The Case for Dividend Growth Investing

Originally published: September 8th, 2015

I mentioned in the introduction that I kind of foundered around in 2014 looking for investing strategies that could accelerate the accumulation phase towards financial independence. To be extremely broad and general we can divide all the different strategies into two big categories, and the difference is in the time horizon: long-term “investing” and short-term “trading”.  That simple binary classification does not do the spectrum justice, but I challenge anyone to find a strategy that doesn’t fit into one of those two descriptions.

To be fair not everyone who’s “trading” is a high-speed trader flipping positions within minutes, and not everyone who’s “investing” has a holding period of forever. And it’s the in between and hybrid strategies that muddy the landscape. I spent a lot of time in 2014 looking in the cracks for something in between. I have long held a personal philosophy against “extremes” of any kind. I believe the universe is fundamentally made up of opposites in balance with one another (positive and negative, convex and concave, light and dark, etc. etc.) So when trying to find my way in the complex world of investing strategies I could not imagine that the “answer” laid at one or the other extremes. I still don’t think it does, but that’s a topic for another post.

I stated in the introduction that I have settled on a strategy and that strategy is dividend growth investing (DGI). Conventionally speaking, DGI falls definitively within the long-term “investing” camp. So how did I find myself here? The truth is, I had (and still have) some serious issues with some of the conventional long-term “investing” attitudes towards the market. The particular attitude I have issue with goes something like this: the market goes up and down; you can’t time it, so it’s not worth trying. If you make what you feel is a sound investment, but it performs poorly in the short term, you should ignore the poor performance and just wait, maybe even average down. Stand by your conviction. It will come back up. Good stocks will always come back up given enough time. The stock market will always go up given enough time.

What’s my problem with that attitude? Is there any part of it that isn’t true? No…it’s true. But how much is enough time? Consider the following chart. This is GE’s stock price from April 1, 1998 to September 1, 2015.

GE_1998-2015

For some reason, the chart appears to start out around $30/share, but according to Yahoo! Finance’s historical price records, GE’s adjusted closing price on April 1, 1998 was $17.28/share. At the time of writing (September 7th 2015), GE trades hands for $24.00 share. Not sure why there’s such a big disparity between how the chart reads and the historical price record, but if anything it’s another lesson in why you shouldn’t put too much faith in charts. If we trust in the historical price, someone who bought GE over 17 years ago, would be sitting on a roughly a 39% total paper gain in share price or about a 2.3% annual return. (The 20year nominal yield on T-notes around the same time in 1998 was just shy of 6%…) Anyone who bought GE between September of 1999 and March of 2002 probably would have paid more per share than GE is currently worth today. From March of 2002 through 2004 there was a dip where the investor would probably have recognized a similar meager gain to his 1998 counterpart (albeit over fewer years, so with a better annual average), but from the end of 2004 up until the financial crisis, the investment again represents a net loser. Anyone who bought late in 2008 up until the end of 2013 is sitting on a gain…for now.

So in a 17 year window, you have 9 years that represent a net loss in terms of share price, and 8 years that represent a gain. 3 of those years’ gains do not outperform treasury yields.

So was GE a good investment? It doesn’t look that great in terms of stock price. Unless you were able to time the bottoms in February of 2009 and January of 2003, you were probably looking down the barrel of pretty mediocre gains or even more likely losses.Or were you? That chart is missing something…can’t quite put my finger on it…oh wait here it is:

GE_1998-2015_with DIVIES

What are all those little blue diamonds with a D in the middle of them along the bottom of the chart? Those are dividends. The purple S in May of 2000 is a 3:1 stock split. Our friend back in April of 1998 who bought GE for an adjusted $17.28/share is actually sitting on 3 times as many shares as she originally bought (that’s why it’s an “adjusted” share price) along with $35.12/share in cumulative dividends paid. The dividend payments alone represent a 103% (6.05% annualized) gain on the original investment. And she still owns all the shares, which are still worth 39% more on paper than they were 17 years ago. Now that looks a little better.

The dividends make the difference. And that was the missing narrative from the generic “buy and hold” gospel that bothered me. “Buy and hold” is a self-evident truth among its disciples, but only some of them talk about the meatiest part of the meal: the cash dividends you should be earning along the way.

Let’s take Amazon.com (AMZN) for another example. Our same friend also happened to buy AMZN on April 1, 1998 for an adjusted $7.65 a share. In this case the chart actually matches the historical price record:

AMZN_1998-2015

AMZN is selling for $499.00 a share today, which represents a 6,423% paper gain. Way to go mythical friend from the past! That is a fantastic investment…on paper. You’ve averaged a 377% annualized gain in imaginary paper money. Tell me, does your local Starbucks (SBX) accept AMZN stock as a form of payment? They do not. Can you buy an Amazon Kindle Fire (retails for $139 at time of writing) with .2786 shares of AMZN stock? You cannot. Your investment is WORTHLESS until you sell it, which flies in the face of the “buy and hold” doctrine. Why does it fly in the doctrine’s face? Because as soon as you lock in a gain or loss you lose out on potential future gains. You have to hold on to the investment if you want to realize the future gains or losses. But all this investment is ever worth is imaginary paper gains. It hasn’t paid a single dividend in 17 years. Just look…no diamonds with D’s in the middle:

dvidend history fail

Now Amazon.com does this on purpose. Instead of paying shareholders, they reinvest their money back into the company so they don’t show any real GAAP earnings and therefore don’t have to pay any taxes on those earnings. The fruits of this strategy show when we look at the exponential stock price curve. The company’s value has skyrocketed. Revenue has grown at a 95% annualized clip since 2005. Book value has increased by a total of 2,222%. Meanwhile GAAP calculated earnings per share (EPS) has declined -161% in that same time period. They have more than doubled the free cash flow per share ($1.11 in 2005 to $2.33 in 2014), but investors haven’t seen a single dime of that except in the form of an increased share price, which they can’t spend unless they sell the stock.

In the throes of the dot.com bust our friend who bought AMZN for an adjusted $7.65/share was showing a paper loss of 22% on 9/4/2001 when it was trading for $5.97/share. The esteemed cardinals and bishops of the church of “buy and hold” will scream from the roof tops that she obviously never should have sold, locking the paper loss into a real one, because by simply holding on, she would soon (14 years later) be sitting on a “six-bagger” (6,000%+ return).

But that impressive return, I’ll remind you, is completely imaginary until our friend sells her shares. And that’s the issue I have with the “buy and hold” doctrine. If you can’t time the market, you never know when the right time is to “sell high”, so you never sell, as long as the company is growing and increasing your equity stake, you must hold on to that investment. Haha yes, Warren, our favorite holding period is forever. Isn’t that clever?

But that means YOU CAN’T USE THAT MONEY! It just grows forever in your imaginary brokerage world. How many shares did our friend buy in 1998? Did she buy 100 shares? 1,000 shares? It doesn’t really matter. Let’s say she wants to be financially independent now, in 2015. To reap the rewards of her brilliant investment she has to sell shares for cash money. 4 shares this month to cover rent (last month was only 3 shares). 10 shares to go on a well-deserved vacation. Half a share for this week’s grocery bill. Wait can you even sell half a share?

Every time she sells, she 1) never knows how much they’ll be worth today since the market fluctuates all over the place and 2) she reduces her share count locking in the gain and limiting any future gains the sold stocks would have earned.

Eventually she will run out of AMZN shares, which means she will have to rely on some other source of income going forward to pay her bills. Hopefully she has enough AMZN stock to last her until she dies.

In the case of AMZN the gains were so astronomical, that it just might work out for our imaginary friend. But, they’re not all six-baggers I can assure you. And every loser sucks gains away from the six-baggers to the point where you might have “beat the market” but not by that much, and at the end of the road you’re just hacking away at your gains every time you sell to pay the bills. To reiterate: you can’t pay your bills with paper gains. You can only pay your bills with cash.

And when you need that cash, and you’re trying to live off all your super-smart investments that you tenaciously REFUSED TO SELL during all those tough times, you will have to sell…the cardinal sin in the church of “buy and hold”.

But what else can you do? Well there are actually some stocks that give you cash as a reward for owning them. They give you this cash on a regular basis and the amount is actually pretty predictable compared to the imaginary paper gains/losses you’ll show in your brokerage account on any given day. And you don’t have to sell anything. They just give you the money. Keep your shares, you’ll need them for the next time we decide to give all our shareholders money, which by the way is in approximately 3 months, and we’re thinking of giving you all a raise. You’ve earned it.

Now that sounds like a plan for financial independence to me.

So let’s rewrite the wording of our doctrine a little bit and put it more into a dividend growth investing context:The market goes up and down; you can’t time it, so it’s not worth trying. If you make what you feel is a sound investment, but the STOCK PRICE performs poorly in the short term, you should ignore the poor price performance as long as the dividends are stable and just wait, maybe even average down. Stand by your conviction. The stock price may or may not come back up, but good companies will continue to pay dividends. Great companies will continue to raise their dividends. Sit back and collect the dividends and invest them wisely. Dividend incomespends the same as regular income, except you don’t have to work for it. The stock market will do whatever it wants.  Make sure you’re collecting a check in the meantime.

 

 

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