A Personal Comment On Dividend Growth Investing, With A Nod To My Favorite Gurus

by: Nathan Kemalyan

Summary

The individual investor should choose a style of investing and adhere to principles that enhance the prospects for acceptable investment performance.

I chose dividend-growth investing, for a series of reasons, outlined below.

Dr. Suess has something to say about applying arbitrary values to one way of behaving vs. another.

I have been lurking around the Seeking Alpha pages, commenting in the dividends and income space. I thought I might toss my hat in the ring and include my voice among the contributors.

I am, broadly speaking, a dividend-growth investor (DRI). It's a loose-fitting jacket, since I throw in some other concepts, often to my detriment from a performance standpoint, but also because managing my own portfolio needs to keep my interest. I purchase some positions out of interest rather than out of strict investment performance criteria. I would like to be the cool-headed dispassionate investor I recognize in some of the most mature authors that I read, but I lack the strict discipline that some of them apply to their portfolio management. I try to avoid being too self-critical in this arena, or it will spoil the fun.

Why do I like dividend growth investing?

First, this school of investing philosophy broadly follows some principles espoused by none other than the Oracle (Warren Buffett) himself. One seeks to buy "high quality" companies at a discount to fair value, or at most fair value. That's more a value investing principle than dividend investing principle, but it's a great foundation for avoiding poor investment performance. Like many others, I find Buffett to be an almanac of common sense in investing. I humor myself by thinking of my retirement portfolio as a mini-micro-nano conglomerate, run by me.

Second, this school of investing philosophy emphasizes buy, hold, and monitor. Moving rapidly in and out of positions has a number of hazards. It is a trader's habit, not an investor's habit. It generates significant "leakage" due to trading fees. It fundamentally is about short-term movement in stock prices, rather than long-term prospects. Holding respects the wisdom that "time in the market is more important than timing the market." The kind of companies that populate the DGI universe aren't generally momentum stocks. They build value methodically over time. Monitoring is about applying criteria for continuing to hold a stock and then being willing to sell a position if that company's business fundamentals or management performance break down.

Third, DGI focuses on companies with a particular characteristic, that of having paid dividends and, more specifically, rising dividends for a period of time. The DGI investor believes that the history of dividends speaks to the character of management and the board, reflecting a philosophy about the relationship between management and the owners of the company. When you add a few more metrics like payout ratio, CAGR of earnings, and dividends over short and long term and dividend yield, you identify a company and management that is in a business with steady growth prospects, healthy cash flow, and with a discipline about allocation of capital allowing some of the profits to flow to owners each year.

The DGI investor focuses on reliability of earnings, cash flow, and the company's ability to fund growth through earnings rather than through repeated stock offerings that dilute ownership. The DGI investor also has an independent streak, preferring to exercise personal discretion in a portion of the capital allocation decision by either reinvesting in the company, selectively reinvesting dividends in another holding, or harvesting a stream of income for other purposes such as living expenses.

The dividend growth investor recognizes that it's possible to achieve outsized performance investing in a mature company with modest growth, if that company is buying back shares at a favorable price to book ratio and delivering a generous dividend to the owner, who can then reinvest that dividend and watch his/her position grow in an accelerating fashion. That is known as compounding. Growth in earnings per share can be more important than overall earnings growth to the individual investor if the company under scrutiny operates in a mature, slow-growing marketplace. The DGI investor recognizes that compounding within the investor's portfolio is just as important as compounding within the position, and even more important than growth in a given company.

The dividend growth investor seeks to protect capital investment with a "margin of safety" at the point of purchase, seeks to avoid the need to sell shares to raise cash for new purchases or living expenses, and allows time and compounding to grow the position and produce a stream of income at or greater than the rate of inflation. The dividend growth investor believes that the individual has the capacity to achieve adequate diversification, safety, and performance through the purchase of a basket of individual stocks without paying a professional manager year in and year out and exposing oneself to all the baggage associated with owning mutual funds or ETFs.

Dividend growth investing recognizes some of the hazards associated with human behavior that lead to poor investment decision-making. When one focuses on stock price and capital appreciation as the primary indicator of investment performance, there is anxiety associated with both significant appreciation of a stock's value as well as any significant correction in the price of that stock. On the one hand, the investor worries about overvaluation and the need to take profits. On the other hand, the investor worries about loss of capital and the possibility of having to sell shares at a loss if one needs to raise cash for any reason.

One is tempted to "do something" when it is often best to sit on your hands. The dividend growth investor pays great attention to valuation at the point of purchase, then pays much more attention to company performance and dividend payments thereafter, releasing one from the anxiety of tracking stock prices on a continual basis. As long as the income stream is rising, the reinvested dividends are producing an accelerating growth in the value of the position and the earnings are healthy, one can largely ignore the stock price.

Corrections become buying opportunities rather than reasons for panic. Updrafts in valuation may cause one to re-allocate dividends to a different holding, but don't necessarily mean one should sell some of all of the position if the earnings and dividend story remain intact. The investor can apply the same mental discipline to non-dividend paying holdings, but he/she has one less indicator of how the management feels about the company performance, and less flexibility in how to respond.

There is an ongoing debate between dividend growth investors and critics who favor total return without regard for income. This is a false dichotomy, because there is ample evidence that companies that pay dividends tend to outperform their more stingy peers. A rising dividend either reflects or drives increasing value, or both. Healthy dividend-paying companies tend to experience healthy levels of appreciation in stock price. I see the difference primarily in the flexibility offered to the owner when he or she is presented with regular dividend checks. One can reinvest, reallocate capital to other investments, or take cash payments for living expenses without the need to sell shares.

The total return investor (TRI) can be every bit as disciplined in monitoring company performance, but without a flow of cash in the account, one cannot purchase more shares or harvest income for living without selling shares. Every business lives on cash flow, and one's personal budget is no different. You can earn scads of money on paper and still starve if you can't pay your grocery tab.

Another straw man hoisted up for target-practice between the camps is the issue of tax efficiency. companies that retain earnings and internally reinvest earning are said to be more tax efficient vehicles for wealth accumulation than those that pay dividends. This can be a legitimate issue for investors who are not looking for a steady flow of cash into their accounts. On the other hand, many of us have the majority of our personal wealth in qualified retirement plans or IRAs. These accounts protect one from taxes on dividends and distributions. In the case of Roth accounts, one pays income tax on personal earnings and then never pays another cent in taxes on capital appreciation, dividends or distributions.

I'm quite certain that the debate between DGI disciples and their TRI counterparts will go on into the indefinite future. I find the debate to be tiring at times. In either camp, one can exercise discipline in choosing companies, monitor earnings growth, valuation and capital allocation practices of the management. If you don't care about current income, you can allow company management to do all of the capital allocation for you. You can seek to discern the culture of management and the board using other indicators than dividend policy.

Those who choose to employ the flexibility of dividend-paying investments within their personal investment portfolio don't feel the need to benchmark their total return against stock market indices. They march to a different drummer. I don't see an issue with that. If you're like me, you can straddle the fence and sprinkle in holdings that reflect both philosophies of investing. Those who think this issue between DGI and TRI is worth fighting over should read The Sneeches and Other Stories, by Dr. Suess. It really is OK to be different.

Finally, I like to sleep well at night. I'm old enough to look back on a whole series of decisions I wish I would have made differently. It helps me to look at every one of my holdings and ask: If this were the only stock I could own, would I sleep well at night? DGI principles help me sleep well at night.

That's why I like dividend-growth investing.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.