How Dividend Growth Covers Up Mistakes

Over the past ten years:

Colgate-Palmolive has grown its dividend by 12.5% annually.

Pepsi has grown its dividend by 13.5% annually.

Exxon has grown its dividend by 8.0% annually.

McCormick has grown its dividend by 11.0% annually.

Coca-Cola has grown its dividend by 10.0% annually.

Disney has grown its dividends by 8.0% annually.

Normally, I talk about these facts in the context of building wealth. But dividend growth also serves another useful function: it preserves wealth. When you have ownership interests in businesses that are raising their cash payouts each year, it allows for you to completely screw up with an investment or two and still do all right for yourself.

When you think about building a portfolio of companies that you truly intend to hold for 20+ year increments, the big fear is that something like General Motors is going to slip in there, go bankrupt, and muck things up.

But here is what makes investing fun: A well-diversified portfolio of dividend growth stocks allows you to use the growth in dividends from the reliable stocks to offset the potential income loss from a bad investment.

What does an average dividend growth portfolio yield these days, something like 3%? Okay, let’s use clean numbers and assume you’ve built up a $100,000 portfolio that is creating $3,000 in income split up into 30 companies each contributing $100 on average to your total. If 28 of those companies grow their dividend by 7.5%, you are going to see your income there grow from $2,800 to $3,010. Basically, you could have two companies eliminate their dividends in a given year, and you’d still come out ahead (although you’d have to adjust for inflation).

That’s the secret sauce of the strategy. If you own 1,000 shares of Coca-Cola, you are going to get $1,120 in dividends right off the bat. But here in March, you are going to get a higher dividend as Coca-Cola continues its half-century long tradition of giving you shareholders dividend raises. The quarterly dividend is currently $0.28 per share, and my guess is that it will go up to $0.31 or $0.32 per share. We’ll say $0.31. That means Coca-Cola is going to automatically increase your income to $1,240 per year. That $120 increase is a security blanket of sorts that allows you to endure a dividend cut elsewhere and still be in the same position you were in before the cut—it’s a great insurance policy against your own mistakes.

And plus, people tend to discount the effect of reinvesting dividends on giving you security. Picture someone with 1,000 shares of BP. The dividend at the start of 2012 was $0.48 per share. Now, as we sit here at the end of 2013, we see a dividend of $0.57. That’s pretty awesome dividend growth of 18.74%, and a lot of that is due to BP’s increase in the payout ratio as the dividend recovers from its cut after the oil spill.

What the numbers don’t reflect, though, is that you would have picked up 94 more shares of BP had you chosen to reinvest your dividends back into the company since the start of 2012. It’s just the 18.74% dividend increase that you benefit from, but you also are the sweet beneficiary of a higher ownership stake as well. Instead of seeing your dividend income go from 1,000 shares paying out $1,920 in annual dividends to 1,000 shares paying out $2,280 in dividends, you really got to have 1,094 shares paying out $2,494 in annual cash deposits into your account. Right there before your eyes, BP increased your dividend income by almost 30% since the start of 2012.

The effects are exaggerated because oil stocks pay out high starting yields, the valuation of BP has been low these past two years, and the dividend growth has been nice. But that’s the thing about it all: it seems to happen right under our noses. We only see the dividend go up a couple pennies at a time, the stock price seems “stuck” in the $40s perpetually, yet you are making 30% more annual income from BP on December 31st, 2013 than you would have been earning when you woke up on January 1st, 2012.

These reinvested dividends plus dividend growth in part of your portfolio is a great buffer. Seeing those BP dividends go from $1,920 in early 2012 income to $2,494 in end of 2013 annual income would allow you to handle dividend eliminations elsewhere and still be protected. Adjusting for inflation, that $2,494 is really like $2,407. In other words, you could make mistakes that cost you $487 in annual dividend income elsewhere in your portfolio and still be in the same position that you were in on January 1st, 2012.

That’s the part about the dividend growth strategy you don’t hear about as much. You can bumble around a bit and make some mistakes, and the reinvested dividends and dividend growth can offset them. Some Pepsi, Coca-Cola, McCormick, Disney, and Exxon dividends that have been growing and reinvested can offset some folly elsewhere. If you make a mistake, it’s not a big deal. In a lot of cases, you won’t have even lost any ground at all.