Dividend Growth Investing

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Why Dividend Growth Stocks Outperform Index Funds

with 4 comments

I was recently reading a series of articles written by Canadian Couch Potato on Dividend Myths.  While some of his points are valid, I think he is missing one of the key reasons that dividend growth stocks have consistently beat index funds, and why they will continue to do so.

The argument made was that there is no benefit to, say, a 6% dividend vs. a 4% capital gain plus 2% dividend.  Or a 6% capital gain for that matter.  This is true, in theory.  But it’s not that simple…  Companies that do not hand out dividends have multiple options:

Continue to stockpile, investing in low risk / low return investments

Obviously this is not their long-term strategy, but it is customary for a company to do this, sometime with a lot of money.  The problem is that I want my money used more effectively.  I’ll pick on a company I know well, Dell.  They have a market cap of $32B, with $14B in cash reserves.  That may be a nice safety net for the company, but how does it help me make more money?

Acquire new companies to achieve growth

This can go really well, or really bad.  The theory is that when a large company buys a smaller one, they use synergy to get more value out of that smaller company than they were getting themselves.  For example, maybe the larger company has great supply chain and can take the smaller company’s great product or business model, apply their own supply chain, and have a big winner.  Unfortunately it rarely works this way.  Instead, the larger company pays a huge premium for the stock (always more than the going rate), takes huge costs to integrate, and only sometimes sees a profitable business in the end.  And even if they do see a profit, it’s usually not enough to beat other ways I could have invested my money.

Develop new products and services

I’ll use Dell again as an example.  They can’t sit back and be outdone by companies like Apple, HP, and IBM so they choose to compete.  While Dell has always made a great PC and notebook, they have spent their cash expanding into MP3 players, smart phones, plasma TV’s, and many other huge failures.  This not only costs money, it destroys the brands reputability.  I would prefer to give my money only to their successful divisions, and not their failures.

Using the example above, I would prefer to give my money only to the server and notebook divisions of Dell, the iPhone/iPad/iTunes division of Apple, and the IT services division of IBM.

And this is what dividend growth companies enable indirectly.  By consistently streaming out cash, the companies are forced to only invest and spend in the highest ROE divisions of the company.  They don’t have the “luxury” of wasting my money in low return investments, or risking it in R&D.  They focus their time and money on the cash cows.

And that’s how I want my capital being used.

 

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Written by dividendgrowthguy

July 12, 2011 at 5:16 am

Posted in Uncategorized

4 Responses

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  1. Thanks for the mention and for joining the discussion. I’m going to challenge your premise that “dividend growth stocks have consistently beat index fund [and] will continue to do so.” The first part of the statement may be true, but you cannot extend the argument to the future. This is classic survivorship bias.

    It should not be surprising that companies that have raised their dividends consistently over the last, say, 25 years have outperformed the market. However, that information would only have been useful 25 years ago. The point is that no one can identify the companies who will grow their dividends going forward. Many investors seem to take it for granted that companies that have done so in the past will continue to do so in the future. But market history shows us that this is never true.

    The other part of the equation is that once companies have demonstrated a long history of growing dividends, they become attractive to investors who bid up their price. You often pay a premium for these companies, which makes it even harder for them to outperform the indexes going forward. As any value investors know, it is unloved companies that outperform, not ones that seem like can’t-miss bets.

    If you can tell me which companies will grow their dividends for the next 25 years (or even 10 years), then I’ll be the first to abandon index funds and become an enthusiastic stock picker. But unfortunately this is impossible. It’s called active management, and the evidence is overwhelming that it cannot consistently outperform the market.

    Canadian Couch Potato

    July 12, 2011 at 6:52 am

    • Hi Couch Potato, thanks for dropping by.

      Your assertion that “dividend growth stocks have consistently beat index fund [and] will continue to do so” is survivorship bias is absolutely true – if I was basing that statement purely on past performance. However, the intent of this post was to explain why these companies outperformed the market over the past 25 years. I believe this is due to the model of returning equity that cannot efficiently increase investors capital.

      Let’s take a company that has done a great job of growing: Apple (or Google for that matter). Right now, they can turn cash into more cash so it makes no sense for them to return money to investors. However, at some point those opportunities will run dry – but will they return any money voluntarily to investors? I believe they will not, and only those active and knowledgeable enough to detect this will know when to start removing capital.

      “The other part of the equation is that once companies have demonstrated a long history of growing dividends, they become attractive to investors who bid up their price.”

      Absolutely. Which is why you must still look at the fundamentals and make sure it’s a solid investment. I believe there are always opportunities to combine value investing with dividend investing. Take Warren Buffet himself – the majority of his personal investments are in good yielding dividend stocks that he bought at a great value. This, of course, takes time and patience.

      dividendgrowthguy

      July 12, 2011 at 9:29 am

  2. I recently did some backtesting to see who actually made money during the lost decade – with a selection of 15 dividend paying stocks, you’d actually come out with a gain of 65.42%!

    That just reinforced my belief in dividend paying, stable stocks.

    MoneyCone

    July 15, 2011 at 12:18 pm

    • Yeah, and not many people can claim much gain over the past decade. I was lucky a little because I started working in 2000, so I had very little money during the initial recession. Then I bought in pretty low on some stocks. I did, however, suffer substantially during 2008. Once I get my capital switched to dividends, my hope is to avoid the roller coaster ride

      dividendgrowthguy

      July 16, 2011 at 5:35 am


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