Published June 13th, 2015
Dividend growth investing focuses on owning stocks that pay increasing dividends.
Dividend growth investing generates both current income and future income, making it a favorite of investors looking to build growing passive income streams.
Dividend growth investing is uniquely suited to individual investors. Once bought, a high quality dividend growth stock will compound investor wealth for years – if not decades.
This reduces the need of having to constantly generate new ideas. Individual investors can’t (and shouldn’t) spend all day analyzing the stock market. That’s why dividend growth investing works so well for individual investors.
How well has it worked?
Since 1972, stocks that don’t pay dividends have averaged total returns of 2.6% a year. All dividend paying stocks have averaged total returns of 9.2% a year. Dividend growers and initiators have averaged 10.1% a year. The image below shows this outperformance since 1972.
Like all things worth doing well, dividend growth investing has a learning curve. The 10 tips below will help you become a better dividend growth investor.
Tip #1: Focus on Total Return not High Yield
Total returns are capital appreciation plus dividends.
Just because a stock has a high yield does not mean it will generate better total returns. In fact, if you put dividend paying stocks into 5 baskets (called quintiles), the highest yielding quintile actually has lower total returns than the 2nd highest yielding quintile.
During the period from 1928 through 2013, the highest yielding quintile had total returns of 10.85% a year. The 2nd highest yielding quintile had total returns of 11.65% a year. The image below shows that high yield does not give the best total returns.
Do not confuse this with thinking that dividend yield doesn’t matter…
Dividend yield does matter. All other things being equal, the higher the yield the better. All other things are never equal, however.
The highest yielding stocks tend to have the highest payout ratios. They therefore have less money to reinvest and grow their business. This means slower future dividend growth and less capital appreciation.
It is more common to find high yield, high payout ratio stocks than high yield, low payout ratio stocks. High yield, low payout ratio stocks have historically produced excellent returns. The image below shows how high yield, low payout ratio stocks have performed well, while high yield, high payout ratio stocks have lagged the market.
By focusing on total return rather than high yield, dividend growth investors set themselves up for future success. High yield in itself is preferred, so long as it is accompanied by a solid growth rate.
If a business has a high payout ratio, it will likely realize sluggish growth. Two notable exceptions are Philip Morris International (PM) and Altria (MO). Both stocks need very little capital to maintain and grow their business and can therefore pay out the bulk of earnings as dividends while still having enough retained earnings to fund growth.
Tip #2: Dividend History Matters
Some businesses have paid dividends for much longer than others. Businesses with long streaks of paying dividends without reductions creates a cultural norm.
This reinforces the important of steady or rising dividends for management. A company that has only paid dividends for 2 consecutive years will more easily justify cutting dividends than a company that has paid increasing dividends each year for 50 consecutive years. No CEO wants to be the one that oversaw the dividend cut.
Historically, stocks with longer dividend histories have cut their dividend payments less frequently. The image below (created by Sure Dividend) shows the percentage of dividend stocks with 25+ years of consecutive dividend increases that held steady or reduced their dividends in 2011, 2012, and 2013 versus stocks with 10 to 24 years of dividend increases.
The image above clearly shows that stocks with longer dividend histories are less likely to cut or eliminate their dividend payments.
Tip #3: Boring Business Are Better
Social media stocks and biotech stocks certainly get more publicity. There is a certain appeal to investing in the hottest stocks on the cutting edge of technology.
In general, these stocks are in rapidly changing industries. The social media landscaping is constantly shifting, as is the entire technology industry. The internet bubble around 2000 clearly shows the ‘irrational exuberance’ that hot stocks can elicit.
Boring businesses exist in slow changing industries. The insurance industry has not changed much over the last several hundred years. Technology might make it easier to do business, but the process of receiving premiums, investing float, and paying claims is very unlikely to change. As a result, insurance companies need not fear obsolescence the same way a tech company should.
Other slow changing industries that allow businesses to maintain competitive advantages for decades rather than years include branded consumer food and beverage products, banking (when done conservatively), branded household goods, and discount retail.
Health care is a unique mix of technology and stability. The health care industry includes many stable corporations with very long dividend histories, including: Johnson & Johnson (JNJ), Baxter (BAX), Abbott Laboratories (ABT), and C.R. Bard. People will always need health care. The industry does change, but the product lifetime of needles, bandages, catheters, and other medical supplies is very long.
Tip #4: Management Needs to Be Shareholder Friendly
Dividend growth investors should steer clear of hostile or unfriendly managements.
One of the benefits of dividend growth investing is only investing in stocks that pay dividends. These companies by definition are returning money to shareholders in the form of dividend payments.
Dividend growth investors should look for more than just a dividend. As mentioned above, the longer the dividend history, the better. Long dividend histories show management’s commitment to rewarding shareholders with dividend payments.
In addition to dividends, shareholders should look for managements that seek to maximize long-term shareholder value. Businesses that will spin-off or divest underperforming or non-core assets show shareholder friendliness. It is in the CEO’s best interest to manage as large a business as possible. The larger the business (often times) the larger the CEO’s paycheck. A management team that is willing to shrink the size of the businesses to become more profitable and grow shareholder value quickly is a positive signal.
Conversely, managements that acquire loosely related or unrelated businesses are trying to build a large empire to rule over rather than maximize shareholder value. Management teams with a history of questionable acquisitions should be avoided.
Dividends and spin-offs are typically positive signs for shareholders. Share repurchases can be very positive as well. If management repurchases shares when the company is trading at or below fair value (which is of course difficult to know), shareholder value rises. Share repurchase of undervalued companies are the best way for a management team to return value to shareholders.
Unfortunately, share repurchases have a dark side as well.
Management can use share repurchases to boost earnings-per-share when the stock price is overvalued. This destroys shareholder value because management is using $1 in cash to buy shares that are trading at more than full value; they are spending $1 to buy $0.75 (or some number less than $1) in value. This obviously destroys value and is not rewarding to shareholders. Businesses that appear to be overvalued should pay out excess cash in the form of dividends rather than repurchase shares.
Tip #5: Look for Quality at a Discount
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”
– Warren Buffett
Value investing is the process of identifying and investing in businesses that you believe are trading at less than fair value. Dividend growth investors should also look for businesses they believe are trading at less than fair value.
The difference is that a strict value investor will buy the business in the hopes that it will return to fair value – and then it’s time to sell.
A dividend growth investor will look for an undervalued business, then buy and hold it while it continues to grow and pay larger dividend payments over time.
The difference is that the value investor looks to make a quick gain by ‘flipping’ stocks, while a dividend growth investor looks to take part in the growth of the business.
If the plan is not to sell, why does value matter? The more undervalued a stock is, the higher its dividend will be. If a company pays $1.00 per share in dividends and it is trading at $100 per share, the dividend yield is only 1%. If that same business falls in value down to $20 per share, the dividend yield is 5%. All other things equal, 5% yield is much better than 1% yield.
The other advantage to buying when you believe a high quality business is below fair value is that you are giving yourself a margin of safety. If you buy a business for too high of a price, the business will have to grow for years to ‘make up’ for the overly high price you paid for the business.
Tip #6: Patience Is a Virtue
Dividend growth investing itself is not as time intensive as value investing or day trading. On the other hand, dividend growth investors will hold stocks for very long periods of time.
Patience is a virtue in dividend growth investors. We must have the ability to hold stock during bear markets, when values are falling. Stock prices may fall, but high quality dividend growth stocks should continue to pay dividends, even during recessions.
Patience is rewarded in dividend growth investing. Businesses that generate solid returns year-after-year create real wealth over long periods of time. An investment with a total return of 10% a year will double your wealth about once every 7 years, and 10x your wealth about once every 25 years.
Dividend growth investing is not for investors who lack patience. Without patience, investors will churn their account and generate higher-than-necessary frictional costs from brokerage fees, slippage, and taxes. Additionally, quickly buying and selling means you will not benefit from the fantastic compounding effects of high quality businesses.
Tip #7: Invest with a Plan
“By Failing to Plan, you are planning to fail”
– Benjamin Franklin
Dividend growth investing is best approached with a solid plan in place.
For many dividend growth investors, the end goal is building a portfolio large enough to live off the dividend income alone.
Your plan should include the dividend income you need to be independent, as well as the investment method you follow.
There are many dividend growth investment methods and plans. The 8 Rules of Dividend Investing uses common sense rules backed up by quantitative rules to determine the top 10 best dividend growth stocks each month for long-term investors.
The Chowder Rule is another method used to find high quality dividend growth stocks. The Chowder Rule looks for dividend growth stocks that have an expected total return of 12% or higher. The dividend growth rate plus the dividend yield should be greater than or equal to 12%. For example, if Coca-Cola has a 3% dividend yield and a 9% historical dividend growth rate, it would pass the Chowder Rule test.
In addition to a ranking or stock selection methodology, a dividend growth investor’s plan should also include a savings goal – if you are still in the accumulation phase. For investors in the retirement/distribution phase, this is not necessary. No style of investing works if you don’t save money with which to invest. Saving a set amount at the beginning of each month is a sure way to fund your dividend growth portfolio.
Tip #8: Continuous Education
Peak performance for most sports comes in your late twenties or early thirties. Investing, however, is a lifelong process.
Unlike sports, there is no ‘peak’ age. As long as you are of sound mind, your investing skill will continue to increase – if you focus on continuous education.
Charlie Munger is an excellent example of an adept investor who has taken a lifelong journey of accumulating knowledge. Munger advocates creating a ‘latticework of mental models’ from a variety of sources. Munger employs the biggest and most important ideas from science, philosophy, psychology, and other sources in order to quickly analyze potential investments from a variety of different viewpoints.
There is no reason to stop learning about the investing process. No matter how much you think you know, there is always another wrinkle or nuance to investing that you haven’t seen before.
Tip #9: Get Ideas from Indexes
Fortunately for dividend growth investors looking for high quality businesses, there are several indexes which greatly shorten the search.
The Dividend Aristocrats Index is comprised of over 50 businesses that all have 25+ consecutive years of dividend payments. The index includes many household-name companies like: Clorox (CLX), PepsiCo (PEP), and Wal-Mart (WMT).
The Dividend Aristocrats Index is an excellent place to look for dividend paying businesses with strong competitive advantages. A business must have – or at the very least recently had – a strong competitive advantage to grow dividends each year for 25 or more consecutive years.
For investors looking for the pinnacle in longevity, the Dividend Kings group is the place to look. To be a Dividend King, a stock must have raised its dividend payments for 50 or more consecutive years. Only 16 corporations meet the exclusive requirements to be a Dividend King. Coca-Cola (KO), Johnson & Johnson (JNJ), and Colage-Palmolive (CL) all meet the strict requirements of the Dividend Kings.
The Dividend Aristocrats Index currently trades under the ticker symbol NOBL. There is no ETF for the Dividend Kings at this time. Of course, index funds have management fees, which reduce total returns. Additionally, not all stocks in an index will be trading around fair value. Many will be overvalued. When you buy the whole index, you buy both the overvalued and undervalued stocks in the index. Instead of purchasing the index, dividend growth investors may be better served by using indexes of high quality dividend stocks to generate ideas for individual stock investment.
Tip #10: Don’t Fund Wall Street
The less you pay in investment fees, the more money you have compounding in your investment account. The after-inflation return of the S&P 500 over the last 100+ years is around 7%. Giving away ‘just’ 1% of fees to an investment advisor or mutual fund manager means you are giving away around 14% of your profits every year. It’s your money, yet you would give away around 14% of profits to a fund manager or investment advisor.
Simply put, the lower you keep your investment expenses, the better off you will be. The image below shows the impact of fund fees on performance; the lower the expense ratio, the better your performance is likely to be.
Individual investors can greatly reduce fees by buying high quality stocks and holding for long periods of time. Buying stocks and quickly trading creates large fees for your broker over time. Imagine you have a $100,000 account, and you buy and sell 1 stock every trading day – at $5 a transaction. Over the course of a full year, you will spend $2,520 on brokerage fees; this comes to 2.5% of account value. An investor must have a sizeable edge to generate an additional 2.5% return every year which is just enough to cover the cost of all that trading activity.
Investing for the long run reduces frictional costs. Buying individual stocks instead of funds eliminates management fees. The strategy of buying individual stocks and holding for the long-run keeps your investment money compounding in your account, where it should be.