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Can A Dividend Growth Portfolio Beat Index Funds?  Why That Is Not A Valid Question For A DGI.

|Includes: Advanced Micro Devices, Inc. (AMD), AMZN, GE, JNJ, KO, MON, NFLX, NOBL, PG, PGC, QCOM, TWTR, WDC
Summary

If you are a Dividend Growth Investor and you are concerned first about capital appreciation, then maybe you're not a Dividend Growth Investor.

While everyone loves capital appreciation of their portfolio, comparing your total return vs. an Index when you are a DGI is just silly and a waste of time.

Every stock has a total return component and ignoring that reality is a recipe for a strawman argument against DGI stocks.

Introduction:

In a recent article (and one that has garnered a ton of commentaries), the author known as "PendragonY" asks the question:  "Can A Dividend Growth Portfolio Beat Index Funds?"

You can read the article to look at the author's take on that question and you can scroll through the commentaries of others who have their own view, relative to the subject.

But, there is a major problem with most of the commentaries that follow the article's premise.

The comments don't stick to answering the question that was posed but instead head off like a bunch of rabbits who hear a dog barking and scramble down their rabbit holes.

What I Know:

There are basically three types of stock that investors can buy.

The first is a stock that pays no dividend.

These are generally referred to as "growth stocks" as the company retains earnings to reinvest back into the growth of the company. Examples of these "growth companies" are Amazon (AMZN), Netflix (NFLX), Twitter (TWTR), Advanced Micro Devices (AMD) and in the S&P 500 Index, a host of other companies.

The second is a stock that pays a dividend. 

But, that dividend can be irregular, relative to the dividend amount changing on a regular basis. Western Digital (WDC), Monsanto (MON) are two examples of stocks that paid a dividend, but had that dividend remain at a fixed dollar amount for some time. Then there are stocks that pay a dividend, but suspend the dividend, like Pacific Gas and Electric (PGC) or like General Electric (GE), that reduced their dividend.

The third is a stock that increases the dividend on an annual basis.

These are companies that comprise groups like the Dividend Achievers, Dividend Champions, Dividend Contenders, and Dividend Challengers. These stocks have a 5 year or greater string of paying and increasing dividends year over year. Examples like Coca-Cola (KO), Procter and Gamble (PG), Qualcomm (QCOM), and many others that you can find on this listing.

What's The Problem:

First, if you are a Dividend Growth Investor, your primary focus is on dividends and dividend growth.  You're investing for income first and capital appreciation second (if at all, since many DGI have a strategy of "never selling).  

So why would you be trying to "beat" and index where the primary objective is capital appreciation first and income second?

That makes no sense at all.

Second, most index vehicles (with some exceptions) contain a basket of stocks that are supposed to represent the index that is being tracked.  

That being said, when you purchase one of the more popular index funds, you are purchasing a basket of stocks that often hold all three of the basic stock types that I've mentioned previously in this blog.

The indexes that track the S&P 500 Index will hold stocks that pay no dividends at all, pay a dividend that does not grow annually, and hold stocks that are Dividend Growth stocks (stocks that increase dividends every year).

So, does the index even mirror your portfolio in the first place?  So my second criticism is that you are basically comparing "apples to oranges."

Third, let's say that you find an index investment vehicle that represents a DGI portfolio.

One that comes to mind is ProShares S&P Dividend Aristocrat ETF (NOBL).  This ETF buys stocks that are known as "Dividend Aristocrats" (companies that have a record of increasing dividends annually for 25 years or more) and that are members of the S&P 500 Index.

So, while a company might be a member of the S&P 500 and have a history of increasing dividends annually, unless the stock meets the 25+ year threshold, that stock is not going to be in the ETF.

Using NOBL as a comparison to your own DGI portfolio, then, is also an "apples to orange" comparison.

Fourth, the idea of benchmarking your portfolio against the performance of an index, is at best, like playing the game of "horseshoes."  

In that particular game, you don't have to hit the target, but getting close will earn you points.  Like the second game, "handgrenades", if the analogy of "horseshoes" is confusing to you.  Just get close.

What I Know:

I'm all for having a benchmark that compares your portfolio to something else.  The problem is that most of the comparisons don't really make a lot of sense, relative to a DGI strategy.

When I invest in stocks, I have a couple of "rules":

1.  I like to buy stock in companies that appear to be priced at a value to their intrinsic worth.

Not to long ago the oil sector stocks seemed like a good place to invest, since many of the companies in that sector had fallen out of favor with the market.

2.  I like to buy stock in companies that have at least a 5 year history of annual dividend increases.

That does not prevent me, however, from buying stock in companies that do not have a 5 year history or that are not even DG stocks.  One that comes to mind is Western Digital (WDC) that I bought in 2016 and sold in 2017.

3.  I like to buy stocks that have a history of increasing their dividends at a rate that is greater than inflation.

Now, mature companies that have been increasing dividends for a long time, often begin slowing down the rate of their dividend increases.  So, making changes to the holdings within the portfolio, for me, makes sense, relative to that particular objective.

4.  In my tax deferred accounts, where I am not currently drawing the income from dividends to supplement my Social Security, I reinvest the dividends back into the companies that paid them.

While a lot of investors choose other strategies, like accumulating dividends and then using that accumulation to purchase a different company, I don't do that.  

In my opinion, reinvesting the dividends back into my stocks, over the long haul has given me better (and I use this term with some reservations) better total returns, but more importantly, larger share counts, which in turn produce more dividend income.

Take a company like Johnson and Johnson (JNJ) for example.  An investment made in 1984, purchasing 50 shares of stock would have grown to $111568 today, without dividends being reinvested.  Those dividends were paid, but used elsewhere in this example.

The second line shows how those 50 shares would have grown to $184,149 today, with dividends being reinvested along the way.  The difference in the two strategies, is $76581.46 dollars.

Now, you might argue that you would have gotten the $76581 in dividends and reinvested that money back into other stocks which performed just fine and dandy.

But you didn't get $76581 in dividend income from your 50 shares of JNJ stock.  You got much less than that because the reinvestment of dividends gave you more shares of JNJ (549 more shares, to be exact) and each one of those additional shares provided you with larger dividend income payments as those shares accumulated, year over year.

The current dividend for JNJ is $3.60 a share.  The 800 share position will get $2880 in dividends, while the 1349 share position will get $4856.40 in dividend income ($1976 more and 68% greater).

Summary And Conclusion:

Dividend Growth Investors often allow themselves to get caught up in total return arguments.  It's easy to fall into that "trap" because most people want to argue that their DGI stocks throw off total return numbers that are good numbers, relative to inflation or any other measurement you want to use.

Those same investors like to argue that their total returns are great, but is that the primary focus of the DGI strategy?  No, it's not.  It's a byproduct of the strategy and not the end game.

I would suggest that exploring these kind of questions is "fun" for some people, but the process is so flawed that sometimes I have to be ashamed of allowing myself to fall into that trap.

The important component to this "debate" is first, identifying what you are trying to accomplish with your investment strategy and then benchmark with a comparative that makes sense.

For me that is a dividend growth stream that exceeds 6% annualized.  Why?  Because if I achieve that end, my dividend income will double every 12 years (see The Rule of 72).

That's something that will never happen with my other source of income, Social Security.  Ever.

Keep things in perspective to your investment strategy and stop chasing rabbits down some random hole.