Thursday, July 02, 2009

Ten Principles of Dividend Growth Investing

Many people forward on to me articles on dividend investing. These articles cover the waterfront from writers opposed to dividends completely to those who believe companies should pay a stated amount of their earnings in dividends. I find that I agree with very few of the articles I see. In most cases, I find it is not a theoretical objection but a practical objection: I have tried it their way and found it didn't work for me.

Elsewhere in earlier blogs I explained how I first learned of the merits of dividend investing in the 1980s and how those early ideas have evolved over time. The following is a short list of the principles of dividend investing as practiced by Donaldson Capital Management.

  1. Consistent Dividend Growth is the most important element of dividend investing.
  2. Beware of high dividend yields where dividend payouts are in excess of 60% for industrial companies, 70% for utilities, and 90% for REITs.
  3. Beware of any company that pays out more in dividends than their free cash flows.
  4. Look for companies where there is at least a 70% correlation between price growth and dividend growth over the long run.
  5. Companies with consistent dividend growth permit valuation using regression models. These regression models can offer an investor an educated guess at the expected total return of a stock over a future period of time.
  6. It is remarkable that many so-called cyclical companies with volatile earnings will have a much lower price volatility if they employ a normalized dividend approach, instead of a lumpy approach.
  7. We are always on the prowl for dividend-paying companies that the market has rewarded with a high correlation between their dividend growth and their price growth and who have temporarily fallen out of favor.
  8. For almost all companies, even the most highly predictable companies in our universe, changes in interest rates will affect relative valuation.
  9. Consistent dividend growing stocks seldom get highly over or undervalued. They get overvalued when the band is playing, the birds are singing, and stocks are flying high. They get undervalued when the media is shouting duck and cover.
  10. Watch carefully at dividend actions in good times and in bad. In good times, dividend growth should be less than earnings growth. In bad times dividend growth should be higher than earnings growth.

We are now enduring a time when the media is doing what they do best: broadcasting duck and cover stories. Save a copy of the most pessimistic article on the economy and stocks you can find. Set a note on your calendar to look at it in three years.

In three years, as the birds sing softly in the background, re-read today's duck and cover article. As you hear the band warming up in the background and the media are cautiously suggesting that things are looking up call me. Surprise me and ask me the following question: How much is Procter and Gamble overvalued?

We own Procter and Gamble.