Dividend Growth Investing: Picking Stocks Or Dividends

The Wall Street Journal recently published an article about dividend stocks. It’s a good article, however I couldn’t help but come out of it thinking they lumped all dividend growth investors together.

First, the article pigeonholed DGI to begin with:

For the past decade, dividend stocks were a pretty simple play: Stable stocks that you hold for building wealth or generating income in retirement.

Right. You just go to your broker’s drive-through window and say, “Gimme three dividend stocks, a large fry, and medium Coke. And, oh, please make sure all three stocks are ‘stable’.”

The article goes on to summarize the challenges facing (some) companies that pay dividends and how they might impact investors.

In conclusion, the article, at least, appeared to indicate that nuance exists among the DGI crowd:

Dividend payers in sectors like consumer staples, financials and utilities, which have been relatively stable this year, are also emerging as stocks that investors are turning to for income because of the sustainability of their payouts despite uncertainty.

But, even still, I’m not buying these sectors wholesale. I pick stocks from sectors, based on the company’s growth story and its dividend.

Dividend Growth Investing isn’t “a pretty simple play”

I sort of regret focusing so much on how dividend growth investing helps take the emphasis off of stock price appreciation. It leads some people to believe dividend growth investors blindly buy stocks, focusing only on how much income a position can and will generate. If this was the case, we would look at one metric only – dividend yield. But, of course, most dividend growth investors don’t do this.

We have to be good stock pickers, just like everybody else, if we want to maximize our returns. In addition to being good stock pickers on the basis of how we think a share price will perform in connection with a company’s growth, we must consider how the dividend will impact our position.

In AT&T’s (T) case, maybe you tell yourself you’re getting paid to wait. With Starbucks (SBUX), I tell myself I’m getting the best of both worlds, growth in operations and the dividend. At Apple (AAPL), the dividend is icing on the cake, however, 40 years from now the company will likely top the dividend aristocrat list with in the neighborhood of 50 years of consecutive dividend increases.

All of this to say, dividend growth investors pick stocks as much as we pick dividends. When we pick stocks, we use some of the same criteria investors who don’t think much about dividends use. The beauty of our approach lies, in part, in the fact that the dividend can tell us a lot about a company at the same time as providing a backdrop of relative safety and security for our position.

So, in this article, I clear up, at least from my perspective, misconceptions I think the broad investment community has about DGI.

However, I really want to know how you select positions for your portfolio. Are you picking stocks or dividends? Probably a bit of both.

Put another way, does a seemingly sound and relatively lucrative dividend help alleviate concerns over holes in a company’s story (e.g., AT&T)? Or are there so many good and good enough dividends out there that you discriminate rigorously and methodically?

Some observers might have you believe that DGI ardents couldn’t tell Colgate Palmolive (CL) from Procter & Gamble (PG) or McCormick & Co (MKC) from Clorox (CLX). You’re just buying “consumer staples” because that’s where you’ll find safety and security today. When that sector lags, you’ll satisfy your income needs elsewhere. I suspect Seeing Alpha readers and DGI proponents will elaborate otherwise in the comments.

But first…

The No. 1 Reason Why Dividend Growth Investors Need to Pick Good Stocks

More than a few people appear to subscribe to the notion that investors in general, but dividend growth investors in particular, sector surf. That is, they rotate into sectors where the prospects for reliable income are greatest, in the moment.

First, this whole notion of rotation at the individual investor level is absurd. They talked about a “rotation into value” that apparently “wants” to happen on CNBC a lot Tuesday. Who’s doing the rotating? Probably mutual fund managers and other professionals moving around big money. I’m not. I suspect you’re not either.

The entire bedrock for DGI centers on buying and holding. Dividend growth investors don’t merely want to generate income, we want to build wealth. You don’t build wealth by rotating in and out of sectors as they fall in and out of favor. You build wealth buy picking solid individual stocks that pay consistent and, hopefully, increasing dividends. You reinvest the dividends. Over time, you realize the power of compounding.

For example, I despise the retail sector right now, particularly retail-focused REITs. But I’m long Realty Income (O). Have been for a while. Based on what I know now and foresee, I probably will be forever. I own Realty Income not because I see the sector rebounding or think there’s a sector-wide opportunity. In fact, it’s closer to the opposite.

In a sector where I have little faith, I own the stock I consider best of breed in a bad space. Realty Income collects rent from a tenant base built for the pandemic. Sure, it leases to a few dogs (e.g., the movies and gyms), but so many of its clients are essential and thriving during the pandemic.

Realty Income pays a monthly dividend. Each month I reinvest money Realty Income pays me. I can literally “see” the wealth-building process taking shape before my eyes. It would hurt my heart to stunt it. So I better darn well do my best to ensure I’m picking a great stock that just so happens to have a great dividend. This is the only way you can reap the ripest fruit of a dividend growth investing approach.

We Care About Share Price, We Just Don’t Need To Obsess Over It

There’s one good thing about AT&T stock trading stagnant and, from time to time, dipping. We have a nice yield and, more importantly, can gobble up more shares at lower prices with incremental buys and dividend reinvestment. However, this only works as an investing strategy if AT&T’s stock eventually recovers and heads higher.

I guess you could argue otherwise. AT&T between $28 and $29 forever, as long as the dividend doesn’t get cut and keeps going up, provides a steady stream of income. It plays its role as one stock in a diversified dividend- and income-focused portfolio. This thought trajectory makes me uncomfortable.

At some point, the story and sagging stock will catch up with the dividend. So, ideally, if you own AT&T, you’re going to want to see the stock price start to rise alongside execution on things such as the successful integration of Time Warner. Amid stock price appreciation, you want to see a dividend that continues to increase as well. In this scenario, you have something like we have seen from Starbucks in recent years – the aforementioned best of both worlds.

Along these lines, I feel confident saying (though I’d love to do methodical research on this) that dividend growth investors are less likely to panic sell than the investor who buys stocks on the basis of one thing only – that they go up. It’s a freak out to see the stocks you own tank. We have discussed this before. When you’re also in it for the income and you have selected best of breed stocks (or stocks with, to some modest degree, a sane and logical speculative story), you don’t have quite as much reason to react to dips, downturns, and dives in stock price.

Here again, you have to be a good stock picker, first and foremost. You have to have made the right call on the company. You don’t rest relatively easy just because the dividend exists. You rest relatively easy because the company paying the dividend exists and operates from a position of strength with a long-term growth story and strategy that remains intact even in periods of market or global turmoil.

I anticipate a solid comments section that digs into the nuances of how you pick your stocks, particularly if you call yourself a dividend growth investor.

Disclosure: I am/we are long AAPL, CL, O, SBUX, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.