Why Dividend Investors Can Ignore Stock Prices

Includes: CL, CVX, JNJ, KO, MO, PEP, PM, T
by: Tim McAleenan Jr.

Whenever I write an article that discusses an investment strategy that exclusively focuses on buying companies at a reasonable valuation and then enjoying the growth of dividend income, I invariably get a response to the effect of "What kind of goofball does not focus on the stock prices and total net worth of his holdings?" Today, I wanted to discuss why it is possible to display a nonchalant attitude towards portfolio net worth.

First, I'd like to establish a premise that shapes the investment philosophy that many dividend growth investors may share. With the exception of high yielders like AT&T (NYSE:T) and some utilities, many dividend growth investors tend to target investments that offer a high probability of at least 6-7% annual dividend growth. You don't hear too many dividend growth investors chanting, "Yeah, Northwest Natural (NYSE:NWN) and its 3% dividend increases and 4% annual earnings growth. It's a Dividend Aristocrat, that must mean it automatically belongs in my retirement portfolio!" There's more discernment than that-many dividend investors look to build a portfolio that consists of the Cokes (NYSE:KO), Johnson & Johnsons (NYSE:JNJ), and Colgate-Palmolives (NYSE:CL) of the world that have long records of 7-10% annual dividend increases and appear poised to continue those traditions into the medium-term.

In other words, the ability and desire to construct a dividend growth portfolio that typically leads to dividend increases of at least 6-7% per year shifts the terms of the debate. When you can create a portfolio that meets that objective, it is easy why many dividend growth investors have a nonchalant attitude about the total net worth of their portfolio. Once you establish ownership in those types of companies, either direction in the stock price can be greeted as good news:

1. Let's say the stock price goes down. This is great news for the investor. If I owned 300 shares of Conoco Phillips at $50 per share and planned on reinvesting the dividends, I'd love to see the share price go down to $40. Why is that? Because when the $198 quarterly dividend check comes in, the $50 share price will only buy you 3.96 new shares to immediately generate $10.45 in annual income. But if you can reinvest at $40 per share, that $198 quarterly check would buy 4.95 new shares that would immediately generate $13.07 in immediate income. Anytime you're buying something-be it with a fresh cash investment or a dividend reinvestment-you will always acquire more ownership (and thus claims on future dividends and retained earnings) as the price goes down.

The best case study on this matter is the performance of the former Philip Morris (NYSE:PM) (NYSE:MO) from 1925 to 2003, in which 11% annual growth translated into 17% annual returns for investors due to the lower stock price. Because many of the market participants overestimated the earnings deterioration that would come from the restrictions and lawsuits related to tobacco, shareholders that chose to reinvest were able to do so at a lower price, thus turbo-charging returns.

If the earnings and dividends keep growing (and you plan on investing fresh cash or reinvesting dividends), then a lower price is your best blessing.

2. Of course, the stock price can go up. And if you have a portfolio of dividend growth stocks that regularly raise dividends by 7%, this is what will eventually happen in the long term. For instance, Chevron (NYSE:CVX) has increased earnings by 15% (and dividends by 8%) over the past ten years. If you buy a company that performs like that over a ten year stretch, do you really have to worry about whether the stock price will instantaneously follow? Of course not. In 2003, Chevron traded at around $35 per share and paid out $1.43 in dividends relative to $3.48 in earnings. Over the course of 2012, Chevron is estimated to pay out $3.51 in dividends relative to $14.40 in earnings (Value Line estimate). What do you think happened to the price over that period? Do you think that Chevron would still be trading $35 per share for a P/E ratio of 2.5 and a dividend yield of 10%? No, the share price rose over the long-term to adjust for the earnings and dividend growth.

I think this is why you see many dividend growth investors display a nonchalant, even cavalier, attitude about stock prices. If you adopt a long-term investing horizon and spend your time searching for dividend growth stocks that grow earnings and dividends by at least 7% or so per year, then you don't have to worry about stock price. If the stock falls, you get to buy more shares and lay a larger claim on future dividends and retained earnings. And if the stock price goes up, you have made money should you choose to sell. None of us can control the stock market, but we can try and craft a strategy that takes the whims of the stock market out of our lives. If you're a long-term investor and you focus on the earnings and dividend growth of your firms, then the stock price will eventually follow. The world isn't filled with Coke and Pepsi (NYSE:PEP) offering 10% dividend yields. The stock market has a way of transforming from a voting machine to a weighing machine over the long-term. That's why some dividend growth investors can be nonchalant about prices.

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

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