5 Myths About Dividend Growth Investing

Bdividend-stocks-y John Heinzl, GlobeInvestor.com for MoneyShow.com

Like most investing, you're not protected from market meltdowns...and there's always the risk of missing out on a non-dividend-paying star

In last week's Yield Hog column, I listed five reasons to love dividend growth investing.

This week, in the interest of providing some balance, I'll address some of the biggest misconceptions people have about dividend growth investing. Knowing these myths -- and why they're wrong -- will serve you well in the long run.

1. It Saves You from Market Meltdowns

It doesn't. Several years ago, I remember feeling quite pleased with my portfolio of dividend-growing banks, utilities, pipelines and consumer staples stocks. The prices had been on a steady incline, and so had the dividends.

Then the 2008 financial crisis hit, and my smugness quickly turned to terror as my portfolio plunged in value. Watching my kids' registered education savings plans sink was especially difficult, because I felt responsible for losing their money.

The stocks have since recovered, but I haven't forgotten the lesson: Even a portfolio of high-quality dividend stocks will get hammered in a market rout. So be prepared (more on this below).

2. It's Foolproof

Wrong again. Once you've assembled a portfolio of dividend-growing stocks, your work isn't over. You still need to monitor your holdings, and take appropriate action if something goes wrong.

To take two prominent Canadian examples, Manulife Financial and Yellow Media both had exemplary records of dividend growth before they ran into trouble.

Manulife was pummeled by the financial crisis and low interest rates, and cut its dividend in half. Yellow Media was burdened by excessive debt as it struggled to make the transition to an online business, and chopped its dividend several times before eliminating it.

It may be easy to say this in hindsight, but investors who got out when these companies first took an axe to their dividends saved themselves a lot of misery, because both stocks are well below where they were at the time.

3. It Always Generates the Highest Returns

True, studies have shown that, over long periods, stocks with growing dividends outperform those with stable dividends or no dividends at all. But that's of little consolation to investors who missed out on the spectacular returns of non-dividend stocks, such as Apple (AAPL), up 554% over the past five years) or Lululemon Athletica (LULU), up 381% since it went public in 2007.

The fact is that young, fast-growing companies often find it more advantageous to reinvest cash flow in the business, and investors who insist on dividends will miss out on these multi-baggers. Some of these companies eventually will pay a dividend -- Apple, for example -- but others will flame out long before that happens -- Research in Motion (RIMM) -- so you needn't feel too badly.

4. It Eliminates the Need for Fixed Income

Repeat after me: Dividend stocks are not bonds or guaranteed investment certificates.

Although fixed-income yields are puny right now, if the market goes for another belly flop -- don't kid yourself, it will happen again -- you'll be glad to have some bonds or GICs in your portfolio. For example, if you maintain a 60-40 balance of stocks and GICs and the market plunges 30%, your portfolio will be down just 18%.

Of course, your gains when the market is rising will be smaller, but that's the price you pay for stability and peace of mind. Your own asset mix will depend on your age, risk tolerance, and other factors.

5. It Eliminates the Need for Diversification

Because Canadian dividend stocks tend to be concentrated in sectors such as financials, pipelines, utilities, and telecoms, it's easy to let one or more of these industries make up a huge component of your portfolio. But dividend investors need to diversify like everyone else.

One way to achieve this is with exchange traded funds that invest broadly in dividend stocks from various industries. Another is to invest in US companies in sectors such as consumer staples, consumer discretionary, health care and technology, which are under-represented in Canada. [Editor's Note: Although U.S. dividend payers are a bit less concentrated than Canadian ones, U.S. investors need to diversify as well, of course.]

Dividend growth investing is a great strategy, but it has its limitations. Knowing them will make you a better investor.

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This is an excellent article. I was pressed to find anything that would try to debunk the dividend growth strategy. These next few questions are for discussion purposes, not trying to discredit your article.

The first reason, it saves you from a market meltdown, did you reinvest the dividends even though the market was in decline? The strategy actually works best when the stock prices drop because the dividends buy more shares as the price declines. Then as the market recovers, those extra shares bought by dividends at the lower prices help you recover faster than non-dividend paying stocks.

The second reason, it's fool proof, what criteria were you using when you bought dividend growth stocks? No stock is full proof but dividend aristocrats, the ones that had been paying for 25+ years fair much better than the rest. Also the companies debt, free cash flow, and dividend payout ratios are also a good indicator of dividend risk.

The third reason, it always generates the highest returns, was there an indication that AAPL or LULU would grow that fast. I know it is possible for non-dividend paying stocks to outperform dividend paying stocks in the short-term but what criteria can be used to find these rare stocks? Because for every, AAPL there are a thousand RIMMs.

The fourth reason, it eliminates the need for income, at what point does a company stop being risky of cutting their dividends? True, Bonds have never cut the coupon payment. Yet dividend growth companies such as KO, EMR, DOV, PG, JNJ, MMM have never cut or stopped increasing their dividend either. For over 50 years. Especially after surviving the craziness of that past 10 years, do you think companies that have been increasing their dividends for over 25 years deserve to be treated as risky? While there is no argument against bonds being the safest, but does the fixed return not increasing with inflation worth the slight risk from dividend aristocrats? I don't think so.

In reason five, it eliminates the need to diversify, how many different stocks in different sectors? Some say 5, some say 10. I do agree putting all your eggs in one investment basket is a poor choice, in case the unthinkable happens. It is interesting because though you need to increase the number of positions to be diversified, the more stocks you get, more risky the extra ones become. For example, you have a top 10 that are solid, as you expand, you are picking up ones that aren't as solid but you are also minimizing your risk in numbers.

Thanks again for the article!

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