I Like Dividend Growth Stocks Because The Market Is NOT Rational

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Includes: AAPL, AMZN, GOOG, GOOGL, HRL, JNJ, MMM, SJM, SPY
by: Brian Soule
Summary

This past Friday the market reacted rather neurotically to two pieces of news.

By concentrating on the amount of dividends my portfolio is generating I don't worry as much about the wild swings in prices.

Owning dividend growth stocks and counting my money as it comes in allows me to sleep rather well at night as well as helps me slowly and steadily grow rich.

Friday was a perfect example of why I believe dividend growth stocks are the way for me and my family to achieve financial independence. On Thursday May 9th, the Dow Jones Industrial Average closed at 23,950. President Trump tweeted early Friday morning regarding trade talks with China and the futures plunged 150 points and by 11:00 AM the S&P 500 was off 1.5%.

Around lunchtime Treasury Secretary Steven Mnuchin called the trade talks with China "constructive" and the markets started heading back up.

At 3:14 PM President Trump again tweeted, this time that the "United States and China have held candid and constructive conversations on the status of the trade relationship between both countries" and the market spiked before finally settling down a little bit but the Dow Jones Industrial Average finished up 114.01 points. A 358 point swing in the Dow from the intraday low around 11:00.

Take a look at the one day chart of the SPDR S&P 500 Trust ETF (SPY) below, courtesy of Seeking Alpha. You can almost see when the news broke based on how the markets reacted:

S&P 500 Daily Chart May 10th

Why Dividend Growth Stocks

Do you know what happened to my dividends projected for the next 12 months based on the President's tweets or Secretary Mnuchin's comments? Nothing. My projected dividends did not go down 1.5% and then back up (though that would have been OK...). But no! No that would have not been OK. The reason I have settled on dividend growth investing as the best path to financial independence is because nothing changed. My future retirement income did not go up and it did not go down by anything the President or Treasury Secretary said on Friday.

There are several advantages to dividend paying stocks and specifically dividend growth stocks. Allow me to enumerate them:

1. Dividends Account for Much of the Total Market Returns

Total return from any stock purchase has to consider both capital gains and dividends. You would take the total cash received from the investment after you sell the stock compared to the amount of cash you initially invested. So:

Definition of Total Return

Obviously part of the total return of a dividend stock includes the dividends the stock has paid you while you've owned it. Growth stocks, for the most part, do not pay dividends. So the total return of a growth stock is entirely based on capital gains.

Let me provide an example of a traditional but relatively unloved dividend growth stock, namely J M Smucker Co (SJM). Smucker's is a Dividend Challenger having raised their annual payout for 21 straight years. As I write this they have a dividend yield of 2.7% and for the last ten years have raised the dividend by an average of 10% per year. That is an excellent track record. The stock price has also performed very well these past ten years.

You could have bought SJM at the market open of May 11, 2009 for $40.32. You could have sold it at the open this past Friday for $125.85. That is a spectacular return, your money would have more than tripled. If you had bought 100 shares in 2009 you would have made $8,500 on your initial $4,000 investment. But that is not the end of the story. You also would have made almost $2,400 in dividends.

Out of a total return of almost $11,000 the dividends paid would have accounted for about 22% of the total return. If you think about it, you would have made nearly 60% of your initial investment back from just the dividends you were paid. And don't forget that in this example you would have received your first dividend, which would have been $35.00, the month after you bought the stock. If you had reinvested the dividends the total return would have been that much more impressive.

And 22% of the total return is not an anomaly, in fact historically speaking that is a low percentage of total returns. In a brilliant paper by Dr. Ian Mortimer and Matthew Page, CFA we see that from 1940-2010 dividends have accounted for more than half of the S&P 500's total return.

During the 1970s, where your total return on an investment in the S&P 500 would have "only" been 76.9%, dividends made up more than three quarters of the total return. During the 1990's when the "tech bubble" was being inflated, dividends accounted for a much smaller percentage of the total return, roughly one quarter.

2. Management of a Dividend Paying Company has to be Very Disciplined

If a company has a long history of paying dividends the likelihood that this will continue is very high. In fact, companies (really the boards of directors) are loathe to even temporarily "freeze" a dividend because of the signals that sends to shareholders and the broader investing community. These people generally own a fair amount of stock themselves (and by "fair amount" I mean more than you or I could ever dream about) and do not want to see their personal portfolios decimated.

But anyway, companies that I like to invest in must first determine the dividend for the coming year. Then they can plan on a certain amount of their free cash flow being used for dividend payments and then carefully determine what the remaining free cash flow will be used for. They must be thoughtful and disciplined when planning capital expenses so that the following year the dividend will remain safe and can grow to the extent shareholders have become accustomed to.

3. No Matter what Happens you Get Paid

Cash Image Credit

As I mentioned in the opening, dividends don't care what the President says, or how trade talks with China are going. I am as close to 100% certain as I can be that sometime this week 3M Co (MMM) will declare a $1.44 per share dividend payable sometime in the 2nd week of June. Even though MMM shares have taken a beating in the past few weeks their payout ratio is such that I can be this confident and that allows me to sleep quite well.

Sure, my dividend growth stocks (most of them) ended the week down and most of them rallied with the rest of the market on Friday, but this week I'll be receiving my dividends from Apple Inc. (AAPL), from Hormel Foods (HRL), and from a couple other dividend growth companies at the same (or higher) rate that I did last quarter.

Could a company slash or suspend their dividend in times of great economic crisis? Sure, and that has happened. But that is why I look at two things before I buy any stock. The first is the number of years a company has been paying and growing their dividend. One of my favorite stocks is MMM. They started paying a dividend in 1916 and have never stopped. They have also raised their annual payout for 61 straight years. This gives me confidence that the management is disciplined and prudent with their cash.

The second thing I always check is the payout ratio, which is the percentage of free cash flow the company generally uses to pay the dividend. If the payout ratio is 50% or less, I feel very confident the company can not only pay that dividend out of available cash flow but can also afford to raise the payout each year.

4. Dividend Growth Compounds

Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.

~commonly attributed to Albert Einstein

Let's continue with the example of MMM. If you had purchased 100 shares of 3M at the open on Monday May 11, 2009 you would have received $51 in June. In June of 2015 you would have received a dividend of $102.50 (assuming you did not reinvest your dividends). Next month, June 2019, you would receive $144, almost triple your first dividend payment.

I think we all understand the power of compound interest, but you should also know that the same principle works when a company increases their dividend each year. Some companies simply add a penny or a fraction of a penny to their quarterly payout but some companies like Johnson & Johnson (JNJ) tend to raise theirs at a relatively constant clip, like 5-7% per year. These are the stocks where the compound interest really starts stacking up and owning them is very, very rewarding.

A lot of dividend growth investors like to calculate a measurement called "yield on cost", meaning what is the investment now yielding on your original cost, not on the current value. In other words, if you purchased $1,000 worth of stock that paid you a $30 annual dividend the yield was 3% when you bought it. If the stock is now worth $2,000 and pays you a dividend of $60 the yield is still 3%, but your "yield on cost" is now 6% ($60/$1,000).

What does this look like with our hypothetical investment in MMM we made ten years ago?MMM yield on cost

We buy the stock in 2009 for $5,941 for 100 shares. The yield at the time is 3.4% based on an annual dividend on $204.

Coincidentally (or not - see point 6) the yield with the current annual dividend at the price as of the open on Friday is 3.3%. The dividend has almost tripled but so has the stock price.

Ah, but you have only invested the $5,941 and you are now getting almost triple the cash you were getting in 2009. Your yield on cost is $576/$5,9741 or 9.7%. You are earning 9.7% on your initial investment, and next year it will exceed 10% when MMM in all likelihood raises the dividend for a 62nd straight year.

5. Dividend Growth Stocks vs. Fixed Income

Well if you are looking for income (which I am) why not just buy bonds or CDs and then you don't have to worry about the stock price? There are several reasons.

First, the most exciting thing about dividend growth stocks to me is the fact that next year my dividends are going to be higher than they are this year. Assuming I don't buy any more shares of MMM in the next year, which is probably not a good assumption, I would earn $40.80 at the previous dividend rate. This year, starting with the new rate this spring, I will earn $43.20. Not a lot of money, no. But multiply that by 25 or 30 stocks, and then consider I probably won't own just the 30 shares of MMM, I'll probably add a little more here and a little more there. It all adds up.

Compare that to bonds. There are two new issues for Verizon Communications Inc. (VZ) bonds that I can see today (May 13th). One of them is a 3.250 coupon and the other one is a 4.000 coupon. I don't know the difference. I don't pretend to be a bond expert, not even close. What I do know is that if you purchase $1,000 of the 4.000 coupon bond you would receive $40 per year in interest. I also know that this particular bond matures in 20 years and you will receive $40 per year every year for 20 years.

At the end of those 20 years you get your thousand bucks back. Compare that to MMM, where similar numbers would be you would get $40 your first year, maybe $42 the second year, $45 the third year, $49 the fourth, etc. And at the end of the tenth year (not twentieth) you could sell the stock for $3,000 instead of your $1,000 bond principal you would still have.

Of course you could lose your shirt, which is what the risks are in equity investing. You want the greater reward which is why you take the extra risk. Of course you could also lose your shirt in bond investing if the company goes belly up. But that is why it is crucial to be diligent in your homework in any investment. Research the company well, make sure you understand how the company makes money and what the external risk factors are. Make sure you are comfortable with the amount of leverage the company has taken on. Read or at least skim an annual report. Listen to an earnings call or if you can't do that read the transcript. There are many things to consider and you need to research each company you purchase so that you are comfortable with being a part-owner.

One more thing.

6. Dividend Growth Stocks Have Outperformed the Market

Stocks that raise their dividend in general tend to go up at close to the same rate as their dividend increases. We saw in the case of MMM the dividend yield from 10 years ago was nearly identical to the dividend yield as of Friday May 10th. But both the price of the stock and the annual dividend were nearly triple what they were ten years ago.

This is not a surprise and you can see this story played out over and over again with many of the dividend growth stocks that I have talked about in my articles. This article shows the exact same thing with two other dividend growth stalwarts.

But other stocks go up despite not paying a dividend, right? Of course there will always be the Amazon.com Inc. (AMZN) and Alphabet Inc. (GOOG) (NASDAQ:GOOGL) out there that have provided spectacular returns over the past decade. But as a class of stock, dividend growers have simply outclassed all other stocks over the long run, and it's not really close.

Source

Conclusion

I mentioned at the outset that I feel dividend growth stocks are the perfect vehicle for my family to achieve financial independence. I hope that the above six reasons showed you why I feel that way. It is possible that dividend growth stocks are not right for everybody. And in fact, they are not the only asset class that I am investing in for our future. I own several fixed income investments, because I feel it is wise to have that kind of bedrock in your portfolio. In case the equity markets get crushed your bonds and commercial paper remain relatively stable and allow you to sleep at night.

We also own real estate, not just our house but the fetching Mrs. Soule and I have a rental property and some after tax money invested in a small (tiny) portion of some apartment buildings that pays us each quarter and the value of the investment doesn't really move much if at all.

But I fully believe that the dividend growth stocks that I own in my IRA rollover account and in my Roth IRA are going to be what allows us to comfortably retire to a life of extensive travel, countless tee times, and the financial means to continue enjoying the "good life" well into our golden years.

Best of luck to you all, and if I have missed anything or if any of you have another reason why you love dividend growth investing I would love to hear it in the comments. If you like what you have read please check out my other articles and don't forget to click "follow" so you can read more of my writing. Thank you, and happy investing!

Disclosure: I am/we are long AAPL, HRL, JNJ, MMM, VZ. 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.