Tuesday, July 2, 2013

Common Misconceptions about Dividend Growth Investing

There are many misconceptions about dividend investing. I have tried itemizing several of them, outlining them, and providing a brief commentary. Dealing with viewpoints that are different from yours is very important, because it opens you up to new ideas, and tests your strategies against scenarios that you might not have thought about. Unfortunately, most of the time I deal with viewpoints which are against dividend investing, I often find the authors are only providing their opinions, without ever bothering to examine any factual evidence on the subject. It is very dangerous to have an opinion on a subject, without knowing it inside out, but sticking to your original viewpoint, even if the evidence refutes your original ideas. As Charlie Munger says " “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” 

The misconceptions are summarized below:

- One misconception about dividend investing is that it is not a good strategy because one needs a high amount of funds in order to generate a meaningful amount of income to live off. For example, high amounts such as $500,000 or $1,000,000 are often used as some sort of an arbitrary yardstick that somehow is the main requirement to use dividend investing. In reality this is nonsense, as investors can start dividend growth investing with as little as a few hundred dollars per month, and then reinvest dividends and keep adding funds to their portfolios. Of course, the less money you can afford to put in your portfolio, the more time you would need to achieve your target monthly dividend income. In addition, in order for any investor to live off their nest egg with any strategy, they do need to accumulate somewhat of a sizeable portfolio. If you decided to live off your rental properties, or sell off index funds, chances are you would need a portfolio size equivalent to a dividend portfolio. It is obviously important to be diversified, and pick quality like Coca-Cola (KO) or Johnson & Johnson (JNJ). The reason why dividend investing shines is because dividend income is more stable than capital gains, and therefore it is easier to live off of. In addition, a regular addition to a healthy mix of dividend growth stocks every month, can turn into a substantial income stream a few yeas down the road.

- Another misconception is that the only return dividend investors receive is the dividend payment. In reality, for many investors their returns are not limited to dividend yields only. Dividend stocks are not bonds, but represent ownership interests in real businesses that earn profits. If these businesses have the characteristics that will allow them to earn more profits over time, they can afford to pay higher distributions over time. The rising dividend payments can generate significant yields on cost over time. The rising earnings can also lead to the potential for capital gains as well. For example, companies like Procter & Gamble (PG) have been paying distributions for over one century, and raising them for 57 years in a row.

- Many investors mistakenly believe that somehow dividend stocks are similar to bonds. In reality dividend stocks are proxies for stocks and they are not a separate asset class. That means that dividend paying companies are real businesses, which generate profits from selling products and services, and therefore are more likely than not to earn more over time and pay more in dividends in the process. With dividend stocks, you can get both a very good total return, and a portion of your returns will always be positive. Stability in total returns is what would provide you the positive reinforcement to stick it out through thick and thin. When your growth stock collapses in the next bear market, the chance of a silly move that involves panicked selling at depressed prices increases exponentially.

- Another misconception is that dividend stocks are only for older investors. In reality, dividend stocks are great for investors regardless of their age – although older investors usually focus on higher yielding companies. There are also different life-cycles of dividend stocks. You can get the low yielders with high dividend growth like Visa (V), which is in the initial phase of building out a dividend growth history. You also get the stocks with yields and dividend growth in the sweet spot like McDonald’s (MCD), which are maintaining their streak of consecutive raises. A company with a slow and steady approach of increasing earnings and gradually increasing dividends is ideal for building wealth. Over time, the growing amount of dividends that is reinvested at attractive valuations will mushroom into a cash machine that is able to provide for in retirement.

- Many investors still believe that it is better to focus on growth companies which reinvest everything back into the business. However, they fail to mention that such pure growth stocks are often overvalued, and your only source of return is dependent on the mercy of Mr Market. You can get quite the ride in the process. Taking risk in your younger years is fine, although gambling your money away is stupid. If you graduated college in 1994, and gambled with internet stocks in the 1990s and lost it all by 2001, you essentially lost on the first 7 years of compounding. You lost the most important period of compounding. In hindsight, you would have been better off just doing index funds because the contribution from the amount of funds in those first few years grows out to be the same as contributions for the next 30 years. Crazy, isn’t it?

There are no short-cuts to learning investments. If you take too much risk, gamble with Chinese internet stocks or the Tesla's of the world in an effort to generate very high returns, you might end up burning yourself. The reason so many investors underperform is because they are gambling, trading in and out of stocks. They pay a lot in commissions, taxes and fees. That’s not the way to build wealth for you – although it’s a great way for your broker to send their kids to private schools. Also if you pick growth stocks, you won’t be only selecting the Tesla's (TSLA) of the world.

- Many investors believe that dividends are a sign of inability of management to invest back into the business. The saying says that there will be no future growth in the company, which is why the stock should be avoided. The problem with this statement is that a company does not need to reinvest all its earnings in order to grow. A company that retains all earnings to fund internal growth might be masking the fact that it cannot earn an economic rate of return for shareholders. A technology company reinvests all profits to be number one in the field, but then it risks being the leader in buggies one day, at which point it will have to reinvest any remaining profits in other businesses to stay afloat. In addition, it could be because a company is cooking the books. Wolrdcom never paid a dividend, which made it very easy to generate great EPS gains on paper. Other stocks like Tesla (TSLA) are speculative companies, that has never turned a profit.  They cannot afford to pay a dividend, as their product is still unproven to generate earnings. The stock price depends on investor expectations – what is fashionable today might be obsolete next year.

On the other hand, companies like Wal-Mart Stores (WMT) have paid dividends since 1974, and raised them ever since. This was 4 years after going public in 1970. Somehow they managed to grow into the largest retailer in the world. An investor who put $1000 in 1974 would be sitting at a neat $ 2.44 million today. This would be generating a neat $61,600 in annual dividend income. I guess dividend investors can have their cake and eat it too.

To Summarize:

- Dividend stocks are great vehicles to build wealth and to live off your nest egg. It is best to start investing in dividend stocks as soon as you have some meaningful savings, in order to start the knowledge accumulation process early. You learn a great deal of knowledge when you are just starting out dividend investing, so as you get promotions and save more money for your dividend portfolio, you can be ready to accumulate your nest egg. Thus, dividend stocks work for all investors.

- A dividend stock portfolio can easily yield 3%-4% today, but this income stream will increase over time, thus protecting you against inflation. You will also generate capital gains in the process, as the companies earn more and become more valuable to investors. When growth stocks are down 50 - 60% from their highs during the next bear market, your dividend stocks will be down, but the level of income will likely remain the same and even increase. It is much easier to get scared and sell everything when your stocks are down 50% if all you rely on is growth and capital gains. During a recession you get none! With dividend stocks at least you get some return on investment that is positive at all times. During a bull market you get cap gains and dividends and hence you have your cake and eating it too.

Full Disclosure: Long V, MCD, WMT, JNJ, KO, PG

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