinvent or create new product categories every few months as it did for several years. Let's just view it as an operating company that incrementally upgrades its products on regular cycles, and maybe introduces something revolutionary every few years instead of every few months. Give it credit for the strength of its ecosystem and its unique brand image. How would it do as a dividend growth stock, assuming they reach a 5-year streak of increases (which is when it would normally enter my radar)?

My hunch is that the company would grade out pretty well. It's possible that by the time they achieve a 5-year streak of increases, we will have seen a couple of years of them actually operating in the way just described, so some of the answer to the question can then be based on data, not just hunches.

(SA): What advice would you offer a 'do-it-yourself' dividend growth investor as we approach the new year?

(DVK): Well, I try not to give advice. I just explain what I do and why I do it. But in the spirit of your question, the Cliff's Notes version of my approach is:

    • Turn off the TV.

    • Figure out your investing goals. Are you more interested in sheer wealth or income? Why are you investing? What do you hope to accomplish financially in 10-20-30 years?

    • Read up on investing, including a few classics by Graham, Lynch, and the collected Shareholder Letters of Warren Buffett.

    • Write out a plan, meaning your goals plus logical strategies to meet your goals. If it's not written, it is not a plan.

    • Narrow your universe of stocks by some intelligent method related to your goals. Examples would be to screen for minimum yield, desired DGR, minimum number of years of consecutive dividend increases, investment-grade credit rating, and the like.

    • Then figure out a method for ranking those stocks, or use some of the many great ideas that get published here regularly.

    • Think probabilistically. Be prepared to have some of your selections turn out to be bummers, because it happens to everybody.

    • Diversify enough so that the bummers don't ruin your overall results.

    • Don't buy anything unless you understand how the company makes money. Have an investment thesis for everything you buy. Buy only companies with great, sustainable business models.

    • Look for companies with managed dividend policies that seem reliable and woven into the cultures of the companies.

    • Evaluate each candidate one at a time. You want not only great companies, but you want to purchase their stocks at decent prices.

    • Once you own a few stocks, monitor them regularly. Your plan should explain the reasons that you would consider selling any one of them. It should also explain what you will do with the dividends, specifically how you will reinvest them (if that's what you intend to do).

    • Keep your eye on the ball - income stream, not price vacillations. Think long term, not short term.

    • Have fun.

Disclosure: I am long CVX, BBL, SJR, GSK, NGG, RCI, PM, KO, PEP, MCD.

To read other pieces from Seeking Alpha's Positioning for 2014 series, click here.