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The Mental Model of Dividend Growth Investing

Charlie Munger is the famous partner of Warren Buffett at Berkshire Hathaway. Since Charlie and Warren met in 1959, they have been inseparable in sharing wisdom. The friendship helped built the fortunes of both men through their investment partnerships and Berkshire Hathaway, resulting in some of the best investment records ever.

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Charlie Munger is famous for his study of mental models. There are plenty of books, articles, podcasts and blogs about these mental models. There are lots of them, many of which I utilize in my own investing.

Dividend Growth Investing: Underappreciated Mental Model

There is one underappreciated mental model, which has never to my recollection been mentioned. The mental model I am referring to is that of Dividend Growth Investing.

In a nutshell, Dividend Growth Investing is the investing strategy, where you purchase shares in a company which grows dividends annually for a minimum number of years. For this company to achieve this track record, it must have grown earnings, and it should also have a chance of continuing to grow the bottom line in the future. The dividend must be sustainable, and the company’s shares should be purchased at an attractive valuation.

Dividend Growth Investors focus on the operating performance of a business first, and the fundamental traits that a successful business leaves in the form of growing dividends. Growing dividends are a byproduct of a successful business, which generates more cashflows than what it needs to deploy intelligently back into the business. By definition, most businesses cannot deploy all cashflows back into growing the business. There is a natural ceiling, after which more investment may actually be counter-productive. The focus on fundamentals means that dividend investors in general treat stocks as real businesses, and not some pieces of paper or blinking bits of information on a computer screen. The focus on annual dividend payments that rise over time results into a shareholder base that is longer-term focused. Smart managements should cultivate a smart long-term shareholder base, and reward them with consistent operating performance, and a continuing track record of annual dividend increases. These investors are not worried about short-term volatility, drops in the share price, or bear markets. Rather, they focus on the long-term trends in the business, and the relentless rise in dividend income over time, supported by fundamentals.

Strong Competitive Advantages

The insistence of a minimum track record of annual dividend increases reduces the number of businesses for research to around 300 worldwide. After a study of dividend growth investing over the past decade, I have come to the conclusion that most of these enterprises have historically been successful due to having strong competitive advantages, stable business model, or an innovative management that focused on returns, rather than chasing growth for the sake of growth itself.  Managements that execute and deliver long track records of annual dividend growth are good at capital allocation.  These management teams allocate capital at the projects with the highest expected values, because the need to maintain the track record of annual dividend increases helps them focus in that direction.

Past performance is not a guaranteed for future success however. Just because something worked in the past, it doesn’t meant that it would work in the future.  This is why Dividend Growth investors also focus on diversification. It matters to hold shares in companies from different industries, without sacrificing quality and the need to obtain the shares at attractive valuations. Of course, that also means that certain sectors may not be perfect for long-term investors, because they are highly cyclical and produce unreliable earnings streams to establish even a minimum track record of annual dividend increases.

Dividend Growth Investors also focus on keeping their investment costs low, by using commission free brokers, holding their investments directly, and investing through tax-deferred accounts such as Roth IRA’s. Using a commission free broker guarantees low investment costs, as does not using an expensive financial adviser that charges a fee for selecting a few mutual funds. Holding securities directly also means that you can control how long you can hold these securities for, and not be subject to the whims of investor inflows and outflows, which could impact you if invested in a mutual fund or a hedge fund. Many high-fee advisers and active fund managers do not like dividend investing, because there is no money in it for them.

I view most investment strategies through the lens of the dividend growth investment mental model.

Dividends vs Stocks

Dividends are more stable and much less volatile than stock prices. Boards of directors set dividend rates based on current and prospective earnings, taking into account economic and business conditions.  If you look at the dividends from companies in the dividend aristocrats or dividend champions lists, they have a steep upward looking slope from left to right. Dividends are more stable and predictable than stock prices, which makes them an ideal source of income in retirement. It is easy to predict how much income a diversified portfolio of dividend growth stocks will generate over the course of the next year. Stock prices are determined by the neurotic crowd that gets fearful or greedy, which explains the volatility. I would never base my retirement on selling off shares, because I cannot predict share prices. People who plan to sell stock to fund retirement, despite evidence that they cannot predict share prices, are speculators.

For example, there are plenty of naysayers behind dividend growth investing. Most of the show elaborate backtested portfolios, which show amazing results for things like shareholder yield. However, when we are no longer in the safe setting of curve-fitting and optimizing historical data, these models always fail to deliver. Because Dividend Growth Investing works in reality, but won’t show you the best backtested model to riches. Promoters will continue ignoring it, since there is not a lot of money to be made off DIY investors.

The other helpful factor is behind active investment management, viewed through the prism of dividend growth investing. Active managers do not like dividend investing, and dividend investors, because they are DIY type investors. These investors are not easily swayed, because they invest in solid companies they understand and can stick to through the ups and downs of the economic cycle. On aggregate, diversified portfolios of dividend growth stocks are cheaper than most mutual funds out there. That’s because most dividend growth stocks are well known blue chips, for which our dividend investors do not need to hire a Harvard MBA to select and manage for a 1% annual fee. Most dividend investors are buy and hold investors, which means that they will have small turnover and therefore pay less in commissions and capital gains taxes than the average active investors out there.

Why FIRE Bloggers Hate Dividend Growth Investing

Plenty of FIRE bloggers hate dividend growth investing for some strange reason. They usually cite the fact that you pay taxes on dividends in taxable accounts as a reason why they do not like dividends. The problem with this faulty thinking is that most investors nowadays invest through a tax-deferred account. Hence, taxation should not be an issue that it is made out to be. Even if everything is invested in taxable accounts, with dividend growth investing you generate your highest income in the future, due to the growth in distributions and the powerful force of dividend reinvestment. In addition, when someone is truly retired and only lives off investment income, they can generate up to $100,000 annually in qualified dividend income with their spouse, and not pay a dime in federal taxes. Of course, if you are a FIRE blogger who claims to be retired, but works tirelessly to generate tax-inefficient blog income that is taxed even worse than employment income, you are deceiving yourself. If you were truly retired, and not just pretending to be one in order to generate money online, you would be living off dividends and not generating any tax liabilities.

Dividend investors looks at stocks they own as pieces of real businesses. The part of the profits that businesses cannot intelligently reinvest are distributed to shareholders in the form of a dividend. This is a fundamental return on investment. Speculators on the other hand look for investment appreciation, and eschew dividends as something old fashioned. In reality, share prices are unpredictable, as market conditions, investment sentiment and economic factors such as interest rates can result in rapid changes.

For example, a dollar in earnings per share could be worth anywhere from 5 to 105 times, due to factors and changes in growth expectations alone, even if the business operating performance is stable and humming along nicely. Since dividends track fundamentals, they are more stable and easier to forecast and rely upon.

Today, we discussed the mental model of Dividend Growth Investing. In a nutshell, Dividend Growth Investing is the investing strategy, where you purchase shares in a company which grows dividends annually for a minimum number of years. For this company to achieve this track record, it must have grown earnings, and it should also have a chance of continuing to grow the bottom line in the future. The dividend must be sustainable, and the company’s shares should be purchased at an attractive valuation.

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Article by Dividend Growth Investor

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