Dividend Growth Investing Myths 21-25

by: David Van Knapp


Dividend growth investing is an emotional subject.

It has spawned many myths. We've already covered 20 in previous articles.

Here are the next 5 myths.

One of the most popular series of articles I have written involves the myths that surround dividend growth investing. I thought I had run out of myths, but the topic is a gift that keeps on giving.

For those who haven't been keeping score at home, we have identified 20 myths over the years. Every myth is something that I have seen in print, often from respected advisors, pundits and major firms.

Here they are:

Article 1 (2012):

1. The only sensible goal in investing is total return.

2. Dividend growth investors don't care about total return.

3. Income from "selling a few shares" is the same as dividends.

4. Dividend growth investors think they have found a free lunch.

5. Each dividend growth stock must maintain its performance for 30 years.

Article 2 (2012):

6. You need more money to live off of income than withdrawals in retirement.

7. Dividend growth investors don't care about current yield, they only care about yield on cost.

8. Dividend growth stocks are all large-cap U.S. stocks concentrated in a few industries, therefore a dividend growth portfolio lacks diversification.

9. The S&P 500 is a good proxy for a dividend growth stock portfolio.

10. Dividend growth investors select stocks based only on yield; dividend growth investing = high-yield investing.

Article 3 (2013):

11. Dividend growth investing does not involve analyzing individual stocks.

12. You can replicate a good dividend growth strategy with ETFs.

13. Stocks with high yields have low dividend growth rates, and vice-versa.

14. Younger investors should take on more risk because they have more time to make up losses.

15. Broad statistics are helpful in assessing individual stocks.

Article 4 (2014):

16. Dividends do not explain returns.

17. The reduction in share price prior to ex-dividend day is permanent.

18. Receiving a dividend is exactly like selling a share.

19. Dividend stocks are all overvalued or in a bubble.

20. You can only spend total return.

You would think the reservoir of myths about dividend growth investing would be exhausted by now, but it is not. New ones keep turning up.

Myth #21. Dividends are irrelevant

In retrospect, this probably should have been Myth #1 because it is the foundation for so many other myths.

Recently, Modern Portfolio Theory [MPT] guru Larry Swedroe published "Swedroe: Investors' Odd Affection for Dividends." In the article, he stated:

In their 1961 paper, " Dividend Policy, Growth, and the Valuation of Shares," Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns… This theorem has not been challenged since.

But actually, if you read the Miller & Modigliani paper, you see that it is based on several assumptions about investor behavior, one of which is that investors do not care whether they get returns via dividends or price changes.

The simple existence of many investors who do care about their source of returns is enough to refute the theorem in real life.

And such an interest in dividends is not irrational. Many investors, especially retirees, depend on dividends for an important part of their cash flow for living expenses. Dividends are, for them, income replacement for the job that they once had. Dividends certainly matter to them.

That said, dividend focus is often labeled as irrational in academia because it violates the principle that the only sensible goal in investing is total return (Myth #1). Miller & Modigliani's paper discussed what investors focus on when valuing a company. They dismiss the "stream of dividends approach" to valuation, stating that a stream of current dividends reduces the terminal value of shares (Myth #17). Having distributed the dividends, a company must access outside capital for its own investment needs.

The authors did not seem to consider that some companies' business may be so good that they generate more cash than they need, and thus paying dividends in no way constrains their future growth.

Indeed, as a dividend growth investor, those are exactly the kind of companies that I want to own.

Also, please note that Mr. Swedroe's statement that the dividend-irrelevance theorem has never been challenged is false. He probably does not count the numerous non-academic studies of dividends and returns that suggest that dividend policy often does lead to differences in returns. Such studies have found not only different returns, but better returns for companies that pay and increase dividends.

For example, the 45-year ongoing study of dividends and returns by Ned Davis Research clearly illustrates that dividend growth stocks have outpaced the returns of other categories of stocks over the years. A simple Google search turns up hundreds of results and images based on the NDR research. Here is an example:


Beyond that, Mr. Swedroe should recognize academic studies, such as a 2003 paper entitled, "Surprise! Higher Dividends = Higher Earnings Growth," by Robert Arnott and Clifford Asness.

The researchers generated a history of the earnings per share of the S&P 500 Index, then analyzed this against the dividends actually paid by the companies. They found a positive correlation between payout ratio and subsequent 10-year earnings growth. Companies with higher payout ratios, as a group, had higher subsequent earnings growth.

Does that sound unintuitive? When you think about it, their finding should come as no surprise. After all, if you are considering excellent, low-risk companies that have the wherewithal to increase their dividends every year, doesn't it stand to reason that over long periods of time, they will do well at increasing their earnings too?

In their study, Arnott & Asness state:

Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.

The last sentence refers to how dividend policies "protect" certain funds from managers, who as a consequence have less opportunity to waste a corporation's excess cash with ill-advised projects and acquisitions. As the authors put it, too much earnings retention creates "an irresistible cash hoard burning a hole in the corporate pocket."

The bottom line is that just because a company pays a dividend does not mean that it has less earnings power than a non-dividend-payer. Decades-long streaks of increasing dividends usually come from companies that have sustainable businesses, strong economics, and are extremely good at allocating capital. Again, those are exactly the kinds of companies that I prefer to own.

Myth #22. To succeed at investing, you must beat the market

Much of investing punditry and advertising revolves around the idea that investing is about competing: Competing with indexes, benchmarks, other investors, or yourself.

The underlying thought seems to be that you are not a successful investor unless you beat something. Often the target to beat is the market itself.

I have seen it stated that investors who focus on dividend growth as a way to grow an income stream are likely foregoing the potential to "beat the market." Here is an example:

Those who use dividend growth as a method to "grow the dividends" and invest on a total income strategy are likely giving up the potential to beat the market.

But many dividend growth investors are not trying to beat the market or any index. They simply want to satisfy their cash flow needs.

The goal for my own Dividend Growth Portfolio, as stated in its business plan, is representative:

Goal: The primary goal is to generate a steadily increasing stream of dividends paid by excellent, low-risk companies. Numerical objective: Deliver 10 percent yield on cost within 10 years of inception. The secondary goal is to deliver competitive total returns compared to the general market.

If you have a goal similar to that, you need not care about beating the market, whether the market is defined as the plain old S&P 500 or as something more complex that includes factor tilts or whatever is the great new thing in the investment industry. You will really be better off if you tune out that kind of noise.

Myth #23. Whoever has the most money wins

This is an extension of the competition myth. Some investors and advisors view investing as a lifetime race, and there is only one way to win: Finish with the most money. As it has been stated, "[M]ake no mistake, whoever has the most money wins. Period."

Winning and amassing the most wealth - while the best goal for some - is not the only sensible goal of investing. There are other legitimate reasons to invest. One of them may be to optimize an income stream for current or future use. Many investors simply want enough income for retirement.

A bad thing about myths like "most money wins" is that they can steer someone away from good investing habits and practices.

For example, most dividend growth investors are patient collectors. They collect income as the natural output of their investments. If they are in accumulation, they reinvest that income to collect more shares. Over an investing career, they collect stocks and dividend rights for the long run, utilizing a long-term point of view and suitable strategies.

Competing, on the other hand, or feeling beaten if you don't have the most money, is psychologically damaging and can lead to self-defeating investment behaviors. It may lead to over-trading, obsession with portfolio values, and getting tripped up by marketplace noise. None of those are good habits for those with long-term outlooks.

Myth #24. All dividend growth investors believe the same things, buy the same stocks, value yield and growth identically, and act in the same ways.

This myth is embedded in so much of what one reads about investing that it is easy to just accept it without even thinking about it.

But that is dangerous, because it causes your critical thinking to get clouded. Just because everyone says something does not make it so.

As applied to dividend growth investors, the myth is clearly wrong, because there is a broad spectrum of how people define, view, and use the basic strategy.

Even their goals can be significantly different. Some dividend investors see income optimization as their only goal. Others see it as a goal that stands ahead of total return, but they also follow total return. Still others use dividend investing techniques to achieve "growth and income." And certainly, some are looking to maximize total return.

Some dividend growth investors distinguish "builder" stocks from "harvester" stocks. Many differ from each other on whether they emphasize yield over growth or vice-versa. Some like to create different portfolios for different purposes, while others would rather mix stocks together into one diversified portfolio.

The bottom line is that there are many flavors of dividend growth investing, but that fact is lost on those who lump everyone together into a regimented block.

Here is another example of how the "everybody's the same" myth can slip by almost unnoticed. In a recent comment stream, the subject was portfolio management, about which it was said, "It is simply human nature… for people to run scared when they see the value of their portfolios decreasing."

Well, no. Not everyone is hard-wired the same way. I have seen this kind of generalization creeping into more and more investing discussions over the past few years, and the trend disturbs me.

The underlying source is often the field of behavioral finance. There is a lot of pop psychology going around. That is not necessarily bad, but an unfortunate tendency has developed to take the spectrum of results of a test or study, find the average of the results, and then present the average as if that describes everybody.

Sometimes a paper's authors do it themselves. But more often, the homogenization happens when a complex subject is condensed for popular consumption. By the time things have been repeated a few times, there is often a departure of the reporting from what the original study or report actually said. Nuances get lost.

Let's go back and reconsider the generalization that it is "simply human nature… to run scared." First of all, that simply is not the nature of every investor. Some people walk toward danger rather than run away from it, or they do not perceive danger where others might. The fight-flight response has two sides, not just one.

Investors have a spectrum of responses to every situation they encounter, including price drops. The inclination to run scared may be the average, or even the predominant, response, but it certainly is not the only response.

Beyond that misstatement of fact, human behavior is determined by far more than prehistoric brain responses. That is ultimately the lesson of Daniel Kahneman's best-selling and award-winning Thinking Fast and Slow.

As implied by the second part of that book's title, you can engage the left side of your brain and slow down your thinking. That is exactly what many investors do. They create goals, strategies, and business plans, and they display considerable skill in executing them.

Many dividend growth investors shift their focus from industry and media-encouraged obsession with short-term price changes and instead turn their attention to income for the long term.

For me, that manifested itself by swinging my gaze from prices to income (cash flow). In my opinion (which of course is biased), that change in focus made me a better investor. I began to look at sustainable company qualities and fundamentals instead of immediate price popularity in the market. My angst about price drops fell to near-zero.

One outcome was that I have stayed fully invested for the bull market that began in March 2009. The bull market has often been described as "the most hated bull market in history." Not for dividend growth investors. For those focused on the growing income streams from great mature companies, there has not been much reason to sell, let alone panic.

Myth #25. Dividend investors appear to be the most skittish when it comes to discussing risks. They may be among the first to bail out (at the wrong time) in a major correction.

When I saw this one, I said to myself "What???" I requested data to back up the charge, but none was forthcoming.

The suggestion that dividend investors are risk-ignorant, most skittish, and most likely to be among the first to bail runs counter to my experience.

First, as to risk, most dividend growth investors do not even equate risk with price volatility, which is MPT's narrow definition of risk. That sliver of a definition has become so embedded in financial writing that suggestions about other kinds of risk are sometimes criticized as ignorant attempts to change the definition of risk.

But it's the other way around. By zeroing in on a single form of risk, it is MPT that has attempted to change the commonsense definition of risk.

I have written about the spectrum of risks facing dividend growth investors several times. My two most recent articles on the subject are "Risk Tolerance for the Dividend Growth Investor" (2015) and "How a Dividend Growth Investor Can Cope with Risk" (2014).

I think it is fair to say that most dividend growth investors would rank the risk of a dividend cut as the biggest single risk that they face.

Second, as to price drops (as in a major correction), many dividend growth investors are just fine with them. Rather than inducing untimely bailing out of the market, price drops and valuation improvements are just as likely to induce buying. Most dividend growth investors are value investors too, so of course they prefer to buy and collect shares at reasonable or bargain prices when they are available.

Many of the dividend growth investors who write and comment hereabouts report that the income component allows them to pay less attention to price skids and allows them to sleep well at night. They don't bail.

I will conclude this article by repeating what I said in a recent comment about coping with risk. It is an example of thinking slow and then executing.

To achieve that goal, different investors will take different routes. Examples:
1. Hold some investments that don't move with the market, such as bonds. That may make it easier to stomach price drops.
2. Hold lower volatility stocks.
3. Hold some cash that is not considered "investable." It's a safety valve for emergencies or to ride out bad times.
4. Think about Social Security or a pension as if it were the output of invested funds that are not subject to market volatility. Note how much of your income is independent of the market.
5. Focus on the income from your investments rather than their prices. [Appreciate] the independence of your income from the market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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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