DGI Lesson 9: My Top 14 Reasons Why Dividend Growth Investing Makes Sense

So far, this series of lessons about dividend growth investing has focused on specifics:

For this lesson, we’re going to take a step back and consider broader questions:

  • What are the advantages of being a dividend growth investor?
  • What is there to like about dividend growth investing?
  • Why should anyone do it at all?

My real-money Dividend Growth Portfolio that is updated every month here on Daily Trade Alert is comprised entirely of dividend growth stocks. In my personal life, both my rollover IRA and my wife’s and my taxable investment portfolio also contain only dividend growth stocks and ETFs.

Why do we invest that way? Why are we essentially all-in with dividend growth investing?

Here are my top 14 reasons why I’m a dividend growth investor.

1. Dividends bypass the market

Market prices and dividends have utterly different mechanisms for converting corporate earnings into cash in your pocket.

“Mr. Market” translates corporate results into market prices. Here is Warren Buffet’s timeless description of Mr. Market.

[Y]ou should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business.  Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and he can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market…doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option.

In short, Mr. Market sometimes goes haywire and takes stock prices through irrational swings that have nothing to do with long-term business performance.

On the other hand, companies themselves determine dividends. Dividends are declared and paid by corporations, not the market.

Corporate dividend policies rarely go haywire. That means that it is possible to build a portfolio of companies that will have reliable, growing income – no matter what the market is doing.

I like that. It suits my goals and my temperament.

2. Dividend investing can relieve obsession over the market

Many dividend growth investors find that the strategy lifts a great worry off their shoulders.

In DGI, you profit from being the owner of a business that sends you some of its earnings each quarter. You don’t regard stock shares as betting slips or lottery tickets.

Rather, shares are income-producing assets. You own pieces of your businesses, sharing in their success over the long term.

You don’t care so much about the daily prices offered by Mr. Market for your shares, any more than a gas-station owner thinks daily about what he could sell his business for. That helps dividend growth investors take the market’s ups and downs in stride.

In DGI, you do not have to win trading battles against other investors to be successful.

3. Dividends are real cash

Every dividend is a positive return to shareholders. It’s cash in your pocket. Dividends are completely transparent and immune from accounting manipulation or trickery.

4. Dividend investing provides ongoing feedback about your investment

Because most dividends are paid quarterly and determined by corporate management, they provide feedback about your investments directly from the companies themselves.

If a company pays and increases its regular dividend according to an established schedule, that in itself is important information about how that company is performing as a business. You own a piece of that performance.

A dividend increase can usually be interpreted as a positive sign that management has confidence in the company’s prospects. As the saying goes, the safest dividend is one that’s just been raised.

A company with a well-designed dividend policy will look ahead a few years when considering each year’s increase to see what it can afford, because it knows that an increase is destined to become permanent under its dividend policy. The company won’t knowingly bankrupt itself by paying imprudent dividends, so an increase is usually a good sign.

5. The best dividend growth companies are outstanding businesses

Dividend growth companies typically have:

  • Proven, time-tested business models
  • Steady growth over long periods of time
  • Sustainable competitive advantages
  • Solid balance sheets
  • The strength to survive recessions
  • Good profit margins
  • Reliable cash generation
  • Low debt

It requires an outstanding business to increase dividends for many years in a row. Weak businesses simply cannot do it.

6. Dividends increase even when stock prices decline

Even when a dividend stock’s price is falling, it still has a positive return component via the dividends.

For example, below is a 15-year chart of Johnson & Johnson (JNJ). Notice how the dividend (blue line) has continued steadily upward, with annual increases, while the stock’s price (orange line) has gone up, down, and sideways.

From 2005-2012, JNJ “traded sideways.” That was Mr. Market talking, and it did not reflect the success that JNJ was having as a company.

Many price-obsessed investors considered JNJ to be “dead money” for nearly a decade. Dividend growth investors never saw JNJ as dead money. We saw the blue line of steadily increasing dividends.

Here’s another chart, from FASTGraphs, that depicts the same timeframe. JNJ’s price is the black line, while its dividends are the greenish line.

The reason I chose this 2nd display is to show you JNJ’s annual earnings growth. It’s in the data row near the bottom set off by blue dots at each end.

JNJ’s earnings went up every year during its “dead money” period. In 2005, for example, JNJ’s earnings per share (EPS) rose 13% while its price fell. If you look across that row of data, JNJ’s earnings rose every year.

Yet its stock price, determined by Mr. Market, was essentially flat from 2005-2012, before finally taking off in 2013.

Both dividend growth and price growth come from a common source: profit growth. Mr. Market, being irrational, often misinterprets a company’s operating results, causing its price not to reflect its profits.

But the company’s management and board – who make all decisions about dividends – can execute a managed dividend policy. They deliberately smooth out the flow of dividends compared to the variations in the company’s earnings. That’s what happened in JNJ’s case.

If a company is committed to annual dividend increases, they can make those happen, even if they hit a bad patch for a year or two on the earnings front.

That’s why JNJ’s dividend growth more resembles its earnings growth than its market price does. JNJ’s management, knowing that they had a rock-solid company with a positive long-term outlook, increased the dividend every year under their managed dividend policy.

7. You do not have to sell the stock to get financially rewarded

If a stock pays no dividends, its total return comes solely from price changes. You can only realize your profit if you sell the stock. There is no other financial benefit from ownership.

A problem with confining your returns to stock prices is that they are determined by Mr. Market, and we know that he’s sometimes irrational. What if you need money and must sell some shares at a time when Mr. Market is depressive? That’s a real concern for investors.

In contrast, a carefully selected portfolio of dividend growth stocks is pretty reliable about its dividend returns.

Critics of dividend investing sometimes state that “a dollar is a dollar,” so what difference does it make if you get a dollar from dividends or a dollar from selling a few shares?

The difference is obvious. In order to get your hands on a dollar of capital value, you must sell shares. Your wealth is embedded in those shares.

Once sold, the shares are gone. They can no longer benefit you, because you no longer own them.

So the huge difference between getting a dollar from dividends or from capital is that you still own the shares in the first instance and don’t own them in the second.

8. Dividend payouts rise over time

Hundreds of dividend companies have a long history of increasing their dividends regularly. Companies such as McDonald’s (MCD), Coca-Cola (KO), and Johnson & Johnson (JNJ) have increased their dividends every year for decades. It is logical to expect that they will continue to do so if they possibly can. (Disclosure: I own all 3 stocks.)

Here is a 10-year chart of those 3 companies’ dividends. To a dividend growth investor, this is a thing of beauty.

Reliable, growing income is the most powerful aspect of dividend growth stocks.

  • It is why dividend growth investors are often content with stagnant stock prices.
  • It is why retirees – seeking income that keeps up with inflation – become attracted to dividend growth stocks.
  • It is why many income investors consider dividend growth stocks to be more attractive than bonds, whose yields are fixed and whose payouts never go up.

9. Dividend stocks tend to be less volatile

A variety of studies have shown that stocks with a history of increasing their dividend each year have less average volatility than non-dividend-paying stocks.

For instance, over the 10-year period ending in 2015, the S&P 500 Dividend Aristocrats — which are stocks within the S&P 500 that have increased their dividends each year for the past 25 years — produced 7% less volatility. (Source)

If you haven’t perfected the ideal attitude of ignoring Mr. Market’s daily price quotes, the smoother price ride generally makes dividend growth stocks easier to hold during times of market volatility.

Dividends have gentle trends that are fairly predictable. For that reason, dividend growth stocks tend to attract owners who are less likely to panic-sell shares when the stock’s price drops. That cadre of long-term owners helps to dampen the price volatility of such stocks.

Indeed, such owners may take advantage of bargain prices to buy more, helping to counteract the prevailing trend in the market.

10. Historically, dividend growth stocks have outperformed the market in total returns

Numerous studies have shown that dividend growth stocks have outperformed the broad market in total returns. The studies differ in their methodology and timeframes, but the similarity in their conclusions is overwhelming.

One such study was published by Robert Arnott and Clifford S. Asness, “Surprise! Higher Dividends = Higher Earnings Growth, (December, 2001). This study suggested that in companies that paid out a low ratio of their earnings as dividends, one often saw inefficient empire building, the funding of second-rate projects, and poor internal investments. These money-wasting companies delivered poor subsequent growth.

In contrast, in companies with a higher percentage of earnings paid out as dividends, the authors found more carefully chosen projects with better returns.

A strong dividend program suggests that management is probably making smart decisions with the cash remaining after dividends are paid. Some companies squander their retained earnings. In the best dividend growth companies, management is disciplined about projects, acquisitions, and costs. The result is a more efficient and focused business.

The Ned Davis Research Group has had an ongoing study of dividend stocks since 1972. Their results show that dividend growth stocks have dramatically outperformed other categories of stocks in the S&P 500 over long time periods.

(Source)

11. You can reinvest dividends to accelerate the compounding effect

Shareholders can do three things with dividends: Reinvest them, keep them, or spend them.

As we explored in Lesson 5, if you reinvest the dividends (either in the same stock or elsewhere), the reinvestment brings into play a second layer of compounding. (The first layer is the rising dividends themselves.)

Dividend reinvestment builds wealth at an accelerating pace. Your share base grows faster and faster because of the reinvestments. As you purchase more shares with the dividends, the number of shares you own goes up. Those shares then generate additional dividends, which can then be reinvested, creating a virtuous circle of dividends reinvestment more shares more dividends, etc.

12. Rising dividends protect against inflation

One of the risks that we all face is inflation. Inflation erodes the purchasing power of money over time.

My own studies have shown that the income from dividend growth stocks generally grows faster than inflation. Speaking personally, sometimes I think that the only benchmark I care about as an investor is inflation. I don’t care so much whether I beat the market so long as I beat inflation.

13. You do not need any more wealth to generate 4% income rather than 4% from sales

One of the rules of thumb in retirement planning is that a safe withdrawal rate in retirement is 4% of your assets in Year 1, incremented each year afterwards for inflation. Back-tests show that in most cases, you’ll never run out of money, even in a really long retirement.

It is also commonly stated that to live on income alone in retirement requires a lot of money, more than if you sell off assets to create retirement “income.”

That second part is a myth. It requires no more money to acquire a portfolio of stocks that pays a dividend stream of 4% than to acquire a portfolio of stocks that must be sold piecemeal to generate the exact same 4%.

The point that 4% of organic income from dividends equals 4% of synthetic “income” from selling assets seems obvious, yet it is missed by many. It’s the same number! And you don’t have to sell shares to get it.

Even if your portfolio does not yield 4%, and you do sell some assets to fund your retirement, every dollar that you get from dividends reduces by a dollar how much you need to sell. The natural, organic income from dividends increases the safety and longevity of your portfolio.

14. Receiving dividend increases is like investing more, except you don’t have to invest more

An investor can look at buying an income-producing asset as “buying income,” as if income were a product that you got off the shelf at a store.

Here’s what I mean. Say you want $1000 per year in income. If you find a bond yielding 3%, that income will cost $33,333. The equation is income = principal x yield. Solving for principal, we need to invest $1000 / 3% = $33,333 to buy that income from that bond.

Because bond interest stays flat for the term of the bond, if you want more income, you have to invest more money.

With dividend growth stocks, you don’t have to spend more money to get more income.

The scenario might start off the same. If you have a stock yielding 3%, it will cost $33,333 to buy $1000 of income from that stock, just like the bond.

But that is just in the first year. When your stock increases its dividend next year, your income goes up. It is as if you invested more in the stock, but you did not have to.

Let’s use Johnson & Johnson as an example again. I first bought JNJ in August 2010. Here is my dividend experience with the stock since then.

As you can see, I have received 8 annual increases from JNJ. They raise their dividend in April each year. During the nearly 8 years I have owned JNJ, my income from them has increased 67%.

In the bond example, assuming you could find a bond on the same terms as the original one, in order to get 67% more income, you would have to invest an additional 67% on top of your original investment.

But with JNJ, to get that 67% increase in income, I have not had to invest anything more. I got the 67% increase simply by owning JNJ. The company made the decisions to increase the dividend each year. As we have seen, the market had nothing to do with those decisions. And as an owner, I didn’t have anything to do with them either. I simply had to own the stock.

Bonds don’t do that. Each bond payment is the same as the last one. That’s one of the big differences between loaning your money to a company and owning a piece of the company. As a part-owner, you get to participate in the company’s ongoing success without buying additional pieces of the company

So these reasons are why my wife and I are all-in on dividend growth investing.

Key Takeaways from this Lesson

  1. Dividends bypass the market. Companies with managed dividend policies smooth and increase their dividends to reflect long-term earnings performance. They make these decisions independently from what the stock market is doing to their share prices.
  2. Dividend growth investing can help relieve stress over market drops, because focusing on your rising dividend stream diverts focus away from price fluctuations. In addition, many dividend growth companies are less volatile than the market, because their price changes are dampened by the dividends, and they often have more committed owners.
  3. The best dividend growth companies are outstanding businesses. Mediocre firms simply cannot maintain long streaks of annual increasing dividends.
  4. You don’t have to sell stock shares to get the dividends. The companies send you dividends in cash, and you still own all your shares of stock to provide future returns.
  5. Rising dividends help protect against inflation.
  6. With dividend growers, you don’t have to invest more money to get more income each year.

Dave Van Knapp