“You have a pair of pants. In the left pocket, you have $100. You take $1 out of the left pocket and put in the right pocket. You now have $101. There is no diminution of dollars in your left pocket. That is one magic pair of pants.”
This ‘magic pants’ analogy was from an article on dividend investing I read about a decade ago and was one of the catalysts for me to take a closer look at this type of investing and see if it truly was magical.
With this analogy, the anti-dividend crowd claims that you own the same percentage of a now smaller company, smaller by the dividend amount. It, therefore, makes no difference whether a company pays a dividend or not.
Here is a quote from the article.
“First, the pants in question are not worn by the dividend growth investor/shareholder. Instead, the pants are worn by the company, not the shareholder. And, they indeed are a magical pair of pants that is continuously filling their pockets with fresh cash, at least the good ones are. And, when their pockets are fuller than they need, they take some of that cash and give it to the shareholders so that they can put it in their pockets. But most importantly, sending out that cash that the shareholder can put in their pocket in no way diminishes their ability to continuously refill their pockets with fresh new cash.
Dividend growth investors believe the actual value of a corporation is based on its earnings power, not how much cash it has on hand. A dividend payment does not reduce its earnings power. A company that is managed so that it provides a regular, sustainable dividend is more likely to be managed to provide long-term growth in value.”
There were a few hundred comments to the article. After reading every comment and every rebuttal I decided there was something more to the dividend growth investing strategy that needed to be uncovered.
First, let me tell you a little about my investing journey so that you can better understand why I chose dividend growth investing (DGI) to write about. I started investing in the late 90s and believed that mutual funds were the best way for everyday investors to protect and grow their hard-earned savings. Books like the Wealthy Barber made this type of investing look easy enough, and I was eager to start. My first significant amount of savings went into highly rated mutual funds. Fund Managers who charged a 2-3% fee with a track record of above-average returns for many years. Then came the ‘lost decade’ of investing. A dollar invested in January 2000 in the S&P 500 was worth ninety cents in December 2009. This pretty much represented my investment returns as well. Here I had paid fees to the most competent managers I could find and ended up with less money than I started with. Losing money on anything is just not part of my DNA.
Disappointed in professionals who charge high fees and cannot beat the market (search the ‘Buffet Bet’ if you do not believe me), I set out to see if there was a better method to invest my hard-earned capital.
“I do believe it is possible for a minority of investors to get significantly better results than average. Two conditions are necessary for that. One is that they must follow some sound principles of selection that are related to the value of securities and not to their market price. The other is that their method of operation must be basically different from that of the majority of security buyers. They have to cut themselves off from the general public and put themselves into a different category.”
– Benjamin Graham
Many believe the right approach is to invest for the maximum total return you can achieve and then redeem whatever units you have to provide for your spending/income needs. I found growth-only investing very difficult to do. Although you can make your own dividends selling shares for income, the problem is that generating income forces you to frequently buy and sell and eventually, you make mistakes.
ETFs did not excite me as they hold too many losers in too big a portfolio. By definition, you cannot do better than the index they track, it’s impossible. Diversification, as you may have already experienced, does not remove downside risk or guarantee against loss.
My research eventually led me to dividend growth investing. Relish the cash flow from your asset: try to ignore the price fluctuations say dividend growth investors, total returns will follow as your capital tends to grow along with the dividend. I was excited to learn more.
What I encountered is that dividend growth investing is a risk reduction strategy and has been around for decades. By its nature, DGI forces investors into higher-quality names. After all, for a company’s management to commit to a dividend payout policy, the company needs to generate cash to pay the dividends. As it turns out, high-quality companies are more likely to consistently be profitable and generate cash to pay dividends.
Dividend growth investing shifts the focus from stock market gyrations to your growing stream of dividend income. It’s not that you ignore the total return, but it is easier to stick with an investment when you can see that the company is increasing their dividend despite what looks like a turbulent stock market. When the dividend keeps going up, it is a sign that your strategy is working, and it’s easier to stick with it even though the stock market might be going nuts.
At its core, DGI is about buying when quality stocks are sensibly priced, rarely selling, and holding for the growing dividend, knowing that this increasing cash flow will eventually drive prices higher. As my Canadian mentor Tom Connolly likes to say, “…dividend growth investors receive a ‘double-double’ from their quality companies. Rising income and rising price.”
Dividend growth investing is simple to understand with only three basic rules:
- Quality; only buy large-cap companies with a long dividend growth streak and good financial safety metrics in an industry that is stable and growing.
- Valuation; look to buy a company that is fairly or undervalued. Undervaluation introduces a margin of safety. You are, in essence, tilting the odds in your favour that future price movements will be upwards.
- Monitor; keep an eye on your dividend growers; especially the current yield; fluctuations in yields send signals. The consistency of a firm’s dividend growth is the best measure of management’s confidence in the long-term growth outlook for a company.
It was also comforting to know the dividend growth investors only needed one metric to measure their short-term performance; How much did my income rise last year!
“I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”
– Charlie Munger
Equipped with a new investing strategy that met our goals (a growing income stream that drives our capital returns), I set out to learn from the best on how to do it successfully. There are many great investing giants to stand on the shoulders of, but the two I have found who apply dividend growth investing simply and effectively are Tom Connolly and Chuck Carnevale. Tom Connolly has been doing DGI for 40 years. He concentrates his efforts on Canadian companies, whereas Chuck Carnevale is American and has created one of the best tools I have found for quickly analyzing dividend growth companies (FASTgraphs). I use their wisdom and tools to build and monitor our real-money dividend growth portfolios.
My goal for this blog is to coach and educate the reader on what I have learned about dividend growth investing with a focus on Canadian DGI stocks. The dividend growth investing community in Canada is not as mature as in the United States, and I see an opportunity to add value. Through my blog, I will demonstrate that if you are patient and follow a disciplined process, the everyday investor can find that elusive pair of magic pants.
