Wednesday, February 15, 2012

Dividend Investing is not a black or white process

My investment strategy is all about finding the right dividend growth stocks that fit my entry criteria, include stocks for as many sectors as possible and then reinvest dividends selectively. Some readers have expressed concerns with this strategy, particularly since to many investors dividend investing is synonymous with chasing high dividend yields.

Dividend investing is more than just including a few quantitative indicators about a certain stock or sector. It is also about understanding the big picture. Some novice investors focus exclusively on yield, which leads to investment decisions which do not take into account risks that the investor might face. I have written several articles on the dangers of chasing yield here and here.

I see several dangers of focusing on just one quantitative indicator. I used yield as an example for this article, but focusing only on dividend growth and projecting it into the future without understanding whether it is sustainable, is just as dangerous.

Stocks with higher current yields typically do not grow distributions at a rate that meets inflation, if they even raise distributions. As a result, investors who purchase such equities and spend all of their income would suffer from the reduced purchasing power of their dividend income.

Investors, who only focus on yield, might miss the boat on total returns as well. It is great to find a company yielding 6% - 8% today. It would take a company yielding 3%- 4% today growing distributions at 12% per year at least 6 years to reach a yield on cost of 6%-8%. Retiree’s who focus on dividend investing for current income might ignore dividend growth investing for this particular reason – they simply do not feel they have the time to wait. But if the only return comes from the distributions, while the value of the stock stagnates or even goes down, then investors would have lost purchasing power of their principal for the sake of higher current yield.

Furthermore, most companies yielding 6% – 8% today are pass-through entities such as Master Limited Partnerships, which could only grow their business by diluting existing unitholders through constant new unit offerings. Companies yielding 2% - 3% today, which could grow distributions by 10% annually for at least a decade, would most probably keep a current yield of 2%-3% for the majority of the time. Patient investors however would be able to generate higher yields on cost coupled with strong total returns over time. In a previous article I illustrated this principle with a real-life example using Abbott Laboratories (ABT). Check my analysis of Abbott (ABT).

Qualitative characteristics are important as well. Deciding whether a strong dividend growth stock will continue paying higher dividends into the future requires a healthy dose of guesstimation. I typically look for companies with durable competitive advantages, where shifts in technology would not lead to product obsolescence for several decades into the future. For example, companies like Coca Cola (KO) have a strong brand name, synonymous with quality that carries a certain level of expectations, which customers are willing to pay a premium price for. Other companies like that are able to pass on price increases onto customers. Check my analysis of Coca Cola (KO). McDonald’s (MCD) is another company that fits this criteria.

To summarize, while it is important to have a set of investment criteria, investors should always try to analyze each investment in detail, before they commit their hard earned cash to it. Being nimble and flexible in the investment world is a skill that comes with experience. After all, Warren Buffett has made billions by having the ability to think beyond a strict rule based investing.

Full Disclosure: Long MCD, KO, ABT

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