Wednesday, January 26, 2011

The Future for Dividend Investors

Dividend stocks have managed to outperform non-dividend stocks since 1972. In addition to that, elite dividend indexes such as the Dividend Aristocrats and Dividend Achievers have also managed to outperform the market for almost two decades. Many companies have managed to grow earnings sufficiently enough in order to be able to create a long record of consecutive annual dividend raises. Some investors however are worried, that the last two decades worth of dividend investing data is an aberration, and as a result should not be included in one’s investment decisions.

Another issue with dividend investing is that nothing is set in stone and permanent. The companies with the longest streaks of consecutive dividend increases of the 1990’s have either been acquired, stopped raising dividends or even worse – eliminated them. This is a particular warning sign for many investors, which prevents them from investing in some of the best dividend stocks such as Johnson & Johnson (JNJ), Coca Cola (KO) or Procter & Gamble (PG).

The truth is that nobody knows which companies would perform well over the next few decades. What investors could do is try to identify businesses that make sense in most economic environments, that have wide moats, low earnings volatility, a balance between distributing and reinvesting earnings and which are also trading at attractive valuations. Being diversified doesn’t really detract from performance, and could smooth out volatility in one’s portfolio income stream. Choosing companies which have a history of at least a decade of dividend increases won’t hurt either – companies which generate excess cash flows after reinvesting to sustain and expand the business and share the money with shareholders in the form of dividends are rare but valuable species in today’s market. Things will change over time, and as a result investors would likely have some turnover in their portfolios. While Johnson & Johnson (JNJ) might stop raising dividends a few years from now, it might still be at least a hold for long-term investors.

My main sell rule is to sell when the dividend is cut. If Johnson & Johnson (JNJ) cuts distributions, I would sell and purchase a position in a company which possesses the characteristics that Johnson & Johnson has today. Being flexible and researching companies which could grow earnings and dividends for potential acquisition is a must for dividend investors.

While the economies of the US, Europe and Japan have not been growing by much over the past decade, emerging markets could spur growth for earnings of international companies such as Johnson & Johnson (JNJ), Procter & Gamble (PG) or Coca Cola (KO). This could drive future dividend increases as well, since the emergence of middle class on a global scale would boost consumption for such consumer products. By being flexible and keeping up with the fundamentals behind dividend stocks, one could also be ahead of the game and not be surprised if a dividend is indeed cut. For example, even during the worst financial crisis since the Great Depression, despite having one dividend cut in 2008 and two in 2009, my dividend income stream still managed to increase. The reason was that I hold almost 40 individual dividend stocks, I do not concentrate too much on a given sector and I pick stocks that raise dividends, which I reinvest selectively. In an equally weighted stock portfolio consisting of 40 stocks where one component eliminates dividends, my dividend income would increase if on average dividends increase by more than 2.40% for the year.

Being flexible and keeping up with what is going on in your portfolio is not a prerequisite however. Even if one just holds on to their diversified portfolio of stocks without doing anything over time, through good times or bad, they would likely do just as well as the market over time. The list of the original S&P 500 companies from 1957 for example has managed to not only match, but outperform the market benchmark over the next half a century.

Full disclosure: Long JNJ, KO and PG

Relevant Articles:

- Best Dividends Stocks for the Long Run

- The right time to buy dividend stocks

- The right time to sell dividend stocks

- The ten year dividend growth requirement

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