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Evaluating The Total Return Vs Dividend Growth Investing Argument

Many investors that focus on growth (or total return) believe that their approach is better because, as the argument goes, one can simply convert their portfolio to dividend paying stocks around the time they reach the distribution stage with essentially the same result. The DGI approach (which I prefer after conducting my own personal research), is focused more on total income generated (rather than total portfolio value/growth) through leveraging the power of compounding dividends over time.

This article looks at the two approaches (total growth verses DGI) using real data from my IRA and evaluates the results over several timeframes. Twelve years ago, I invested some money in one of the highest rated growth funds (Fidelity Growth Company Fund), as rated by Morningstar, which has held a five star rating as long as I can remember. I bought into the fund in 2002 when I converted a 401K to a rollover IRA after changing employers. My original investment in that fund was $8,114.23 on September 30, 2002. Since then, I've enjoyed 358% in total growth. My position is now worth $37,185 (about 4 ½ times my initial investment in only 12 years).

The following graph demonstrates that this fund is a top performer and has been for a long time. It has handily beat the performance of its benchmark indexes for growth over 1, 3, 5, and 10 years as well as life of fund.

I'm going to compare the results of purchasing the high growth fund with buying the same amount of stock in General Mills (NYSE:GIS). I chose GIS because it is one of the most highly mentioned DGI stocks and is considered a "steady eddy" among DG stocks. It doesn't have a high-flying rate of return but is consistent and pays 3%. I already know that my growth fund has significantly outperformed GIS (and S&P) since 2002 on a total value basis (without dividend reinvestment). What I intend to evaluate is the difference in income between holding GIS compared to holding my growth fund and later converting the money into a dividend paying stock such as GIS.

The following graph shows the 12-year performance of my growth fund (green line), the S&P (blue line) and GIS (lighter red and green line). As shown, my growth fund has significantly outperformed the S&P. GIS has fairly closely mirrored the S&P on the chart. The graph (generated on the Fidelity website) does not assume dividend reinvestment. Without reinvestment, the growth fund would have ended up with about 300% growth, with reinvestment, the results add another 50%. In the past year or two, the distribution payout of this particular fund has grown substantially, and appears to be about 1% last year; however, prior to about a year ago, the dividend payout was very minor - well less than 0.2%.

The FASTGraph dividend data, assuming I bought the same amount of GIS 12 years ago, is shown below. My current dividend income from this particular stock in 2014 would be about $770 (extrapolated based on the anticipated number of shares [~470] and dividend payment [$1.64/share] expected in 2014).

What income can I expect if I took the current money from my growth fund and converted it to GIS stock? The present day value of $37,185.61 would buy 679 shares of stock at the current stock price of $54.75. That, in turn, would generate $1,114 in income. That's a significant increase in income if I converted my growth fund today compared to investing the same amount in GIS 12 years ago, and does indeed demonstrate that, if you are lucky (or smart) enough to invest in some fast growing stocks or funds, you may come out ahead. However, it should be noted that I had good timing with my growth fund (actually, it was luck); I put my money into that fund right after the dot com bust, as you'll see below. Most growth stocks were significantly undervalued at that time!

Different Timeframes, Different Results…

What if we did this same exercise over a somewhat longer timeframe, for example 15 years? My investment in that same highly rated growth fund has gone up about 230% (due to the dot com bubble and bust). With dividend/earnings reinvestment (not shown on the chart), I'll round the growth fund up to a 280% increase. That means my $8,114 becomes $30,833. The following graphic shows the comparative performance (this time, GIS ends slightly ahead of the growth fund and both are significantly ahead of the S&P).

Using FASTGraph, I find that my dividend paycheck from GIS would be about $1,050. In this scenario, the present day value of my growth fund ($30,833) would buy 563 shares of stock at the current value of $54.75. That, in turn, would generate $923 in income. What a difference 3 years has made! Now my income is at least $100 less with the growth stock converted into a dividend paying stock. The difference in this scenario results from buying the growth fund before the dot com bubble and bust. Notice in the graph that that GIS was not highly affected in that timeframe; in fact, the price went down as the dot com bubble went up (reverse correlation to the peaks and valleys) and I believe that part of the reason was because investors, including fund managers, were jumping on the technology stock bandwagon. In my experience, this was certainly the case - quite a few funds that were supposedly "diversified" held huge amounts of technology stocks. The most egregious of the companies (and fund managers) practicing this was Janus (oh, yes, I remember it well - but I digress!). The other reason for the different income is the power of compounding from holding and reinvesting dividends in GIS is starting to kick in.

What about 19 years? (The upper limit on the FASTGraph tool.) This time, the growth fund outperformed GIS, but how about the dividends? The growth fund shows about a 350% increase and, with the dividend/earnings reinvestment, I'll round it up to 400%. In this scenario, my $8,114 becomes $40,570. The 19-year performance graph is shown below.

This time, FASTGraphs indicates that my annual income from GIS is about $1,500. If I convert my growth fund into shares, I'll get 741 shares, which will generate an income of about $1,200 (about 20 percent less). What happened? My favorite growth fund outperformed GIS, but my income after converting to the dividend fund is less! The answer is, of course, the power of compounding. Note that the dividend growth curve, shown below, begins to show a steep increase after 10 years and it really takes off after 15 years.

Conclusion

Although it is certainly possible to end up with a higher total return by focusing on growth during the accumulation phase, you need to substantially outperform the overall market to end up with the same income that a DG approach produces in the distribution phase because you lose the power of dividend compounding.

In the 12 year example, the growth fund significantly outperformed the "steady eddy" stock. However, in my opinion, the growth fund's momentum was fueled by the fortuitous timing of buying into the fund at the market bottom. Had I bought this fund two years earlier, at the height of the bubble, the results would have been very different, despite the fact that this is a very highly rated fund.

In the 19-year example, the growth fund still ended up with a higher value when dividends were excluded from the equation; however, with dividends reinvested, GIS came out ahead due to the compounding effect of dividend reinvestments.

Both approaches (total growth and dividend income growth) can be valid, but in order to achieve a higher dividend payout at the end of 20 years or more, the growth investor needs to have impeccable timing and skill to avoid the inevitable market downturns that occur, on average, once or twice a decade. What I'm observing in looking at the graphs over increasing timeframes is showing that, over shorter periods of time, a growth oriented stock or fund can definitely outperform the S&P or a "steady eddy" dividend stock, but with increasing periods of time, the ups and downs start to level out the playing field and the growth stocks/funds start to converge on the overall market performance.

While I'm not suggesting that growth investing is wrong, it's certainly wrong for me - I know that I am not smart enough to beat the market on a continuous basis and history has told us that even the best fund managers fail to outperform even the S&P over long periods of time. Additionally, if you look at the 19-year graph, it's apparent that GIS has a low volatility. In fact, it has a 3-year beta of just 0.26 compared to the growth fund beta of 1.17. With the DGI approach, I can sleep well at night and ignore the big peaks (and inevitable valleys) that are essentially the norm for growth stocks over the long haul. As for my growth fund, per my portfolio business plan that I wrote in February, I plan to sell it to convert the proceeds into DG stocks in the coming year. I am currently in the process of converting funds and ETFs into individual stocks to position myself for a reliable income during retirement, and I am using a DGI approach to accomplish that. At the time f this writing, I have converted approximately 1/3 of my portfolio.