DGI For Dummies: Managing Your Dividend Growth Portfolio

by: Nicholas Ward

I explain why I've chosen to become a dividend growth investor.

Key thinking points of DGI explained.

Results analyzed to confirm my DGI decision.

Before the title of this piece insults someone, I should introduce myself. Although I don't consider myself to be a dummy any longer, it wasn't long ago that I fit properly into this definition. It wasn't long ago that I couldn't have told you the difference between P/E and EPS or ROI or any other investing related acronym for that matter. It wasn't long ago that I had no idea what a 10-K form or even a ticker symbol was; and now, several years into my investing experience, you'd be hard pressed to give me a major American corporation that I didn't know the ticker symbol of. I had never heard of Peter Lynch, Leon Cooperman, Warren Buffett, or Jim Cramer even. I think the only major figure in the investing world that I was familiar with was T. Boone Pickens, and that was only because I'm a major college football fan and Mr. Pickens has been a prominent supporter of the Oklahoma State football program. Investing seemed so foreign, something that men and women so far away on Wall Street did, but not something that little ole me had to worry about. Well, things changed. I graduated from college and my wife and I moved out of our run down college apartment building and into a rundown cottage on a horse farm on the outskirts of town. The quality of our living quarters didn't change much, but our view improved drastically. The peace and quiet was a wonderful change, but an even bigger difference in our lives was the fact that neither of us were being supported by our parents any longer. We had bills to pay and taxes to worry about; money really started to matter (it wasn't just for buying books and pizza any longer). No two stories are the same, but in most cases we all come to these same crossroads: where money and savings rise to the forefront of our minds as our lives evolve. For me, investing is about a possible early retirement and my dream of owning and operating a small organic farm (or buying a 28 foot boat and drifting around the Caribbean for the rest of my life being rocked to sleep by the ocean every night, I'm not sure which notion is more practical/romantic). It doesn't matter what your plans are for your money, but that you have a plan to get there.

So, why DGI?

Personally, it meshes well with my personality. I joke around a lot and consider myself to be laid back and lighthearted kind of guy, but when it comes to important tasks I like to be very systematic and efficient.

I think that dividend re-investment is a great tool for me in terms of wealth building. It takes a lot of the guessing game out of market timing and allows for me to average into positions over a long time frame, even when I don't have excess cash flow, which I can dedicate towards my portfolio. It also has a great long-term track record of success - I'm an empirical person and I've been impressed with many of the historical DGI portfolio models that I've come across. It is important to understand that past performance does not guarantee future results; however, I think that in the case of many of the blue chip DGI stalwarts, because of their well-established brands, product lines, effective management teams, and the wide moats that these factors grant them, past performance is likely to be an accurate indicator of future results.

So, what do you need to know?

Most importantly, I think - It doesn't have to be complicated. It seems to me that so many in the professional wealth management community want individual investors to believe that managing a portfolio is a stressful, daunting, and near impossible process. Maybe I've just had a case of beginners luck, but I don't think this has to be true; on the contrary, I think taking control of one's finances and methodically pursuing a goal is both an enjoyable, and gratifying experience.

To be a successful investor, you must understand your goals, your time frame for achieving them, and formulate a plan to do so within your bounds of risk tolerance. I'm fairly conservative when it comes to investing, I've said this before, but it still holds true, I hate losing even more than I love winning. If conservatively managing my potential downside limits my potential upside, I'm O.K. with that. A common theme amongst many of the traditional DGI stocks is a low Beta. Often times a strong dividend can create a floor for a stock, serving as a catalyst for bringing investors in. Because of this, dividend aristocrats on the whole are less volatile than the rest of the market, especially during periods of high uncertainty and bearish sentiment. Dividend aristocrats also offer the potential investor a double edged sword during periods of time when the market struggles because many of the traditional DGI companies are also very defensive plays offering products or services that are either economical or require spending regardless of the economy's outlook.

Below is a graph showing how several of my favorite defensive DGI stocks: Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL), Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), Kimberly-Clark (NYSE:KMB), McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG), Wal-Mart (NYSE:WMT), and the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) stacked up to the S&P (NYSEARCA:SPY) during the 2008 crash and the immediate recovery. The graph gets a little jumbled, I apologize for that, but please note, that none of the DGI stocks I mention crossed the bright blue line during the initial decline and all of them posted better relative results during the downturn and the two recovery years following. I admit that I am cherry picking favorites here; I am sure that there were dividend aristocrats that underperformed during this period. That being said, the Vanguard fund comprised of a wide assortment of DGI stocks posted near double-digit out performance during this time frame as well.

By understanding both the pros and the cons of the investment strategy that you've chosen, you'll be able to maintain an even keel as a portfolio manager. You will also be less likely to be emotionally swayed by potential naysayers of your chosen methods. In regards to dividend growth investing, I often hear people complain that companies would be better served using the cash spent paying shareholders dividends to improve their infrastructure, or in R&D, or M&A. They say that dividends do not help the company improve itself or grow its business. They say that dividends are an inefficient way to reward shareholders from a tax perspective due to dividend taxes in non-qualified accounts.

Berkshire Hathaway (NYSE:BRK.B) is often used as an example of this; a company that has a tremendous amount of cash on the balance sheets but has decided it is able to bring the shareholder more value investing excess funds itself, rather than giving it away to shareholders to do as they please. I own shares of Berkshire because I believe in its management's ability to do so. I also speculate that eventually, this company will initiate a dividend. I'd rather get in early and reap the benefits that the company currently offers while I await my speculative cherry on top than be on the sidelines because I've stubbornly decided not to own any companies that don't pay me a dividend and miss out of owning shares of a great company at a reasonable price because I think it's safe to say that BRK shares will receive a significant boost (outside of any annual performance appreciation that happens between now and then) when a dividend policy is announced similarly to the recent jump in Apple (NASDAQ:AAPL) share prices when they announced their stock split and plans to pay a growing dividend moving forward at the end of Q2.

But, I've become side tracked. DGI naysayers point to Buffett himself to prove that dividends are worthless, "otherwise Berkshire would pay one." In this situation, I agree with them, that they probably are relatively worthless in my hands compared to Buffett's; however, in most situations, I'd rather have cash to spend where I please, than to trust a company's management team to spend it wisely, with shareholders in mind. Unfortunately, I think that in some cases, the latter part of this statement is not always applied to capital allocation within a business. Sometimes, a very successful business with enormous cash flows doesn't have a better avenue to spend extra funds than on dividends; buy backs or acquisitions can be prudent, but valuation always plays a role there. I think that by rewarding shareholders with cash dividends companies are not being wasteful, but tactically creating a sense of loyalty amongst its fans. This sense of loyalty becomes a self-fulfilling property when things go south in the market, helping to prop up share prices. As far as taxes go, I won't linger very long on the subject. I'm sure that in some cases a cash dividend is inefficient, I'm not a tax professional, but I'm sure that if you saw one they could help you in this respect. I know that for me, dividends aren't any more inefficient than capital gains (they are less so than short-term gains), and some aren't taxed at all in a Roth, or not until later in an indirect fashion, in a traditional IRA.

I also hear that dividends are not important to an eventual financial freedom. The naysayers here say that a DGI investor is limiting himself to owning a small portion of the market, a portion that is likely mature and lacking major growth prospects, and therefore, in the long run, will underperform a portfolio with exposure to smaller cap, higher growth potential stocks. Instead of relying on dividends to cover expenses during retirement, they often argue that an investor would be better off adhering to the 4% rule; where 4% of the portfolio is sold off on an annual basis to cover expenses once retirement begins. This is a common practice for the funding of a retirement; however I see several flaws. My major issue with this plan is the fact that over time, one's assets are eliminated. I would much rather retain my shares and rely on the passive income they generate than be forced to depart with them (more on this later). In regard to the previous argument they make about holding growth stocks, especially through the accumulation phase, I've yet to see a convincing model that shows me a drastic long-term out performance of growth stocks over dividend aristocrats. First of all, companies become aristocrats because of their ability to continually grow earnings over a long term of time, which enables them to pay a sustainable, increasing annual dividend. Even without multiple expansion, these increasing earnings drive the stock price higher over time at respectable clips. I admit that by primarily investing in more mature and predictable companies I've missed out on some of the huge gains shareholders of more speculative growth stocks like Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), or Facebook (NASDAQ:FB) have had over the past couple of years. That being said, for every company with an irrationally high multiple that has succeeded in rewarding shareholders for their abnormally high risk, there are a handful that have turned out to be duds, or even fiascoes. The risk associated with owning a company whose current multiple can only be justified 5 years out (assuming their current pace of growth is sustained) is not a risk that I'm willing to take; I'd rather be paid 3% annually to hold a company with a predictable earnings growth in the high single digits.

Speaking of reliable, safe holdings, I think it is extremely important to make sure you own an anchor or two to help assuage the mind during troubled times. It is human nature to become fearful when you see the value of your holdings eroded by a bear market. The common reaction to this fear is to run and hide, meaning to sell a depreciated asset, and this is how many investors get themselves into trouble. By selling a depreciated asset you're locking in losses. You lose any potential that that investment had going forward. In general, holding dividend-paying companies helps with this fear, because you're essentially being paid to wait for their prices to recover; however, even then it can still be difficult to hold your ground when you see years of collected dividends wiped out in weeks or months by a falling stock price. This is why I've made a point to allow several of my holdings to grow into outsized portions of my portfolio. These are the companies that I feel best about owning. I sleep well at night because I own them. I have conviction in their products, their services, and the long-term trajectory of the industry that they operate in. I strongly suspect that in a decade or two these companies will not only be surviving, but thriving. I have the utmost confidence in these companies and they serve as anchors for me in stormy waters. They also give me easy answers as to where I should allocate my newly collected dividends when it comes time to re-invest if there are no clear answers as to which of my other holdings are undervalued or deserve greater exposure.

My anchors are Coca-Cola , Apple , and Disney (NYSE:DIS). I like Coke because of its incredible brand. The company does business in over 200 counties, sells over 3,500 products, 17 of which have grown to be $1B+ brands. There isn't much that I can be certain of moving forward; however, I do know that humans will always have a need to consume potable liquids and providing these liquids is service that Coke excels at offering. As of late, Coke has been on a spree of acquisitions, buying stakes of Keurig Green Mountain (NASDAQ:GMCR) and Monster Beverage Corporation (NASDAQ:MNST). Because of its large size and cash flow operations, KO is able to grow in multiple ways; with its slow and steady existing brands, which has posted low single digit volume growth so far this year, and through M&A activities in growth spaces, using its worldwide marketing and distribution systems to take these companies to the next level. I expect to see this M&A trend to continue as KO diversifies its product line, continuing to move with public sentiment, away from traditional sugary, carbonated products and towards more alternative, natural beverages like teas and even milk with rumors about interest in White Wave (NYSE:WWAV) floating about the speculative media networks. KO has paid an increasing dividend for 52 consecutive years and currently yields just under 3%. KO has become my largest holding. Through all the negative news, I can't fathom an environment where KO isn't at the forefront of the non-alcoholic beverage space and I expect this company, sugary beverages or not, to continue to reward shareholders with a steadily growing dividend for years and years to come.

Apple is not a traditional DGI holding. The company has existed as a growth stock for some time now, but I believe this company is maturing and because of its massive cash hordes, it offers income-seeking investors an interesting haven, offering both dividend growth and high potential for capital gains. Like Coke, Apple's brand awareness is stellar. The company has a cult-like following worldwide. What I like about Apple is the mass hysteria that consumers and investors alike experience every few years with a renewed product cycle. The momentum that a new iPhone or iPad or really any iGadget of any kind creates serves as a great catalyst for stock price appreciation (although it has also proven to set the table for massive downfall in stock price if the product does not meet market expectations). More than any other company, I think that Apple has done a great job of both giving the consumer not only what it craves in the present, but products and services that it wants, and will eventually "need", but just doesn't know it yet. Apple's track record of industry foresight has been amazing. Many contribute these wonderful ideas to Steve Jobs and fear that without his leadership, the company will lose some of its competitive advantage. I don't buy into this train of thought; Steve Jobs was obviously a visionary man, but Apple, alongside rival Google (NASDAQ:GOOG) (NASDAQ:GOOGL), has taken steps to offer some of the most sought after jobs in the tech industry and is able to continuously attract the most qualified and intelligent individuals that this planet has to offer. Not only does this company offer me double-digit expected earnings growth because of its product pipeline, but it is in the midst of a $90B buyback. Management feels that the stock is undervalued (Apple's forward P/E is hovering just above 13x)and I feel good knowing that due to the simple rules of supply and demand, just about every morning when I wake up, the shares I hold have become slightly more desirable than they were the previous day or week (I can only assume they are averaging into this $90B purchase) because of massive amounts of retired shares. This will also have a positive effect on the EPS numbers in the short/medium term. Some may call this financial engineering; I call it effective management. Apple shares currently yield 1.83% and give investors $1.88/share annually. The company's payout ratio is a conservative 28.5%, which leads me to believe that the dividend has plenty of room to grow. Management has also made a commitment to shareholders to continue to increase the dividend with CEO Tim Cook saying, "We also understand the importance of the dividend to many of our investors and we're increasing it for the second time in less than two years. We believe this is a meaningful increase for those shareholders who value income and we are planning for annual dividend increases going forward." in the second quarter conference call, making me all the merrier to continue to own and purchase more shares of this wonderful company.

Coke is one of my core holdings because it offers a product that humans need to survive. Disney is my last core holding because of the fact that for many highly developed species, once survival requirements are met, the first thing that is sought after is leisurely entertainment. I don't see human beings plummeting back into the dark ages any time soon (and if we did, I'm sure that my stock holdings would mean very little to me at that point anyway) and I love the position that Disney holds as both a content provider and distributor in the entertainment world. The company has a diversified portfolio from its theme parks, to both its animated and live action films, to its related merchandise, and my favorite, its athletics broadcast channels, namely, ESPN and the newly created SEC network (I was very happy with their production of the Texas A&M vs. South Carolina game last Thursday to open this college football season, top notch talent all around, on the field and in the broadcast booth). Disney understands the power of enthralling content and has done well in my opinion with its foresight of major trends, namely, the rapid growth of the popularity of football in the United States and its prediction that comic book characters would transition successfully onto the big screen. I think the company is right-on with its purchase of Lucasfilm and I expect that the Star Wars franchise will be as successful, if not more so, than the Marvel Brand. I understand that Disney's bottom line is somewhat dependent of the state of the US and world economies; entertainment is one of the first things that families cut back on when times become tough financially. With that being said, I am a long-term bull when it comes to the US economy and I see Disney as a company that will continue to benefit greatly from both worldwide economic recovery, the rise of the middle class, and population growth in general. DIS does not pay a large dividend; the stock's current yield is just under 1% with its $0.86/share annual payment. Something else that turns many dividend growth investors away from Disney is its annual payment schedule rather than the more typical quarterly or monthly payments. While I would rather receive payments throughout the year for re-investment purposes, I'm always happy when my big lump sum check arrives in my brokerage account, and I expect Disney to continue its general uptrend in dividend growth.

Be disciplined...and flexible

As I've stated, having a plan that will enable you to achieve your goals is very important as a portfolio manager. What's probably more important is having the wherewithal and the gumption to believe in yourself and stick to this plan through thick and thin. So long as a DGI investor chooses stocks conservatively, I believe they're making a safe bet that their income will continue to come in on schedule, at an ever-increasing rate. Now, this being said, I think it's important to know that it's okay to break stride every now and then. Changing things up can keep things fresh for a manager, because admittedly, this investment philosophy is not the most exciting one to adhere to. DGI has proven to be a great way to build wealth slowly and I think sometimes investors feel trapped within the bounds of the dividend aristocrat mindset. I wouldn't recommend that anyone devote a very large portion of their portfolio towards speculative stock picks, but having some more lively skin in the game every now and then can really freshen things up. I also think it's important to continue to push your boundaries as an investor, to learn about new industries, and even other investment philosophies; even if you never put this knowledge to good use, knowledge is power and in an interconnected market, I think you'll find that useful synergies form as you continue to learn.

A recent example of this for me is the several purchases of Gilead Sciences (NASDAQ:GILD). Gilead is a biotech company that has recently been blamed for popping what was thought of as a bubble industry wide for the biotechs who had experienced an impressive run-up over the past 2 years. The dip was short lived however, as dip-buyers flocked in strong numbers as the iShares NASDAQ Biotechnology ETF (NASDAQ:IBB) fell into recessionary territory in mid April. GILD was put to blame because of the fear that arose due to a pricing scandal over its new 'wonder drug' Sovaldi in Congress. There were fears of big government stepping in and regulating prices-which seemed to be enough to cause many investors to ring the register and cash in on their profits. As all of this was going on, I watched GILD, a company who had just created a drug that cures a potentially fatal disease that affects over 100 million people worldwide, fall and fall, until it bounced off of its 200-day moving average. I don't typically trade on technicals but this seemed like a great entry opportunity, especially with the upcoming earnings growth expected to be through the roof, driven by Sovaldi sales and the company's forward P/E hovering around 13x. Gilead doesn't pay a dividend (though now there are rumors reverberating throughout the more speculative DGI community that one may be initiated due to the massive amount of cash on hand due to the massive success of Sovaldi) so I had a decision to make: buy shares of a company on what I deemed to be an irrational pullback that offered roughly 100% earnings growth potential at a 13x forward multiple, or stick to my guns and let this one pass by the wayside because it doesn't meet my typical conservative purchase perimeters. I hesitated and lost my initial opportunity, but the value investor in me got the best of me and I bought a sizable lot of shares when the stock fell back down to the 200-day average about a week after its initial bounce and luckily for me, the shares have not looked back since. I'm up over 60% on my first batch of shares after nailing the bottom at $67.31/share and now my only regret is not buying more (the competitor in me is rarely satisfied). I more recently bought another lot when the company announced a second straight stellar earnings report, once again driven by massive Sovaldi sales, and the market didn't move the stock. I thought this lack of movement was also irrational and jumped in at $90.82, and I guess I wasn't the only one who came to the conclusion that the stock was still undervalued as it currently trades at $108. My point with this story is not to brag (thought I will admit that I am happy about these trades) but to show that if I wasn't willing to consider the technicals in place and go with my gut on a beaten down non-dividend paying stock, I would have lost out of these massive potential gains. I still hold my shares because I don't think that the run is over and I like GILD's pipeline moving forward, but if and when I cut ties with this company, assuming it's at or above current levels, I will have enabled myself to buy many more shares of a traditional DGI company that I otherwise would have with the original capital dedicated towards this investment.

Another point that I would like to make with this story is that investors, even if they are strictly sticking to a DGI strategy, should not narrow their focus when it comes to their tracking of the market. This ties in with what I was saying about the importance of an ever-continuing education. You never know when something is going to go on sale in the market, and unless you have a wide field of vision, you will miss them all together as other buyers clear the shelves.

I will end this section with another piece of advice from a famous American figure: Peter Lynch. In his book, Beating the Street, Lynch begins by talking about "the miracle of St. Agnes." This miracle that he speaks of is the story of a grade school class beating the market by almost 200% in 1990 by investing primarily into the stocks that were familiar to them. These children chose stocks like Walmart , where they bought their school supplies, and Nike (NYSE:NKE), the shoes they thought were cool, and Gap (NYSE:GPS), where they bought clothes, or Topps, their favorite baseball card company. While these children were not master analysts, they were able to use the information readily available to them in their everyday lives to decide which businesses were best run or likely to be more profitable than their peers, not because they scoured balance sheets or earnings reports, but because they spent time in the stores themselves and got to know the products they offered. The elegantly simple understanding that these children had of the companies they decided to own in their theoretical portfolio inspired Lynch and caused him to create "Peter's Principle #3" which is: "never invest in any idea you can't illustrate with a crayon." I think he is right on with this reasoning. I'm happy to say that once again, my humanities education that I received from the English department at U.Va is paying off- professors harped and harped in creating writing classes that you could never write a good poem or story, if you weren't writing what you know. As shown by Lynch's example, the same rules go for investment decisions. Gaining and maintaining a thorough understanding of the business practices of the companies you own, or want to own, will not only help you to evaluate and decide when is an appropriate time to buy the stock, but to formulate an educated exit plan as well. So, while I think it is incredibly important to continue to broaden your horizon as an investor, it is paramount that you stay within yourself, investing in what you know and can easily understand and predict, and not jumping into something that you don't feel comfortable with.

Be patient

This section isn't going to be long. It is pretty self explanatory. An investor interested in a DGI strategy must understand that compounding takes time. Sometimes it can be hard to wait, especially when bull markets flare up and you see the momentum stock of the week posting outrageous gains compared to your slow and steady growers, but take solace in many of the long-term reflective models that can be found here on SA in the dividend investing section. There are many contributors and commenters here that are willing to share the successes of their dividend growth portfolios. Follow their results, their advice, and trust in the process. I've bought in, both literally and figuratively, and sleep well at night because of it.

Disclosure: The author is long KO, GILD, WMT, JNJ, DIS, AAPL, XOM, BRK.B. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.