Dividend Growth Investing: Why I Don't Own Index Funds

by: Nicholas Ward


I examine the historical performance of my individual DGI holdings against the S&P 500.

I address several of the common concerns that those who disagree with owning individual companies have brought up to me.

I've come to the conclusion that if a DGI investor were forced to only own one entity, it would be Berkshire Hathaway.

I recently published an article here on Seeking Alpha that served as an introduction to my personal portfolio. I've constructed a dividend growth portfolio by purchasing shares of individual companies when I believe their share price offers great value. I've come up with a strategy - a business plan - for my investment portfolio that focused around the accumulation of undervalued stocks who pay a predictably increasing dividend. I built my portfolio around dividend reliability and sound fundamentals with hopes that one day I will be able to retire and live well off of my dividend income. I've made it clear to myself that my holding company will not be chasing yield, nor the latest market fad with sky rocketing prices and multiples. I think of myself as the CEO of a holding company, and as CEO I demand accountability and trust between myself and the [very small parts of the] companies that I own. To do this I must adhere to a disciplined approach to stock selection and thus far I've been happy with the results.

However, after posting a list of my holdings there were two common threads in the comment section. One, which I was very happy to hear, were all of the compliments I received from other dividend growth investors on the foundation I've built thus far. Seeking Alpha has such an active dividend growth community and I was glad to read personal anecdotes that closely related to the story that I am beginning to tell regarding the management of my own dividend growth portfolio. The second common sentiment expressed by readers was a question: "Why not just buy and own an index fund that tracks the general market, or at least a relevant subset of the market like Vanguard S&P 500 ETF (NYSEARCA:VOO), Vanguard Dividend Appreciation Fund (NYSEARCA:VIG), Vanguard Total Stock Market ETF (NYSEARCA:VTI), or the Vanguard International Equity Index Fund (NYSEARCA:VEU)?

Several of the major concerns that I heard in this regard were:

  • It takes too much time to manage a portfolio and low-cost index funds offer an investor a quicker and easier way to invest.
  • It is not possible to be properly diversified owning individual stocks.
  • It is not worth the time and effort that it takes to build and manage a portfolio considering the fact that many (if not most) investors under perform the general market.

I took some time to think about these concerns. They are similar to those of my financial adviser, who wishes that I would not take funds to manage personally so that he could continue to manage them. My adviser has been a long time family adviser and while I'm not oblivious to the fact that he loses management fees when I take money out of his account and put it into my own, I know that he does genuinely care about my wife and I's financial well being and he worries that I (the amateur) will make an irrevocable mistake that will cost me dearly in the long term. The point is, due to the similarity of the concerns expressed, I wanted to analyze these concerns to ensure that I was not making a grand mistake. I do not share the same level of concern that my adviser and several of my readers have regarding the potential damage that I could do to my family's finances by investing in individual companies' stock. I am confident in a strategy based around buying and holding very high quality dividend paying stocks and reinvesting the passive income generated by the positions back into my holdings. I understand the power of compounding; such power is shown using a tool like F.A.S.T. Graphs and when reading about the long-term success of other dividend growth investors who commonly post on SA.

For instance, David Crosetti recently posted this table in an article about building wealth by holding DGI stalwarts Coca-Cola (NYSE:KO), Procter and Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), Johnson and Johnson (NYSE:JNJ), and Kimberly-Clark (NYSE:KMB).

David freely admits that he is not a professional investor nor adviser, but, "The guy who lives next door to you that drives an old pick-up truck and is always willing to lend you one of my tools for some project you have going on at your house." He talks about patience and loyalty; how he views the act of purchasing a company's stock as the act of entering a "partnership" with the company. He said that he hasn't sold a share of the companies above since entering positions in 1986 and because of all of this, is able to post such respectable results. It is evidence such as this that truly motivates me to continue on my chosen DGI path.

Before things start to seem too rosy, I acknowledge that things aren't always so simple as buy and hold forever for the dividend growth investor. I admit that it is possible for a dividend in my portfolio to be cut. I admit that the possibly exists (though I would think highly unlikely due to the research work that I've done) that one of the companies that I own could do more than stumble, but fall down in a drastic fashion and die, in a financial sense. I should note that it is unlikely that I would ever incur devastating losses associated with a failing business because of the nature of dividend growth investing. Sure, if a company whose maintained a long standing streak of dividend increases decided to cut its dividend the stock would sell off. To do so a company would most likely be in financial dire straights and the sell-off would be warranted. One of the rules that I have for my portfolio is to sell a position on the announcement of a dividend cut because it no longer meets my primary goal of generating a reliably increasing passive dividend stream. I believe that dividend health serves as a bell-weather for the overall health of companies who've decided to initiate a dividend. By selling companies on the news of dividend cuts I may have to settle for a sale in the red. This is never a good thing, when selling low I am essentially locking in losses that may not be inevitable with patience, but I would also be protecting myself from potentially major destruction. During my stock selection I do my best to avoid catastrophic situations by owning companies with solid fundamentals, sustainable balance sheets, and wide, strong moats protecting them from competition, but, for the sake of this argument, I admit that every now and then a dividend champion type company gets cut from David Fish's Champions list, causing major concern for the DGI investor. I have taken all of this into consideration and I have protected myself from a dividend cut situation by owning a wide variety of companies that I deem to be healthy and productive. If one company is determined to be a sell, I hope, and expect, for my others to more than make up for the deficiency and possible loss with their dividend growth and performance.

Now, with all of that being said, let me address the common concerns that have been brought to my attention and then share data that I collected regarding the historical long-term performance of the companies that are in my Stress Free Portfolio relative to the S&P 500 benchmark.

  • When asked why I invest the way I do, rather than buying index funds with time and energy consumed in mind, the first response that pops into my head is, "where's the fun in that?" I acknowledge that a lot of time can be saved by either investing in index funds, actively managed mutual funds, or by simply paying another qualified individual to manage my investment portfolio. I think that these strategies all offer great options to those who find themselves in a time crunch or who aren't interested in portfolio management. However, I do have a fair amount of time of my hands now. This is compounded by the fact that I have a bad habit of staying up late, past the hours when there might be something worthwhile to watch on the television, and therefore, I have several peaceful hours just about every day during the wee hours of the night that I can devote to my investment research. I am sure that there will be a time, maybe when I have kids, or when my profession changes, that I will not have the proper time to dedicate towards my portfolio. But, for the time being, I do. What's more, is that I thoroughly enjoy the time and energy that it takes to effectively monitor the markets and my holdings. I look forward to 9:30 every week day morning and I am disappointed at 4:00 pm most Friday afternoons because it means that I have to take a break until the ensuing Monday.
  • As far as diversification goes, I think that DGI diversification standards are different than typical diversification standards. To me, diversification is a method of downside protection. The idea is that with a widespread asset base, chances are when one section is being adversely effected by the market environment another section should already be built in as a potential positive hedge. While I think it is important to diversify across different sectors and industries within a DGI set-up to help to ensure that you're exposed to growth opportunities within the markets that you feel comfortable investing in. I go even further, sometimes buying several major players within an industry that I like over the long term to reduce the competitive risk; for instance, in the non-alcoholic beverage industry I own both Coke and Pepsi (NYSE:PEP), and would be happy to buy some Doctor Pepper Snapple Group (NYSE:DPS) in the event of a major pullback. I do not think that it is paramount to be exposed to nearly as much hedged downside protection such as bonds or alternatives as an investor would in a non-DGI portfolio because the idea with a dividend growth portfolio is to essentially double down on your investments so long as the fundamentals and businesses are sound by dollar cost averaging during bear markets through reinvestment with your steady dividend stream. This is why I am comfortable owning primarily domestic large-cap stocks. I believe that the American economy offers me the safest and most predictable growth moving forward. Predictability is incredibly important with my downside hedge being my assumed future dividends and their projected growth. I am able to make what I deem to be safe assumptions by analyzing earnings results, forward guidance, and balance sheets. The key to this approach is not only having the ability to carefully select companies to own, but to have the intestinal fortitude to hold them and re-invest through bear market periods, rather than hit the abort button at the bottom, locking in losses due to fear. I'm sure this is easier said than done, but history has proven that the market has always come back, no matter how bleak the outlook was, making severe bear markets perfect times to make fortunes for those with the strongest stomachs.
  • Only time will tell if my personal dividend growth strategy will beat, or even compete with the market long-term. Obviously everyone who manages their own portfolio believes that they can meet the goals that they've set out for their portfolio and their financial future. The research that I've done has convinced me that a dividend growth approach will allow me to meet my goals, both from an income and a total return perspective. There are countless examples of the possible success than an investor can have with a DGI philosophy here on Seeking Alpha; recently another SA contributor, Timothy M. David McAleenan Jr., posted a list of his favorite authors on SA, many of whom focus on dividend growth and value related strategies. For anyone interested in learning more about DGI investing and hearing first hand, the possible success that this management philosophy can offer, this list will serve as a great jumping off point for their research. It is authors like these who've shown me the light in regard to dividend growth investing, and until I decide (or am shown by my performance) that investing in the dividend aristocrats individually will not allow me to meet my goals, I will stand by this philosophy with conviction.

Now we come to the aforementioned data. Because of the alternative strategies brought up to my style, I decided to step into a time machine of sorts and check my holdings against the S&P 500 retroactively. There is no selective survivor bias in this study, I can assure you that I did not select a stock for ownership based solely on past results so that I could write an article such as this. The past results of stable businesses with long-term business plans may be indicative of their future results; however, there are no sure things in the investing world and entirely too many variables at hand to simply use history as a basis for future expectations. I plan to own many of these companies for decades to come and I based my decision to buy primarily on three things: my gut feeling regarding a company's industry headed into the future, current, and projected earnings. With this point being made drawing a line between the past and the future, it is still interesting to see how I would have fared if I had began investing in the exact same fashion 1, 3, 8, and 18 years ago (these time periods were not selected with a goal in mind, I meant to do a more regular study of 3,5, 10, and 20 year holding periods but I did not realize until after I had collected my data that F.A.S.T. Graphs projects earnings out 2 years into the future, so my 3,5,10, and 20 year periods had accidentally morphed into 1,3,8, and 18 year periods). These figures represent the stock being bought and held throughout the duration of the study period with all dividends being re-invested.

The Stress Free Portfolio's Historical Return Figures

Ticker Symbol Company Name 3 year 5 year 10 year 20 year
AAPL Apple Inc. 0.9 17.7 27.9 26.1
AFL Aflac Inc 19.3 6.7 6.3 14.4
ARCP American Reality Capital Properties Inc 14 N/A N/A N/A
BAX Baxter International 2.1 11.5 9.3 8.6
BLK Blackrock Inc 37.6 17.9 15.4 N/A
BRK.B Berkshire Hathaway Inc 29.7 14.2 9.4 10.6
CAG Conagra Foods Inc -0.2 12.2 8.3 5.5
CB The Chubb Corporation 13.7 14.5 9.7 9.6
CMI Cummins Inc 25.2 9.4 26.7 18.5
COF Capital One Financial Coporation 21.5 18.7 -0.9 13.7
COH Coach Inc -7.9 -15.7 5.8 N/A
CSCO Cisco Systems Inc 10.5 3.9 3.6 9.8
DE Deere and Co 3.2 3.7 14.4 11.4
DIS The Walt Disney Company 48.6 28.1 17.1 9.1
DLR Digital Reality Trust Inc -16.9 4.5 14.8 N/A
ED Consolidated Edison Inc 2.3 7.3 7 8.5
ESV Ensco PLC -12.8 -0.1 2.7 9.2
GE General Electric Company 19.3 13.9 -0.5 6.9
HCP Health Care Properties Investors Inc -11.5 5 10.4 11.5
IBM International Business Machines Corp -2.5 8.7 12 13.4
INTC Intel Corporation 19.2 8.5 6.8 8.7
JNJ Johnson and Johnson 30.6 17.5 8.8 10.8
KMI Kinder Morgan Inc -5.3 5.3 N/A N/A
KO The Coca-Cola Company 7 7.6 11.2 6.2
KR The Kroger Company 54.5 25.5 12.4 9.5
MA Mastercard Inc 49.6 47.8 44.6 N/A
MKC McCormick and Company Inc 7.5 14.8 12.6 12.3
MO Altria Group Inc 17.8 18.7 N/A N/A
O Reality Income Corporation 9.3 12 14.8 14.8
OHI Omega Healthcare Investors Inc 37.7 20.7 20.4 8.7
PEP PepsiCo Inc 18.9 10.4 6.8 8.2
PM Phillip Morris International Inc 0 14.5 N/A N/A
POT Potash Corporation of Saskatchewan Inc -10.6 -10.3 19 14
QCOM Qualcomm Inc 21.8 16.6 8.9 21.2
SBUX Starbucks Corp 32.3 31.5 12.5 20.5
SJM J M Smucker Co 9.4 15.4 12.8 N/A
SO Southern Co 5.3 8.6 7.6 8.2
STKL SunOpta Inc 75.3 11.5 9.5 11.5
SWK Stanley Black & Decker Inc 9.3 8.4 9.2 9.3
T AT&T Inc 2.2 8.8 9 5
TGT Target Corp 0.7 1.5 2.3 14.4
TRV Travlers Companies Inc 15.5 16.3 10.6 10.2
V Visa Inc 38.9 44.5 N/A N/A
VTR Ventas Inc -1.9 8.8 13.1 8.9
WFC Wells Fargo & Co 35.8 17.1 8.1 13
WMT Wal-Mart Stores Inc 7.8 13 7.8 12.3
XOM Exxon Mobile Corporation 9.8 10.8 8.9 11.4
Total Average 14.78 12.78 11.36 11.51

The Stress Free Portfolio's S&P 500 Relative Results

Ticker Symbol Company Name 3 year 5 year 10 year 20 year
AAPL Apple Inc -22.80% 3.70% 21.20% 18.10%
AFL Aflac Inc -4.40% -7.50% -0.50% 6.40%
ARCP American Reality Capital Properties Inc -9.70% N/A N/A N/A
BAX Baxter International -21.60% -2.70% 2.50% 0.60%
BLK Blackrock Inc 13.90% 3.70% 8.60% N/A
BRK/B Berkshire Hathaway Inc 6.00% 1.60% 4.60% 4.90%
CAG Conagra Foods Inc -23.90% -2.10% 1.50% -2.50%
CB The Chubb Corporation -10.00% 0.30% 2.90% 1.60%
CMI Cummins Inc 1.50% -4.80% 19.90% 10.50%
COF Capital One Financial Corporation 3.00% 4.50% -7.70% 5.70%
COH Coach Inc -31.60% -1.90% -0.80% N/A
CSCO Cisco Systems Inc -13.20% -9.90% -3.00% 1.80%
DE Deere and Co -20.50% -10.30% 7.70% 3.40%
DIS The Walt Disney Company 24.90% 14.10% 10.40% 1.10%
DLR Digital Reality Trust Inc -40.60% -9.70% 8.00% N/A
ED Consolidated Edison Inc -21.40% -6.90% 0.20% 0.50%
ESV Ensco PLC -36.50% -14.30% -4.10% 1.20%
GE General Electric Company -4.40% -0.30% -7.30% -1.10%
HCP Health Care Property Investors Inc -35.20% -9.20% 3.60% 3.50%
IBM International Business Machines Corp -26.60% -5.50% 5.20% 5.40%
INTC Intel Corporation -4.50% -5.70% -4.10% 0.70%
JNJ Johnson and Johnson 6.10% 3.00% 1.90% 2.70%
KMI Kinder Morgan Inc -29.80% -8.00% N/A N/A
KO The Coca-Cola Company -17.50% -6.90% 4.30% -1.90%
KR The Kroger Company 30.00% 11.00% 5.50% 1.40%
MA Mastercard Inc 22.40% 33.30% 37.60% N/A
MKC McCormick and Company Inc -17.00% 0.50% 5.80% 4.20%
MO Altria Group Inc -6.70% 4.20% N/A N/A
O Reality Income Corporation -15.20% -2.50% 7.90% 6.70%
OHI Omega Healthcare Investors Inc 13.20% 6.20% 13.50% 0.60%
PEP PepsiCo Inc -5.60% -4.10% -0.10% 0.10%
PM Phillip Morris International Inc -24.50% 0.00% N/A N/A
POT Potash Corporation of Saskatchewan Inc -35.10% -24.80% 12.10% 5.90%
QCOM Qualcomm Inc -2.70% 2.30% 2.10% 13.10%
SBUX Starbucks Corp 7.80% 17.20% 5.70% 12.20%
SJM J M Smucker Co -15.10% 0.80% 5.90% N/A
SO Southern Co -19.20% -5.90% 0.70% 0.10%
STKL SunOpta Inc 50.80% -1.40% 4.50% 5.70%
SWK Stanley Black & Decker Inc -15.20% -6.10% 2.90% 1.20%
T AT&T Inc -22.30% -5.70% 2.70% -3.10%
TGT Target Corp -23.80% -13.00% -4.60% 6.30%
TRV Travelers Companies Inc -9.00% 1.80% 3.70% 2.90%
V Visa Inc 14.40% 30.20% N/A N/A
VTR Ventas Inc -26.40% -5.70% 6.20% 0.80%
WFC Wells Fargo & Co 11.30% 2.60% 1.20% 4.90%
WMT Wal-Mart Stores Inc -16.70% -1.50% 0.90% 4.20%
XOM Exxon Mobile Corporation -14.70% -3.70% 2.00% 3.30%
Total Average -9.72% -1.72% 4.46% 3.42

* These figures were compiled on the dates of 3/23 and 3/24. I apologize for the fact that they are not entirely up to date; however, I believe that due to their long-term context the absence of a week's performance does not change their overall meaning.

Once the data was finalized I was happy to see that my current holdings did outperform the S&P 500 over the long term. If I had started investing nearly two decades ago not only would I have achieved one of my goals: a double digit annualized return, but I would have achieved alpha relative to the market. What's more, is that these figures do not account for the value measures that I take as an investor. In this study, all theoretical ownership began on January 1 of the years, 2013, 2011, 2006, and 1996 meaning that any pullbacks that I might have taken advantage of are not reflected in these results. In the historical short term I would have not done so hot. I am not all that surprised that they've under performed so much in recent years. Being a value investor I typically look for beaten down companies whose business fundamentals still look attractive. The fact that these companies have under performed in the recent past is why I own many of them.

I can't help but think that this long term market out-performance is based off of two things. One, being the compounding effect created by my dividends; I didn't include this figure in the tables, but my share count increased dramatically over the two longer periods because of reinvestment. The other is the fact that for a company to pay an increasing dividend for years, they must remain profitable for years for this to be sustainable. There is, and will continue to be, a lot of turnover within the major indexes on an annual basis. I think by choosing to adhere to a dividend growth method and using annual dividend increase streaks as a stock selection screen, an investor has given himself an easy way to eliminate many of the more risk laden companies, regardless of their market capitalization.

I'm starting to feel like I'm beating the dead dividend horse with my ramblings. To me, the end result of this experiment was clear: it is possible to outpace the general market indexes over the long haul by carefully selecting undervalued dividend growth companies, holding them throughout economic downturns, and re-investing their dividends. Looking at my holding's results, my 18 year return was an alpha of 3.42%. Being that this comparison was spawned by others clamoring about owning index funds rather than individual companies, I knew there was one final comparison that I'd have to make. Let me preface this comparison by saying that I know that Berkshire Hathaway (NYSE:BRK.B) is not a market index fund. However, I do think that it is a widely diversified holding company and stacks up well against many of the domestically weighting mutual funds in terms of why one would want to own it. I should have mentioned this before, but one of the major reasons that I don't own actively managed mutual funds, or even low cost ETF's for that matter is that I try to avoid paying fees at all cost. My investment philosophy is built around the principles of positive compounding, I do not want to add in a counter productive negative fee schedule into this equation. Berkshire does not charge investors management fees. Berkshire also has an astounding long-term history of market out performance, having posted an alpha of .9.9% since its inception in 1964.

Source: Berkshire 2013 Annual Shareholder Report

While I've attempted to implement many of the same value investing principles that Buffett and Munger preach into my dividend stock selection, my portfolio doesn't stand up to these results. So, in conclusion, I would say that if I was forced to own only own one equity, it would still be an individual company. Call me old school, but I like the human element, the human calculus associated with an actively managed fund (especially during unpredictable periods of time) and Berkshire offers me a top notch example of this without charging my for the services. The dilemma for me, and the reason that I am not more heavily invested in BRK/B currently, is that while Berkshire doesn't charge any fees, it also doesn't pay its shareholders an annual dividend. This is in direct conflict with my primary investing goal, and I know that this will be considered DGI heresy, but against Buffet's own advice to his family upon his death of investing 90% of their inheritance into a low-cost S&P 500 fund and 10% in short-term government bonds, I would choose to own shares of Berkshire, trusting that its management will continue to add to the incredible base that's already been built through years and years of calculated and prudent value investing schemes, enabling this company to maintain its trend of market out-performance. In doing so I would be abandoning my current philosophy of creating a reliable passive income stream; however, in terms of reliable total return prospects, I don't think an investor can go wrong when looking at Berkshire's holdings.

Disclosure: I am long AAPL, AFL, ARCP, BAX, BLK, CAG, BRK.B, CB, CMI, COF, COH, CSCO, DE, DIS, DLR, ED, ESV, GE, HCP, IBM, INTC, JNJ, KMI, KO, KR, MA, MKC, MO, OHI, PEP, PM, POT, QCOM, SBUX, SJM, SO, STKL, SWK, T, TGT, TRV, V, VTR, WFC, WMT, XOM. 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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