Make Dividend Growth Investing Your New Year’s Resolution

  • Dividend growth investing is based on sound investment principles
  • Dividend growth investing borrows from both value investing and growth investing
  • See 3 studies of how dividend growth investing has outperformed
  • Additional resources on dividend growth investing for further reading

Dividend growth investing is an investment style focused on growing an investor’s dividend stream through time.  The style shares similarities to both value investing and growth investing, but is unique.  Keep reading to see why switching to dividend growth investing could be the best new year’s resolution you’ll ever make for your bank account.

Philosophy of Dividend Growth Investing

The value of a business comes from the expected future cash flows shareholders can expect to receive.  Common stocks generate cash flows to shareholders through dividend payments.  As a result, the value of a stock comes from the expected dividend cash flows an investor expects to receive.

Dividend growth investors acknowledge that dividends are the most critical aspect of stock ownership.  A dividend growth investor does not focus only on high yielding stocks.  Rather, one should look at high quality businesses that will raise their dividends year after year.  These businesses will maximize an investor’s investment income stream over long time frames.

The end goal for most dividend growth investors is living off the dividend income stream created by their investment portfolio.  I believe one only reaches true financial freedom when they can comfortably sustain their lifestyle with just the income from their portfolio.  An investor who can live off their dividend income alone will never have to sell shares of their portfolio to sustain lifestyle.  Instead, their dividend income stream and portfolio will (hopefully) grow year after year.

Dividend growth stocks are like fruit trees.  Your investment may start out as a small sapling, but it will eventually grow into a large tree.  You can either eat the fruit from the tree (spend the dividends) or replant the fruit and grow new trees (reinvest dividends into other dividend growth stocks).

Similarities to Value Investing

Dividend growth investing has several similarities to value investing.  A value investor attempts to identify the intrinsic value of a stock and the purchase it for less than its intrinsic value.  When the stock reaches its pre-calculated intrinsic value, the value investor sells the stock.  Common value investing metrics include the P/E ratio, the P/B ratio, and dividend yield.

Dividend growth investors take valuation into account.  A stock trading at a very high P/E ratio will have a low dividend yield.  This impacts the current and future cash flows a dividend growth investor will receive from their investment.  A stock growing at 10% a year with a 1% yield will pay you less than a stock growing at 10% a year with a 3% yield.  Value matters to dividend growth investors.

Similarities to Growth Investing

The classic growth investor looks at the future prospects of a business and invests in businesses that have massive growth potential.  Typically, a growth investor looks for businesses that are already growing in double digits.  Examples of growth stocks today are Facebook (FB), Ali Baba (BABA), and GoPro (GPRO).  Growth investors look at future potential rather than current income.

Value is only a part of dividend growth investing.  As the word ‘growth’ in dividend growth investing implies, dividend growth investors care about growth.  Current yield is only a small fraction of a company’s future worth.  The potential market size and growth prospects of a company matter greatly to dividend growth investors.  A stock yielding 6% a year with 0% growth will have a lower yield on cost in 10 years than a stock growing its dividend at 12% a year that starts with a 2% yield.

The Price Decline Advantage

Perhaps the greatest advantage to dividend growth investing is that dividend growth investors do not depend on stock price increases for their returns.  A dividend growth investor looks at their yield on cost (the current dividend payment divided by purchase price), rather than the price of the stock.

During bull markets, a dividend growth investor may not have the same sense of satisfaction as someone who only watches stock prices.  Of course, during bear markets, a dividend growth investor will find it much easier to hold on to their high quality stocks through serious price declines.  This is because most high quality businesses don’t cut their dividends during recessions, so the dividend growth investors yield on cost will not change during recessions.  Recessions simply give the dividend growth investor an excellent opportunity to reinvest their dividends into stocks with an inflated dividend yield due to their discounted stock price brought about by market fears.

The Historical Record

Dividend growth investing doesn’t just sound good on paper.  The historical record backs up the efficacy of dividend growth investing.  Several historical examples of dividend growth stock outperformance are below:

Example One:  Dividend Aristocrats
The Dividend Aristocrats Index is made up of 54 businesses that have increased their dividend payments for 25 or more consecutive years.  The index is full of high quality businesses that have proven they can withstand recessions and are focused on rewarding shareholders through dividend payments (and often share repurchases as well).  Over the last decade, the Dividend Aristocrats Index has generated total returns of 10.91% a year, versus 8.06% a year for the S&P 500.
Source:  S&P Dividend Aristocrats Fact Sheet

Example Two:  Dividend Growth Versus No Growth Dividend Stocks
It is important to make a distinction between no-growth dividend stocks and dividend growth stocks.  No-growth dividend stocks pay the same dividend payment each year.  These are stocks that, for whatever reason, are not willing or able to raise their dividend payments.  As you might expect, no-growth dividend stocks have underperformed dividend growth stocks.  From 1972 through 2013, dividend growth stocks have outperformed no-growth dividend stocks by over 2.4% a year.
Source:  Oppenheimer Rising Dividend Fund Fact Sheet

Example Three:  Dividend Stocks Versus Non-Dividend Stocks
In the period from 1928 through 2013, dividend stocks have outperformed stocks that do not pay dividends.  Using data from Kenneth French and CSRP, Heartland Funds dividend all stocks that pay dividends into 5 quintiles based on yield.  Stocks in quintile one were the 20% lowest yielding dividend stocks, and stocks in quintile 5 were the 20% of stocks with the highest yields.  In the long period from 1928 through 2013, all quintiles of dividend stocks outperformed non-dividend paying stocks.  The lowest yielding quintile outperformed by 0.77% a year.  The best performing quintile (quintile 4, not quintile 5) outperformed non dividend paying stocks by 3.33% a year.
Source:  Dividends:  A Review of Historical Returns

Examples of Dividend Growth Stocks

The Dividend Aristocrats Index is an excellent place to look for dividend growth stocks.  3 high quality Dividend Aristocrats worthy of further research are:

You can find a complete list of all 54 Dividend Aristocrats with links to detailed analysis on each Dividend Aristocrat (along with my Top 7 Dividend Aristocrats) at this link.  Another good starting point to research high quality dividend growth stocks is the Dividend Achievers Index which include stocks that have increased their dividend payments for 10 or more consecutive years.

Additionally, the DRIP Investing Resource Center keeps a list of businesses with 25 or more years of dividend payments with a reduction called Dividend Champions.  The list is more inclusive than the Dividend Aristocrats, as the Dividend Aristocrats Index has certain size and liquidity requirements that disclude some stocks that are included in the Dividend Champions list.

Final Thoughts

Dividend Growth Investing naturally drifts toward buy and hold investing. This reduces fees for brokerages and financial professionals who get a commission every time you buy a product.  Dividend growth investing can be implemented by individual investors who are diligent in sticking to the strategy and invest for the long-term growth rather than short-term profits.

In 2015, you owe it to yourself to give dividend growth investing some thought.  The strategy’s strong historical returns and common-sense methodology will likely appeal to many independent minded investors tired of high mutual fund fees, stock price performance chasing, and the uncertainty of not knowing what businesses’ stock you own in your over-diversified funds.

Disclosure: None.

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