Dividend growth investing, or DGI as it is often known, is a popular strategy for investing in stocks that receives immense digital ink on investment websites like Seeking Alpha and other places retail investors congregate. I think the main reason that it is so popular is that it is a strategy that works for retail investors in that it can be put into practice without too much effort and without requiring huge amounts of research. I have generally found it sort of lazy, even as I have considered the importance of dividends in my own investing. I realize that there is much value in the approach, it is the writing that is lazy - a source of poorly researched clickbait. So, I want to give it a fuller and fairer treatment here on my own personal blog.
Depending on how you count them, DGI has three (four) major virtues as an investment strategy.
The first is that it is long term. I have heard several investors argue that in spite of considerable efforts by folks like AQR to reduce alpha to the impact of a set of factors, that duration - a willingness to simply let an investment strategy compound for long periods, cannot be deconstructed in this way. At a minimum, long term as in any form of buy and hold, minimizes transactions and therefore minimizes fees, which is always helpful.
A second factor, which is related to the first is that having a long term orientation of this kind pushes the investor towards QUALITY. Dividend paying firms - particularly those that are able to raise dividends regularly, are firms that are going to generate stable and recurring cash flow far in excess of reinvestment requirements. They will generally have considerable ability to apply leverage to goose returns and to do deals, minimizing the amount of equity that has to be held on the balance sheet - capitalizing on the (often unrecognized) goodwill.
Third, I think dividends, and particularly dividend growth, enables the investor to ride out periods of market volatility, or indeed just the normal up and down of the price cycle, because of a psychological "stabilizer" that is the history of rising dividends. It is so much easier to ignore the current price of a stock when looking at your gain / loss or cost basis, you get to watch a history of rising dividend payments stretching back unbroken to your first purchase. For myself, I can say that one of my long term holdings, Colgate (CL) does this for me. It was a large position when I started, and has gotten smaller as some other investments have grown faster, and as contributions have been allocated to other things, and yet, the value has increased dramatically since I bought it 15 years ago, with the dividend stream rising 5x (I DRIP dividends on CL). It is so much easier to look at THAT trend and ignore the "noise" in the price signals in the daily market moves of the stock. If CL is able to increase dividends by another 5x over the next 15 years and 5x in the 15 years after that, I will have dividends 125x my first dividend payment and will receive quarterly about 75% of what I invested. Sure, that will have taken 45 years, but so what? Would $4k invested in Social Security be worth $12k in annual pensions 45 years later? This is the power of long term thinking. There is no guarantee of course, that CL can continue to extrapolate dividends at this rate. For one thing, dividend growth there has slowed considerably in the last few years as slow top line growth has caught up with the company. The former CEO used financial leverage and engineering to keep the dividend rising, but the new CEO wants to derisk and is slowing dividend growth. Anyway, the previous CEO found that he had to do the same in the end, lest the payout ratio rise too high.
This sort of equanimity is possible because of the fourth factor, which is that dividends are valuable not so much because of the change in the duration of returns (which is the way that most academic financial writers talk about it: as risk reduction. The real benefit is that you have a source of return other than the market itself which makes you less dependent and less interested in the market volatility. Receiving your return internally - paid by the operations of the business - makes your stock much more akin to a bond. One without a fixed maturity, admittedly, but a perpetual bond is an attractive investment in many cases, particularly if there is an inflation kicker. It tends to moderate the market swings, too.
Given this, I think there is no reason to discourage this approach. In fact, I think it is an entirely reasonable way to build a portfolio of above average quality businesses while reducing market sensitivity over time and experiencing solid compounding as one gets the chance to reinvest dividends to acquire more shares.
Particularly if one pays especial attention to the price paid, some dividend stocks can offer truly excellent rates of return and the ability to purchase a long term income stream at very attractive prices and thereby lock in considerable retirement (or extra investing) income for prices that could not be purchased any other way. I wrote about this in an article about BAC, answering a comment from a Seeking Alpha article. A commenter was trying to understand why so many BAC shareholders were rooting for continued low prices (enabling faster and larger buybacks and therefore faster long term dividend hikes).
WHAT I DISLIKE
My problem with this approach has less to do with the theory or even the mechanics than with the commentariat on the topic. All too often dividends history serves as a substitute for fundamental research necessary to estimate the sustainability of those same dividends. In this way, it focuses its adherents on the capital account, rather than business fundamentals, as a means of evaluating the investment and this is not a good way to think.
The most common way of doing this is to have people look at questions of sustained dividend increases by selecting names from a list of Dividend Aristocrats. To the extent that this is a list that identifies quality (you have to have a good business to be able to raise dividends consistently over very long periods) and a management priority to provide a return via dividends, it is a good place to start. But when the discussion is about how many years the investor "require" to be a good investment I think it overlooks the not small probability that some long-running dividend payers can suddenly find themselves in tough going. Often these are mature tech companies, but we see it in other firms as well.
The worst sort of articles are those that focus on the yield. All to often these are really retiree clickbait, like discussions of REITs or MLPs. The emphasis all to often is on the tax implications of dividends - low taxes, or almost always issued with smugness, an idea that "return of capital" accounting provides the owner with some way to screw over the tax man. These sorts of discussions, where the author is putting the cart before the horse, focusing the reader on easy to understand things, make me crazy.
In few cases are they writing about how DGI darlings are capitalized - how many articles were written by the DGI crowd explaining how the large yields they were receiving were an indication of the instability of the firm's capital structure, analyzing how it sought new investment through net share issuance while sustaining a high yield because that yield provided access to capital markets in the form of yield hungry investors?
My problem, in short is less DGI itself - though it tends to put the investor into mature firms, these can still produce excellent returns (look at SPGI, which I purchased in Feb of 2012) - the problem is with the way that the writing inevitably ignores or elides important considerations, aimed as it is on retail "investors" with limited experience or skill evaluating business quality or prospects.
Mostly, I fear this is a result of two or three factors: first, there is an element of the blind leading the blind in this area. The analysis is superficial because it is written for people with limited knowledge and understanding by people with only slightly less knowledge and understanding. (The Dunning Krüger effect runs deep in this set). Second, the audience is one that lacks a more sophisticated toolset for some of the more important analysis - introducing lots of information that requires frameworks the reader lacks to be intelligible is basically unhelpful. At best it leads them to conclude they don't know what to make of it. This is not popular, though which leads to the third factor. Many of these articles are written not to be thoughtful and thorough, but to fast and provide lots of clicks. Quantity is much more important in building audience (brevity, at which I am hopeless, also helps), and so the nature and content of these things is set up to get people reading the material.
DGI then, is a solid strategy I believe that can help an investor focus on the strategy - the long term approach that they are taking and helps tune out the noise associated with stocks of "infinite" duration. In the end, the basic problem is that it is a hermeneutic that is too often used as a shortcut that short circuits the more difficult analysis that are required for fundamentals investing.
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