The Flaws in Dividend Growth Investing…and The Likely End of The Fad and “Sure Thing”

The low interest rate environment and once in decades situation where dividend yields were above bond yields for the broad indices and individual companies has spurred a “new investing philosophy” of “dividend growth investing”. With interest rates in an up cycle as Warren Buffet said “when the tide goes up we will see  who is naked.

This “strategy” seems to be all over the blogosphere.e Typical is seeking alpha’s popular “dividends and income section” . Unfortunately, but not surprisingly the financial services industry has fed the bandwagon bring ing out a seemingly endless number of dividend and dividend growth ETFS and actively managed funds.  Brokers/Salespeople were happy to feed the frenzy as well without much deep analysis of the pitfalls of such an approach

Since this crew gets pretty abusive when its views are challenged I’ll post this on my own blog

Here for example is a methodology  common in the analysis of dividend growth: investing  in the blogosphere :

• Pick a stock and assume that if one bought a stock and owned it for decades the “dividend growth” of reinvesting the income will produce a secure income stream for retirement.
• Make sure when you buy the dividend stock you hold your dividends and wait till that stock is a “bargain” which of course you will know and time extremely well. This means of course that you are not reinvesting the dividend but trading with the dividend . Thus  the growth of an investment  with dividend reinvestment is not your strategy at all. So those numbers don’t of a long term position with dividends reinvested and doesn’t match  the “dividend growth” strategy at all certainly not a DRIP strategy.
• In figuring out what future dividends that will fund the retirement  the methodology of calculations is a bit fuzzy to say the least.

 The analysis takes a lump sum purchase at the beginning of the investment period calculate what the dividend stream will be decades later at retirmen and presto you have a cash flow to fund retirement.

Of course this assumes that you have enough cash to purchase that amount of shares decades prior to retirement. In other words in your 20s you have a massive sum to put into your account. Seems to me most people I have met are struggling to generate cash flow above their expenses to cover those massive student loan bills…a massive lump sum ? maybe for trust fund babies who never had to worry about cashflows in retirement…or in their 20s.

Oh and that amount used in the calculation is way to large to put in an IRA so most of the dividends will be taxed along the way. And if you’re a high earner in NY or Silicon Valley you’re paying local AND federal tax on those dividends…so knock some more money off that “dividend growth “ calculation in the real world.

• I could do a similar argument for a total return investor:

I can assume a lump sum at retirement equal to the lowest 30 year return of the s+p 500 or even a 60/40 stock bond allocation reinvest the dividends automatically and don’t touch the principal.  Take even the worst 30 year period since the depression (actually longer ) and you will come up with a sufficient sum for retirement. In fact a simple present value calculation will give you that lump sum you need.

At retirement pull your retirement cash flow out of dividends interest and capital gains you earned over 30 years…all at likely at a lower marginal tax rate than your current rate

…and if you retire to Nevade, Florida or Texas  from say California or NY you avoid the state tax on interest dividends and capital gains.

In other words there is not magic formula to fund a retirement need….unless you inherit at 25 or 30 a sum large enough so it will grow over 30 years to an ample retirement nest egg (add in some savings of your own along the way) . Otherwise it’s not as easy as “dividend growth investing”. Its pretty much the same problem for the much disdained “total return investor” in the view of this group of dividend growth zealots as for them.

I notice that the dividend income section of seeking alpha has lost regular postings form many  of the fans of dividend growth investing. I think we have the updated version of the famous shoeshine boy story with Joseph Kennedy and the well know dictum when it shows up on the cover of Business Week or Time it’s a sure sign of time to go in the opposite direction, Substitute blogger s that are do it yourselfers/neophytes and chat rooms for the 2 above and you have the 21^st century equivalent.

As interest rates reverse course and start to provide yields equal to or higher than equity dividends this dividend growth” strategy will look less attractive. And there is no way around the fact that future returns on a stock are low when you buy them at a high valuation The dividend growth favorites, usually conservative slow growing stocks that trade at low p/es have been trading at high valuations during this time of “dividend growth investing”.

No surprise then to look at this graph comparing returns of utility stocks (XLU) a traditional sector bought for its dividends, HDV the high dividend ETF and VTI the total stock market index and to note that when interest rates turned abruptly higher in the beginning of May stocks bought for their dividend suffered the most. It’s actually no surprise to anyone who has taken a financial markets class and paid attention when the dividend discount model of stock valuation was taught.

Here is an explanation of the model from  investopedia . http://www.investopedia.com/articles/fundamental/04/041404.asp

 They note it is..

“…one of the oldest, most conservative methods of valuing stocks - the dividend discount model (DDM). It's one of the basic applications of a financial theory that students in any introductory finance class must learn

  

And here’s the chart of HDV high dividend, XLU utilities and XLP consumer staples another favorite of dividend growth investors compared to VTI the overall US market since May 1 when interest rates started their sharp ascent.

No doubt  some may argue this short term movement is irrelevant. I view it as a fire drill although the market may stabilize or even recover we know from this move which sectors are most vulnerable to higher rates. Not just are these sectors most vulnerable to higher rates because of the simple math of the dividend discount model, the dividend growth investors bid them up in valuation.

Or one could look it quite simply. If dividends were touted as a bond substitute logically it would mean that if interest rate go up dividend stocks will suffer. After all would you rather own a 4% return on a treasury bond or a stock of a dividend grower" paying the same yield or lower. Back to reality stocks are riskier than bonds....period.