I have given this article the same title as that of a recent article on Morningstar, which can be found here. That article was the transcript of a video interview with Josh Peters, who is Morningstar’s dividend investing guru. His title is Director of Equity-Income Strategy, and he edits a monthly newsletter that I imagine many of you subscribe to. I am a former subscriber.
The subtitle to Morningstar’s article was, “Worry less about beating the benchmark and more about dividend growth and achieving your desired outcomes, says Morningstar’s Josh Peters.” I agree with that statement completely, and it was what enticed me to read the whole transcript.
I would like to go through some of that article and show where I agree and disagree with Peters’ remarks. All indented quotes in this article are Peters’ words from the interview.
Benchmarks are important. To be able to compare your returns over a long period of time against, say, the S&P 500 is not a bad idea because that’s sort of a default option that you can get with very low cost. If, over a very long period of time, you’re taking just as much risk as–or more than–the S&P 500 and not getting as much return, then maybe you should just index. So, for active managers everywhere who are sort of under siege, that is what you have to do. You have to add some value either with less risk or more return or preferably both.
I have split feelings about this. As we will see later, in this comment Peters is talking about total return performance.
I do not place much weight on measuring the total return of my dividend growth investing against benchmarks, because total return is not my goal. Instead, my goal is to produce a sufficient, reliable, rising stream of income. The endgame is to be able to live off that income in retirement.
I have no problem with benchmarking my dividend growth performance against alternatives. I do that informally, for example, against the S&P 500 (NYSEARCA:SPY) and a few more focused “dividend” ETFs. What I have found is that I have been able to advance my goals better with portfolios of individual stocks than with common benchmarks. My Dividend Growth Portfolio[DGP], for example, throws off twice as much income as SPY, and it has grown its income faster than SPY since its inception 7 years ago.
I also believe that my portfolio has displayed less volatility than that benchmark, although I have not measured that precisely. The average beta of the stocks in my portfolio is about 0.7-0.8, which suggests less volatility than SPY overall.
Less volatility is important to me, because it helps me stick with the plan and not be subject to panic or very much uneasiness when the market turns down or my portfolio loses value. Indeed in the interview, Peters called out “less risk” (meaning less volatility) as adding value to a portfolio.
[B]ut that (beating a benchmark) is actually not how I manage [Peters’ portfolio]. I figure to really achieve the best results you have to start by thinking, “What is the desired outcome?” And for the portfolio I manage, the number-one objective is to generate income that can either be used to fund withdrawals for people who are in retirement and have living expenses to meet or for people who like the strategy and want to reinvest that income to drive future income growth so that they’ve got that much more income available to them when they retire.
I agree almost totally with this statement. The only way I would have changed this remark would be by emphasizing organic income growth – the kind you get when your equities raise their dividends – as well as growing income by reinvesting dividends that purchase more shares. Both “layers” of growth are important during accumulation, in my opinion. More importantly, organic growth is the only growth available in retirement if you are spending rather than reinvesting your dividends.
So, my preferred metric for looking at the performance of our portfolios is to look at the annualized income it throws off. So, if I have 200 shares of XYZ that pay $1 per share annually, then that’s $200. I add up that value for each position in the portfolio–have 27 individual stocks in the portfolio right now–and that comes up with a single number that expresses the income of the portfolio as a whole. It’s a little over $17,000 now for a portfolio that’s worth $440,000 or $450,000. So, that correlates to about a 4% yield right now. But the yield itself–half of it is a function of the stock prices. The market could be high or it could be low–that’s going to influence the yield.
I totally agree with this statement. I measure performance by the amount of income that I receive as well as its rate of growth from year to year.
Peters’ statement about yield is true. The current yield of your portfolio will vary as prices vary. My own DGP’s current yield varies over time from about 3.6% to about 4.2%. Most of that variation is caused by price changes. If prices grow faster than the income stream, the portfolio’s yield drops. If prices grow slower than the income stream, the yield rises.
Notice that yield does not equal amount. Let’s say that prices go up 5% in a month when you have no dividend increases. That means that your yield dropped 5%. So if your portfolio’s yield at the beginning of the month was 4.0%, at the end of the month it is 3.8%.
That does not mean that your income went down 5%. Your income stayed the same. What happened is that the fraction (income / price) went down. It did so solely because “price” in that equation went up.
What I really figure I have some control over and what I want to manage and measure the progress of is that $17,000 today. Is it $18,000 or $19,000 next year? Is it $21,000 or $22,000 year after that? Or am I having dividends cut or not getting the dividend growth I expect and, therefore, my income is stagnating? So, to me, that’s really the most powerful indicator of whether or not we are moving in the right direction. And historically, we’ve had a very close correlation between the market value of the portfolio and the annualized income.
In the last sentence, Peters switches from talking about income and income growth to total return. He states that income growth correlates well with total return growth.
Over very long stretches, that is usually true. But over short stretches, income growth and price growth may be completely disconnected. In fact they may go in opposite directions.
When the market is in a bull run, as it has been almost continually since March, 2009, it is easy to forget that market price changes have almost no impact on dividends. During a bull market, they are both going up.
But let’s go back to 2011, which is the last complete year that had a significant short-term market drop. Here is what the S&P 500 did in 2011. This chart shows the percentage change rather than the raw value of the index.
One thing that makes 2011 interesting is that despite the big price drop in late summer and early fall, it ended the year almost exactly where it started.
I recall that some investors thought that 2011 was a hellacious year, filled with angst and fear at the tumbling market. At its low point in October, the index fell 12.5% from where it began the year and about 20% from its high in July. Many investors sold, fearing that the 2-year-old bull market was over.
But for a dividend growth investor paying attention primarily to equity income, 2011’s price action was meh. Dividends went up on schedule. Here is the quarterly dividend return from my Dividend Growth Portfolio in 2011 compared to 2010:
|Quarter||Dividends Received 2010||Dividends Received 2011||Change|
As you can see, for an investor watching the income performance, there were no temptations to sell based on the market price drop. It had zero effect on the income.
(Disclosure: In preparing the above table, I discovered that the full-year total dividends shown on my website for 2010 and 2011 had been in error. Therefore I went back and checked every year since 2010 and made the corrections on my site. The impact on 2011 is that there actually was more of an annual increase in dividends than I had been showing. The annual increase of +17% for 2011 compared to 2010 shown above is correct.)
So, you might think of it as our yield has been pretty stable over time and as we’ve grown our income, that in turn has helped push up the value of the portfolio. That’s where you get your total return. Total return is always the bottom line. The question is, “How do you achieve the total return that you’re looking for?” To try to compete, head to head, with a benchmark–saying, “I’m going to try to beat the S&P over the next 12 months”–that’s a very different game. It’s a very difficult game, and it doesn’t even necessarily serve your personal investment objectives directly.
My principal disagreement with Peters comes here. I feel that dividend growth investing, the way it works for me, is not all about total return. My goal is to build a dividend stream to eventually live off in retirement, so total return is not the bottom line, rather it is a secondary goal. The primary goal is what Peters said in an earlier comment: “[F]or the portfolio I manage, the number-one objective is to generate income that can either be used to fund withdrawals …or…to reinvest that income to drive future income growth.”
My primary goal is building an income stream that is (1) enough, (2) highly reliable, and (3) beats inflation by growing more than inflation each year.
One of the advantages that I see in looking at things this way is that dividend growth is easy to measure. You simply take your total income each year and compare it to the year before. Did it advance by the percentage that you expect or require?
That is easier to track than price or total return, which are far more volatile than dividends. It is hard to track a volatile number toward a goal that may be 20-30 years away, especially when some years the portfolio’s value drops.How can you possibly make projections or answer the question of whether you are on track to hit whatever your wealth goal is when you retire?
The ease of tracking dividend growth compared to total return applies no matter how old you are. Dividend growth is relatively smooth over time (or at least it has been over the past 40-50 years or so). You can graph your progress toward a distant income goal (10-20 years out) with much more confidence than you can map out a total wealth goal.
I do agree with Peters’ last sentence in the above passage. Comparing yourself over and over to a benchmark on total return “doesn’t even necessarily serve your personal investment objectives directly.”
There is more in the full interview, and I encourage you to read it. My purpose in writing this article is to note how the measurement of success in a dividend growth portfolio will differ depending on your goals. While there is a lot of overlap between what Josh Peters is doing and what I do, differences are created based on his goal that “total return is the bottom line” compared to my objective, which is that income amount, growth, and reliability together are the bottom line.