Why Accomplished Dividend Growth Investors Can Ignore Price Volatility
For a lot of reasons, dividend growth investing is becoming more and more popular every day. The historically low interest rate on fixed income is perhaps one important reason for this trend. However, an equally important, and perhaps even the most important reason, might just be that investors are better informed on the dividend growth strategy than ever before.
On the other hand, there seems to be a side effect to the better medicine that dividend growth investing offers. As dividend growth investing has become more popular, there have been many proponents gleefully willing to share their enthusiasm and commitment to the benefits of dividend growth investing for their retirement portfolios.
This has simultaneously created the equivalent of a negative feedback loop against dividend growth investing. Sometimes dividend growth investors appear to come off as smug, and this irritates certain people. Personally, I don't believe they are as arrogant, as they are enthusiastic disciples of the incontrovertible logic supporting dividend growth investing as a prudent and viable strategy.
However, as it often is with controversy regarding investment strategies, much of the consternations are rooted in biases rather than facts. Furthermore, I believe there is also a strong element of prejudice against all things equities built into many of the arguments against dividend growth stock investing. Investors remembering the enormous trauma of falling stock prices during the Great Recession of 2008 are quick to paint all equities with the same high-risk brush.
Moreover, the stress from watching their retirement portfolios depreciate in value, as stock prices fell, caused many to take unnecessary losses. The Great Recession, and all the media blitz that surrounded it, panicked people into selling perfectly good stocks at the bottom of the market. For those whose investment objectives were total return in order to accommodate liquidating part of their portfolios under the so-called 4% rule, this behavior was somewhat rational. Here is a link to a recent Wall Street Journal article that elaborates more on the 4% rule:
However, dividend growth investors, as I will elaborate more on later, who are mainly focused on the income component of their portfolios, were spared this financially devastating fate. But for now, let me state that what differentiates the dividend growth investor from the total return investor most, is their focus on income over price volatility. The point is that even though the prices of their dividend growth stocks were falling during the great recession of 2008, for the most part, their incomes continued to grow. Dividends usually don't fall with stock prices, they are usually only in jeopardy if earnings are simultaneously falling.
Most of the arguments that I have seen being placed against dividend growth investing as a safe and reliable investment strategy for retirement, are caused from a deeply rooted level of trauma caused by these previously mentioned massive 2008 price drops. The rhetoric usually goes something like; quality dividend paying stocks did not protect investors from the enormous losses to their portfolio values caused by the Great Recession of 2008. Dividend stocks, they argue, fell just as much and alongside non-dividend paying stocks.
The mistake behind this logic is in not understanding that all stock price drops are not the same. For example, if the business behind the stock remains strong, i.e. earnings continue to grow and advance or at least remain profitable, a falling stock price will often represent an opportunity. However, if stock prices are falling in concert with an unending deterioration of business fundamentals, then the stock price collapse may be generating a permanent impairment of capital. Understanding these distinctions is critical with implementing a successful stock investing strategy. I will provide examples later in the article.
Why Accomplished Dividend Growth Investors Can Ignore Stock Price Volatility
First of all, let me start this section by saying that it is not true that dividend growth investors do not care at all about capital appreciation (Total Return). In truth, they care very much, and who doesn't enjoy seeing the value of their stock holdings appreciate over time. However, the competent dividend growth investor attempts to build a dividend paying portfolio that will support their retirement needs without ever having to harvest any of their principal. Therefore, as long as their income is not affected by price volatility, they can calmly and intelligently ignore volatile market actions. This is a great and powerful advantage.
Furthermore, the accomplished dividend growth investor also attempts to position their dividend paying portfolio in stocks that can provide them an increasing dividend each year. Consequently, the income component of their dividend paying stocks offers a built-in inflation hedge. With a well-designed dividend growth stock portfolio the retiree is no longer subjugated to living on a fixed income. Dividend growth stocks with a long legacy of increasing their dividend every year offer the retiree the benefit of a raise in pay each year.
With Quality Dividend Growth Stocks, Dividend Income Is Stable But Prices Are
Most investors are fixated on, and some even obsessed, with the price movements of their common stock holdings. If the price of a stock they buy drops after they buy it, it is immediately categorized as a dog, and vice versa. The problem with this line of thinking is that a price rise, or drop, can actually be quite irrational, and therefore misleading to the extent that it can cause the opposite reaction to what it should. In other words, it often incites people to buy when they should be selling and sell when they should be buying.
Consequently, investors are often conned into making the classic mistake of buying high and selling low. Peter Lynch tried to point out the error in this line of thinking when he said:
"Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock and it goes down does not mean you are wrong." Peter Lynch 'One Up On Wall Street'
I believe that investors in common stocks, dividend paying or not, need to recognize that price volatility is a fact of investing life, and cannot be avoided. The stock market is an auction, where people are continuously buying and selling stocks. Therefore, like any auction, prices can be quite volatile and often emotionally charged. In the short run, it's all about how many buyers show up today versus how many sellers. Business results take a back seat, but longer term they matter most.
The Truth About Recessions
Much of what this article is all about, is my recommendation to do all you can to keep emotions in check when making investment decisions. It is very easy to get caught up in the hype and hysteria, especially when mainstream media bombards us with endless tales of doom and gloom. And nothing seems to strike more fear in the hearts and minds of the everyday investor than the "R" word. Just the mere mention of the word "recession" can cause the bravest investor to go weak in their knees.
As I previously mentioned, I believe that the Great Recession of 2008 has had a lasting negative impact on the attitudes of many investors towards common stocks. The old adage that "Wall Street climbs a wall of worry" comes to mind. Since the stock market bottomed in February of 2009, we have had four years of exceptional stock price appreciation. Yet through it all, there's been an endless barrage of negative prognosticators warning us of the pending collapse. These dire forecasts continue today.
Therefore, I thought it would be valuable to put recessions into perspective. First of all, they simply represent a temporary interruption in the long-term upward business cycle of growth. And as it pertains to the stock market, recessions normally bring with them a bear market. However, it's important to remember how all bear markets have ended. Following every bear market in history has been an extended bull market. When thought of in this way, it becomes apparent that recessions are more about great buying opportunities than they are catastrophe.
Please do not take what I'm saying to imply that I do not recognize the pain, suffering and angst that recessions cause. Instead, my goal is to simply put a recession into its proper perspective in order to help investors relieve some of the anxiety that they bring. The most important message is that recessions do end, and that we should fear the fear of a recession more than we do the recession itself.
I offer the following hypothetical dividend growth portfolio to illuminate the veracity of my major positions about dividend growth investing and recessions. First, I want to show that a portfolio of high-quality dividend growth stocks can fall in market value during a recession, while simultaneously continuing to increase their dividend income stream. Secondly, I want to illustrate that these recessionary price drops most often represent extraordinary opportunities at best, and at worst simply embody a valley that shrewd investors are willing to walk through.
A Hypothetical Dividend Growth Portfolio
I offer the following 10 dividend growth stocks as an example of a hypothetical dividend growth stock portfolio that was built one year prior to the Great Recession of 2008. Therefore, the portfolio is fully exposed to the price erosion that accompanied the Great Recession. Moreover, this portfolio will illustrate how this price volatility affected annual capital appreciation, but also how dividend income continued to steadily increase in spite of price volatility.
As a few points of clarification, I'm only utilizing 10 examples so that I can provide detail on each without asking the reader to endure too much redundancy. In the real world, I would build a dividend growth portfolio comprised of 20 to 25 stocks for investors in the accumulation phase, and 30 to 50 stocks for retired investors in the distribution phase. My logic is simple; I prefer more concentration when attempting to generate a higher total return, and more diversification when there is not enough time to overcome the risk of loss.
Furthermore, I chose the specific 10 examples for various reasons. I wanted to include companies that were able to go through the recession with little or no damage to their business results. Colgate-Palmolive, Family Dollar Stores, VF Corp. and Kimberly-Clark represent companies that showed little stress with their earnings growth in 2008. Consolidated Edison, Air Products & Chemicals and W.W. Grainger had a more severe earnings drop in 2008, but yet all three remained very profitable ongoing enterprises.
Illinois Tool Works and Stanley Black & Decker are two examples of companies whose earnings decreases extended beyond one year. Nevertheless, both companies remained profitable and increased their dividends, albeit at a lower-than-typical rate of growth. Finally, I included Franklin Resources as an example of a financial that suffered more recessionary damage than the other nine, but was still able to increase their regular dividend, and even made several special dividend distributions that rewarded their shareholders above their historical norms.
Hypothetical Dividend Growth Portfolio Review
Performance Prior, During and After the Great Recession
The following table illustrates several important attributes and benefits of how this quality dividend growth stock portfolio comprised of Dividend Champions or Aristocrats performed through the Great Recession of 2008. The first column shows the capital appreciation/depreciation effects of stock price volatility. Here we discover that capital depreciation of just under $25,000 (24%) in 2008 represented a lack of liquidity more than a loss.
As long as the investor did not panic and turn an unrealized loss into a realized loss, there was no permanent damage to their net worth. But more importantly, we see from the Dividend Income column that their cash flow increased from $2,313 in 2007 to $2,530 in 2008. Accomplished dividend growth investors primarily focused on their income, were happy to receive a raise in pay during the throes of the Great Recession.
What is really interesting about this portfolio is how quickly it recovered from the losses of 2008. By year-end 2009, the portfolio's value had recovered to its previous high valuation, and capital appreciation and the growing dividend income stream both continued their strong ascent thereafter.
Hypothetical Portfolio Performance, Capital Appreciation & Dividend Income
The Angel is in the Details
At this point, I would like to turn to the F.A.S.T. Graphs™, fundamentals analyzer software tool, in order to illustrate how benign a recession, even a doozy like we had in 2008, can really be longer term. I would utilize the specific examples of the 10 companies in my portfolio to alter the adage "the devil is in the details" to turn it into the angel is in the details. In other words, a picture is worth 1000 words towards bringing a clearer perspective to what a recession really means to investors long-term.
I tend to let the graphs speak for themselves. However, a few tips on interpreting what the Earnings and Price Correlated graphs and performance tables are depicting should prove useful. The orange line on the graph plots earnings, the light blue shaded area represents dividends, the dark blue line represents a calculation of how the market has normally valued the business over the time frame graphed, and the black line is monthly closing stock prices.
Therefore, as each graph is reviewed, notice what happens to earnings (the orange line), how stock prices react and look to the bottom of the graph, or the dividend cash flow table, to see how the dividend grows each year. I have placed a red circle around the price action during the Great Recession for focus. Notice how seeing the price action in graphic form diminishes the fear and anxiety that the price drops generated as they occurred. In other words, even though the price drops were huge, they don't appear so frightening when a longer-term perspective is taken.
Colgate-Palmolive Co. (CL)
Colgate-Palmolive, the business, went through the Great Recession almost as if it never occurred. Both earnings and dividend growth showed strong growth. Price dropped, but quickly recovered. Finally, notice that Colgate-Palmolive is routinely awarded a premium valuation by the market.
Family Dollar Stores (FDO)
Although Family Dollar Stores experienced a slight weakness in their earnings during the Great Recession, note how profits and dividends both accelerated as the recession came to a close.
VF Corp. (VFC)
VF Corp. experienced very mild stress and interruption of their earnings during and one year after the recession, but also experienced rapid acceleration as the recession ended. Notice how stock price closely correlated to VF Corp.'s earnings.
Kimberly-Clark is not the fastest growing company in this group, but their record since 2007 shows that they may be the most consistent business. Other than a temporary drop in stock price, Kimberly-Clark shareholders might not have noticed that a recession occurred.
Air Products & Chemicals Inc. (APD)
Although Air Products & Chemicals experienced a severe price drop during the Great Recession, there are two factors that should be considered. First of all, the company was overpriced in the early part of 2008. Also, even though earnings did fall 22% during the Great Recession, stock price dramatically overacted.
Consolidated Edison (ED)
Consolidated Edison is a slow-growth utility that experienced a drop in earnings and stock price during the Great Recession. However, notice the long-term correlation between price and earnings.
W.W. Grainger Inc (GWW)
W.W. Grainger Inc experienced a moderated interruption in earnings during the Great Recession followed by a strong acceleration of earnings growth in 2010 and 2011. Consequently, performance over the time frame 2007 to current has been extraordinary despite going through the recession.
Illinois Tool Works (ITW)
Illnois Tool Works did experience two consecutive years of falling earnings during the throes of the Great Recession. However, stock price and earnings both have recovered nicely, and the dividend was increased every year.
Stanley Black & Decker Inc (SWK)
Stanley Black & Decker Inc also had two years of down earnings during the recession, but was still able to raise their dividend both years.
Franklin Resources Inc (BEN)
Franklin Resources Inc is in the financial services industry, but the company was not nearly as exposed to the credit markets like the money center banks were. Nevertheless, they did experience a severe earnings drop in calendar year 2009. However, the company did continue to raise their regular dividend and pay special dividends following the Great Recession. Therefore, their shareholders' income component was actually better-than-normal since the Great Recession.
Two Examples Where Business Results Created More Permanent Price Damage
For the sake of balance, I did want to illustrate with the following two examples that not every company was able to navigate the Great Recession with as little damage as my 10 portfolio sample companies did. The Great Recession did have a lasting impact on many companies, especially those with major exposure to financial lending. General Electric is a conglomerate that greatly expanded their financial lending segments in order to participate in the large level of profitability that lenient lending practices were generating. Of course Citigroup was a major player whose business model is highly exposed to the reckless and leveraged lending practices of most financials.
A quick review of their Earnings and Price Correlated graphs reveals that price drops, in conjunction with permanent or at least more lasting impairments of capital, are more serious than temporary interruptions. These examples illustrate the importance of comprehensive monitoring and due diligence on each company that an investor holds in their portfolio. Even then it would be impossible to be correct in every case. However, appropriate diversification, coupled with research can keep any damage to a minimum.
General Electric Co (GE)
Citigroup Inc (C)
Summary and Conclusions
Building a portfolio comprised of high-quality dividend-paying companies, especially Dividend Champions, can be an excellent way for retirees to fund their retirement. Moreover, and in contrast to the widely promoted 4% rule where retirees are actually liquidating portions of their portfolio to make distributions, a well-designed dividend growth portfolio can avoid this problem.
There is more than one way to accomplish this feat. If you build a diversified portfolio of dividend growth stocks where your average yield is 4% or greater, then you can meet the suggested 4% distribution requirement without ever having to touch any of your principal. Even better, mix in enough Dividend Champions or Aristocrats, and you can expect to receive a raise in pay each year.
For those that may be years away from retirement, the portfolio could be constructed with a greater focus on growth than on yield with the idea that growth yield (yield on cost) could fund your retirement needs when retirement actually comes. Additionally, there are several iterations and variances of these two themes that can be initiated depending on the unique situation of each individual.
Finally, in order for a dividend growth portfolio to succeed, investors must accept and recognize that continuous due diligence and monitoring is an absolute necessity. However, there are many sources and tools that can provide investors an edge and/or make it easier for these objectives to be accomplished, FAST Graphs™ is one, and websites such as Seeking Alpha, GuruFocus, Forbes, Morningstar, Value Line, Google Finance, Yahoo Finance, MSN Money, TheStreet.com, and many others too numerous to mention are also readily available.
Disclosure: Long ITW, CL & KMB at the time of writing.