I am a big fan of Dividend Growth Investing. I like the mental model of Dividend Growth Investing, where a rising stream of annual dividend increases that spans over many years is a sign of a quality business. Characteristics of quality businesses include generating excess cashflows, high returns on investment, wide moats/competitive advantages and dominant market position and brand power. It also means have a business model that is not too cyclical either. Perhaps some pricing power as well.
Only a good business can afford to grow and also throw off a rising torrent of cash annually for many decades. If you generate a high return on invested capital, you know that there are only so many opportunitities in the physical world to deploy at that high rate of return anyways. Hence, a quality company with a 20% return on capital can afford to reinvest half of profits to grow EPS at 10%/year, while a mediocre company with a return on capital of 8% would have to reinvest everything to potentially grow EPS at 8%/year.
That ROI provides a good yardstick, and focuses management's attention only on those high value projects. The rest is sent back to shareholders.
In other words, a consistent history of dividend increases is the end result of having a quality business that has grown the bottom line for a long time.
If you look at the statistics of many of America's great businesses, you see rising earnings per share over time, which fuels rising dividends per share and rising share prices over time as well. The issue of course is that share prices tend to be more volatile than the dividends and earnings.
Now, there are many good businesses in the world. There are also many businesses in different stages of their lifecycle.
For example, a start-up is unlikely to be paying dividends. However, most start-ups are lottery tickets, because the likelihood they will survive is very very low.
Companies in their decline/the end of their lifecycle also cannot pay dividends, because they are struggling for their survival.
The middle point, where a company is established and thrives is where you get to see dividend growth appear.
Most quality companies cannot reinvest everything they earn at a high rate of return. Hence why they send it back to shareholders in the form of dividends. Very few quality and established companies can afford to generate a high durable return on investment and reinvest everything in their business at a high rate of return. Warren Buffett has discussed this in his discussion of his ideal business
This was a rather long introduction. I wanted to provide some nuance about Dividend Growth Investing. In my opinion, it is a worthwhile strategy as there are a lot of quality businesses that are dividend growth companies. Studying the lists of dividend achievers, dividend champions, dividend aristocrats and dividend kings can help identify and select good quality investments to hold for the long run.
That being said, not every company that is a dividend growth stock is a good investment.
There are various studies about Dividend Growth Investing, the most popular being the Ned David Research one. It shows that companies that grew or initiated a dividend have experienced the highest returns relative to other stocks since 1973.
This chart shows you that dividend growers & initiators had a better performance than dividend cutters & eliminators and dividend non-payers. They also seem to be showing that the equal weighted S&P500 index did worse than dividend growers and initiators. In addition, dividend growers had a low standard deviation.
This outperformance looks very convincing, when you look at it in a chart format.
So case closed, right? You are sold on Dividend Growth Investing.
The problem for me is that I want to trust this data, but I have to verify it.
I simply took a look at historical S&P 500 total returns data since 1973. Source: Adamodar
According to this data source, a $100 investment in S&P 500 index at the end of 1972, with dividends reinvested, would have turned to $20,639.81.
This is a logaritm chart of those total returns off a $100 investment at the end of 1972:
This shows me that S&P 500 itself did better than the dividend growers and initiators. And the S&P 500 itself did much better than the S&P 500 in the Ned Davis Research Study.
Which to me raises more questions, rather than solves anything.
Why is it that the performance of S&P 500 in Ned Davis Research so poor relative to the actual S&P 500. Perhaps it has something to do with the way they weight their portfolios. Perhaps it could be due to their data integrity. Again, these performance gaps raise questions about the Ned Davis Research Study and data. I do not believe we have an apples to apples comparison.
Also that being said, their equal weighted data on S&P 500 does not feel right. That's because from all the research papers I have ever read, equal weighted indices typically have tended to OUTPERFORM market weight indices. This is a second reason why I am questioning the data in Ned Davis Research Study on returns based on a dividend policy.
Perhaps, if they did a comparison based on a market cap weighted basis, it would be a better apples to apples comparison. That can clearly show investors how Dividend Growth companies have done per their dividend policy.
But in reality, it would be really helpful to understand what methodology Ned Davis Research used on their studies of performance on companies per dividend policy.
Perhaps this study is used as a marketing tool from mutual funds to sell you dividend growth funds. As investors however, we know that nobody else cares more about your money than you do. Hence why you need to trust, but verify. And while that Ned Davis Research Study does look convincing at first glance, it does not seem right, as it raises more questions than it answers.
The issues are that it uses a methodology that is not well explained.
The study's results do not link to the performance of S&P 500 index itself. Why are dividend growth stocks showing as outperforming, when in reality that index seems to have done worse than the actual returns of the S&P 500 index?
The study uses an odd performance for S&P 500 equal weighted index, which has done much worse than the actual performance of S&P 500. It looks as if they forgot to add dividends on the performance of their equal weight index. Which seems odd to me.
The conclusion for me is to learn to read reports and studies critically. They are mostly marketing materials, rather than anything else.
It's also important to keep learning, and gathering different data points in your toolbelt, so you can try to connect the dots and identify gaps.
