When 'Dividend Growth' Doesn't Mean Anything At All

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Includes: FDGFX, PRDGX, VDIGX
by: Reuben Gregg Brewer

Summary

Buying dividend growth stocks is a great investment approach for income investors.

The idea has, rightly so, been co-opted by the mutual fund industry.

Only many funds don't live up to the spirit of “dividend growth”.

Why do you buy a company that has a long history of raising its dividends? For most people that's an easy question to answer. But knowing your answer is important before you make the mistake of thinking that a mutual fund with "dividend growth" in its name is a short-cut to meeting your investment goals.

Why dividends?
For most income investors, dividend growth is about owning a company that will pay you more over time. So you buy one great company and year after year your paycheck gets bigger and bigger. With any luck, your principle will grow over time, too, as the dividend increases. It is, truly, a wonderful thing when this works out as planned. And as long as you don't get too greedy on the yield side of things, it's not that hard to pick stocks that do work out as hoped.

But maybe you don't have the time, energy, or desire to buy individual stocks. Maybe it would be easier for you to buy a mutual fund that does the whole "dividend growth" thing for you. If you aren't careful, you may end up making a big mistake.

Why is that? Because dividend growth can turn out to be more important in the stock selection process than in the fund's results for investors. For example, T. Rowe Price Dividend Growth Fund's (MUTF:PRDGX) objective is: "...to seek dividend income and long-term capital growth primarily through investments in stocks." That's a far cry from Vanguard Dividend Growth Fund's (MUTF:VDIGX) objective: "The Fund seeks to provide, primarily, a growing stream of income over time and, secondarily, long-term capital appreciation and current income."

From the names, you'd think the two funds do the exact same thing, and exactly what you'd do if you were buying individual stocks. In fact, you might even think the objectives are essentially the same thing and I'm just mincing words. But of the two only Vanguard's goal is, basically, the same as your own if you want a rising stream of dividends over time. A look at the numbers will help show what I mean.

VDIGX has watched net investment income (essentially dividend payments) increase every year since 2010, going from around $0.27 a share to $0.44. PRDGX's net investment income fell in 2013, though it did increase from $0.29 a share to $0.47 over the five-year span. Maybe that one-year drop doesn't sound like a big deal to you. Well, if you were relying on dividend payments to provide for your living expenses, the nearly 9% net investment income drop in 2013 might have been bigger than it sounds on paper.

Fidelity Dividend Growth Fund (MUTF:FDGFX) was no better. Its distributions from net investment income were $0.12 per share in 2010, $0.15 in 2011, and back down to $0.12 in 2012. Distributions from net investment income then jumped to $0.30 a share in 2013 and $0.37 in 2014. That's a pretty volatile income stream if you are trying to live off of the dividend income your portfolio creates. By the way, the fund's objective is capital appreciation -- dividends and income don't even get a mention.

One big complication in this is that mutual funds pass on both their interest income (dividends and bond interest) and their realized capital gains. So, capital gains distributions will make the distributions from these funds more volatile and can actually hide the distribution changes attributable to net investment income. That can hide solid dividend growth at a fund like Vanguard Dividend Growth or cover up dividend shortfalls at funds like the "dividend growth" options from Fidelity and T. Rowe Price.

To get at what's really going on with dividends when you examine any fund with "dividend growth" in its name, you need to dig into the latest annual report and look at the Financial Highlights section. You also need to think carefully about what the wording of the objective really means and how it matches with your expectations. For example, if you want steady and rising dividend income, the "dividend growth" funds Fidelity and T. Rowe Price don't live up to that.

Stock tool or investment goal?
What it really boils down to is how "dividend growth" is viewed at the funds you are examining. For some funds, dividend growth is the goal, as it most likely would be for you. For others, dividend growth is really just a stock selection tool. The idea being that buying companies that increase dividends will lead to better total returns -- not necessarily growing dividend payments to shareholders.

This isn't to suggest that you shouldn't consider a fund with "dividend growth" in its name. But it is a warning that sometimes funds use catchy names that don't mean what you think they do. In this case, a deeper look at a fund's results can help you decide if including dividend growth in a name is a marketing decision or if it actually means what you expect it to.

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 (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.