Dividend Growth Or Closed-End Funds REVISITED

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Includes: CEFS
by: Faithful Steward Investing

Summary

Reader interest in my previous article over the past year regarding DGI vs. CEF strategies has prompted a fresh look at the analysis.

Discussion and further thought revealed a fault in my original premise that should be addressed.

Although the new premise changed the outcome of the data by a wide margin, my main conclusion remains intact: time horizons matter.

In August 2016, I published an article titled Dividend Growth Or Closed-End Funds: What's Your Time Horizon? In it, I compared both the growth of income and the compounded growth of investment between three strategies: a closed-end fund income strategy, a dividend-growth strategy, and a high-growth dividend strategy. The shorter-term income prospects (10-15 years) greatly favored the CEF strategy, and the long-term income prospects (30+ years) favored the Hi-DGI strategy. Long-term compounded growth on investment (30-40 years), in that study, were astronomically high for the Hi-DGI strategy. The mid-ground DGI strategy fell between the other two.

It was pointed out by one of my readers that a fault in a key premise I used in the extrapolation of data skewed the long-term results. I toyed with the idea of going back to the drawing board and creating a new data set, but instead I put it on the back burner. Recently, however, an article by a fellow SA author prompted re-evaluation of my previous analysis but with more care given to operating from a more realistic premise. Acknowledgements to Stanford Chemist and Steven Bavaria for getting the wheels turning again on this from a new perspective.

THE PROBLEM WITH THE OLD PREMISE

The data set I created in my previous study was based on the premise that the share prices of dividend-growth stocks fluctuate up and down but average out flat over time. This was a faulty assumption on my part. Dividend-growth stocks grow their share prices over time just like the S&P 500. As a matter of fact, the S&P 500 is made up of such stocks, so it is far more reasonable to assume that a DGI strategy's pricing would mimic the S&P's price growth.

Because I used a flat average share price in determining growth upon the reinvestment of dividends, the outcome was that progressively more shares were added over time than could be reasonably expected. If the share prices had increased during the time frame, the number of shares added upon reinvestment would have been more stunted. For instance, $480 in dividends bought 48 more shares when I assumed a flat price of $10/share, but would buy only 40 new shares if the price had increased to $12/share. The accumulating effect of that key difference has significant ramifications long-term.

THE NEW PREMISE

Analysis of the Dividend Growth Investing strategies should reflect an increase in share price over time upon reinvestment. One study I read stated that the stock market has averaged 7.54% per year in growth for the past 50 years. My new premise assumes similar average growth for dividend-growth stocks.

As for the CEF strategy, I still think it's fair to assume an average flat pricing over time, because CEFs are not known to grow their share prices over the long run. But I was curious if that was a fair assumption.

I looked at various stats on the average return for CEFs over the past 5 and 10 year time frames, which showed positive returns, but I realized those are poor statistics to use because they only include the recent bull market trend. I couldn't track the whole of CEF-dom back 50 years like the S&P, so instead, using my own portfolio of 20 CEFs, I tracked each fund's return since inception and averaged them out. My calculations revealed an average of -0.89% per year. Of course it depends on the particular mix of funds, but this leads me to believe that assuming a flat average share price over time is really quite reasonable. Even so, my new data set reflects a change in annual CEF share price of -0.89% in an effort to be more realistic about one of the dark sides of CEF investing.

OTHER ASSUMPTIONS WORTH NOTING FOR THIS ANALYSIS

  • Dividend growth is only on the original investment (new money does not buy the increase in yield)
  • Price growth is on both original investment and reinvested income
  • Reinvestment is once a year for purposes of simplicity for all three strategies. This differs from my previous study of reinvesting monthly for CEFs and quarterly for DGI, which was laborious at best
  • All extrapolations are based on a one-time investment of $10,000
  • CEF distributions do face periodic cuts, but the effect can be minimized by reinvesting income monthly and thereby building income faster to help offset any decreases. To lessen the effect on the study here, I assume that using annual reinvestment calculations will more closely resemble a real-life scenario of monthly reinvestment while absorbing any potential distribution cuts
  • I used the actual average current yield of my 20 CEFs for the comparison. That figure was 9.7% during my previous analysis, but has dropped to 8.97% as a result of the overall uptrend in market prices since then
  • For the DGI strategies, I used my previous figures of 5% yield/5% growth and 3.4% yield/10% growth for the standard and high-growth DGI strategies
  • I may have handicapped the comparison by adjusting the CEF strategy average down but keeping the DGI figures as they were before. I am aware of this, but because I don't participate in a DGI strategy, I can only take a stab at the DGI numbers based on what I've read from others. (As an aside, the initial income and price-change percentages can be adjusted in the data ranges. For a copy of the Excel workbook to play with the numbers, upload it here: compare_yield_growth_revisited2017.xlsx)
  • It is especially important to note that using long-term averages in a study like this makes shorter-term analysis problematic. Such analyses become more accurate the further out in time they go due to the nature of shorter-term market trends and the law of averages

INCOME AND GROWTH COMPARISON

The following table shows a summary of the data over 30 years. Using long-term return averages, the market value of the DGI strategies immediately outpace the CEF value right out of the gate (see high-lighted cells). However, I wouldn't hang my hat on these early figures because short-term scenarios could be vastly different and should be taken with a grain of salt. The figures after 10 or 20 years become progressively more in line with what could be reasonably expected.

New Comparison

(source: author's spreadsheet)

By the end of 30 years, the DGI strategies have far outpaced CEFs in investment growth.

The other key information to glean from this table is income: the CEF strategy stays well above the DGI strategies in income for the first 25 years. In year 26, the Hi-DGI strategy surpasses CEF income, but the standard DGI income never catches up at all.

Here is that same data in chart form for a better visual representation of the differences in income generated.

Income Comparison Chart

Now let's take a look at compounded growth in chart form

Growth Comparison Chart

(source of all charts: author's data in Excel)

For the shorter-term time horizons (around 15-20 years), the more typical DGI strategy is the winner for compounded growth. Longer term, especially by year 30, Hi-DGI is by far the strongest in compounded growth. By year 40 (not shown), DGI outpaced CEFs by over 41%, and Hi-DGI outpaced CEFs by a whopping 210%.

WHAT'S DIFFERENT FROM LAST TIME

In the previous study utilizing flat reinvestment prices, Hi-DGI income surpassed CEF income in year 16, and DGI income surpassed it in year 21. This time, the inclusion of increasing reinvestment prices pushed Hi-DGI's catch-up to CEFs out an extra 10 years, and DGI's out forever - in other words, DGI income never caught up to CEFs. The significant lag in income growth was rather surprising.

The data from my previous study also showed compounded growth of the Hi-DGI strategy reaching over $2.2 million by year 30, and standard DGI reached nearly $263,000. The growth chart of Hi-DGI exceeded the bounds of reason, and is what led to establishing a better premise on which to base the current study. Under the new paradigm, Hi-DGI reached a little under $330,000 in the same time frame, which is far more reasonable, and DGI reached a little over $238,000.

WHAT DIDN'T CHANGE

Closed-end funds clearly provide the best income for the first two decades, while Hi-DGI shows the best income beyond that. Both DGI strategies compound their growth much faster than the CEF strategy does.

SOME DIFFICULTIES AND CAVEATS OF THIS STUDY

  • Hi-DGI is probably a pipe dream over the long haul. I have a hard time believing that achieving 10% growth of dividends is sustainable long-term. Perhaps there are some very long-term Hi-DGI investors who have achieved this and can share their experience with us. I would really like to know. I am inclined to cast it aside for its lack of long-term feasibility.
  • Regular DGI seems to be a much more reasonable scenario and is likely much more sustainable long-term
  • CEFs will experience the occasional distribution cut. This must be mitigated by the investor's portfolio management strategy
  • All three strategies require periodic re-evaluation of holdings and occasionally trading up. Such portfolio changes will alter the numbers as well

CONCLUSIONS BASED ON THE NEW PREMISE

It's a bit humbling to eat crow over the faults in my previous study, but doing some more digging into the topic has taught me a lot about theoretical data analysis: It is very subjective and always requires a critical eye. One conclusion we can draw from this re-analysis is that even modest changes to the initial premise or to any assumptions made in a study can significantly alter a data set long term.

The study also showed me that broader conclusions can still be reached, or confirmed, no matter what inherent mistakes exist in the original theory. For better or worse, my original conclusions remain pretty much intact. The CEF strategy is still clearly the better income scenario for investors who are already well into adulthood, while a Hi-DGI strategy would be the ideal income-generator for younger investors with at least 25 years to invest. The DGI strategy beats CEFs by far in compounded growth, especially for investors with 30-40 years of investing in front of them.

As my regular readers already know, I still hold to the argument that because CEFs fare far better than DGI in income, they are much more likely to reduce the investor's need to deplete underlying positions to meet expenses in retirement. In this study, the typical DGI approach results in 1/3 the income of CEFs but almost twice the growth after 30 years. Growth can most certainly provide for retirement as long as it is sufficiently large enough. Unfortunately, depleting portfolio holdings will also deplete the dividend income, and that must be factored into any plan.

Analyzing the differences between these two sets of data revealed - or rather confirmed - to me that flat (or negative) price changes contribute positively to compounding income-producing shares and to the overall return on all portfolios. This makes market fluctuations much easier for the investor to ride out when compounding dividends.

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.

Additional disclosure: I am not an investment professional. Nothing in this article should be construed as investment advice. Please do your own due diligence before embarking on any investment strategy.

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