Benefits of Dividend Growth Investing

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”

John D. Rockefeller

Dividend investing is a way of buying stocks that pay regular dividends on your investments. Those dividends represent a portion of the company’s profits paid to investors.

Some people might find investing in dividend stocks boring. That may be for some folks. However, I find it exciting, not tedious, to collect this income from high-quality companies as part of its total investment return. Returns can come from three potential investment sources:  income, dividend growth, and price appreciation.

Dividend growth investing is a great way to build wealth. Dividends grow through compounding, reinvesting, less volatility, and satisfying investors with current income. A considerable part of Warren Buffett’s investment strategy, Berkshire Hathaway earns significant dividend income over $4 billion associated with stock purchases of high-quality companies in their portfolio. As Warren Buffett said, “Above all, dividend policy should always be clear, consistent, and rational.” 

Growth Stocks Pay Dividends

Sure, it is always exciting to find the next Amazon to invest in on the ground floor. It is the ultimate prize for venture capitalists, investment bankers, and investors, but they are tough to find. Growth stocks have been great places to invest in recent years and through 2020. They are at high valuations. Don’t forget some growth stocks pay reasonable dividends, such as Apple, Microsoft, and other tech-oriented names.

Dividend growth investing offers investors a lot of benefits that can complement growth stocks in your portfolio. Add dividend stocks to your investments to provide essential diversification.

The market has been absorbing many IPOs in 2020 (550 to date), causing some market turbulence. When there are many new offerings, institutional investors need to sell some of their growth stocks to raise money to participate in these new issues. Dividend-paying stocks can provide less volatility. 

What Are Dividends?

Most stocks usually pay dividends. More than 80% of the S&P 500 pay dividends. The S&P 500 dividend yield is currently low at 1.67% based on the strong stock market. However, the average yield is around 2% over the past decade.

Typically, stockholders receive cash dividend payments. The corporation’s board of directors usually declares a dividend four times a year. Some companies may pay this income monthly or annually.  These dividend payouts are rewarding investors with a share of the company’s profits.

Some companies may pay special “non-recurring” dividends, such as Costco Wholesale, rewarding investors for a company milestone or robust earnings growth. You can’t count on these payments to pay for your living expenses. 

Dividend Cuts Are Historically Rare And The Last Resort

If the firm is experiencing unprofitable times, the money may come from money reserves. Occasionally, a company may borrow to pay dividends to maintain its reputation for consistency. The safety of the dividend is always on investors’ minds. Most companies view a dividend cut or suspension as a last resort impacting their reputation and investor confidence about the dividend’s sustainability. Dividend cuts or suspensions are relatively rare.

However, several companies quickly moved to reduce or suspend their dividends temporarily in 2020 as the pandemic caused a severe economic downturn as lockdowns occurred. In recent months, many dividends have been reinstated, increased, or for some companies, initiated for the first time.

Dividend Growth Investing

Even in challenging times, individual companies have grown their dividends. Find the highest quality companies with longstanding track records to increase their dividends and survive a range of market environments. These companies are particularly desirable to find as they are dividend-paying royalty.

“Dividend Aristocrats”

To be part of this elite group of the S&P 500, “Dividend Aristocrats,” a company must have raised its dividend consecutively for 25 years or more. They must also meet specific minimum size and required liquidity. Initially, only 26 companies fit high-quality dividend payers’ profiles based on their strong histories of revenue and earnings growth, solid business fundamentals, and strong company management. These stocks have attributes of both growth and value investing, which we discuss in this article.

As of December 2020, 65 companies are Dividend Aristocrats. Some companies have fallen off the list, replaced by others, particularly during the Great Recession. Dividend Aristocrats’ dividend yield is usually 50 basis points above that of the S&P500 dividend yield, or closer to 2.5%. Many of the stocks carry yields in the 3+% range.

To invest in dividend growth stocks, you don’t necessarily have to limit yourself to this elite group, although it is a great place to start. Look for securities that have similar attributes of dividend growth, above-average yields, and sustainability. As recently as November 2008, Dividend Aristocrats delivered an average of 4% yields.

8 Benefits of Dividend Growth Investing

 

1. Fits With A Long Term Perspective

When investing, use a long term strategy instead of short term trading. This strategy recognizes that stock values increase over the time horizon despite intermittent market volatility. When investing for dividends, you collect cash payments through your continued stock ownership, even if the company did poorly. A side benefit of holding stocks for more than a year may be the ability to pay lower taxes through capital gains and loss strategies if they are qualified dividends.

2. The Power of Compounding

Compounding, or earning interest on interest, is a powerful way to build wealth. As we already said, investors are encouraged to keep stocks longer when they collect regular dividend payments, aligning with a Buy/Hold mentality. By reinvesting your dividends, you can accelerate the compounding benefits in your investment and retirement accounts. We discuss compounding along with other financial concepts you should know in this article.

An automatic dividend reinvestment plan (DRIP) is a program offered by your brokerage firm, mutual funds it exchange-traded funds (ETFs)  that allow investors to have their dividends automatically used to purchase additional shares of the underlying security.

3. Dividend Stocks Are Less Volatile

Stocks that pay dividends tend to be less volatile. When markets undergo turbulence, stocks with yields tend to do better. While dividend payers are not as safe as Treasury yields sporting AAA ratings backed by the US government, they offer an alternative source of stable investment income. With lower risk-to-reward ratios, dividends provide an anchor to falling stock prices.

4. Investor Confidence In Corporate Financial Health

When companies pay dividends and increase their payouts, it gives investors confidence in the stocks they hold. Companies that consistently pay dividends tend to be well run, are transparent about their revenue and earnings growth, and reflect financial discipline. 

5. Creates Passive Income

Dividend stocks provide a great path to creating passive income. This kind of investing is particularly desirable for a range of investors–retirees or seeking to retire early–who want to supplement their income. Investors relying on fixed securities may find insufficient balances from interest income given the low-interest environment we have been experiencing in recent years. Dividend investing can play a substantial role in boosting returns based on higher dividend income.

The steady flow of dividend payments can be used for spending, funding living costs, or reinvesting the money into similar stocks. Generally, there are lower or no trading commissions to pay, and dividend income gets preferential tax treatment for dividends of stocks held more than 60 days.

An Example

How much dividend income do you need to support your lifestyle is dependent on your plans. If you are hoping to become financially independent, dividend investing can help you grow alternative income or help you pay your living expenses.  Back of the envelope calculations of annual dividend income can get you started. Let’s say, your portfolio consists of $1,000,000-$2,000,000 of dividend-paying stocks.

Assume your $1-2 million portfolio has an average dividend yield of 2%. Your annual dividend income would amount to $20,000 to $40,000. At a 3% dividend yield of a $1,000,000-$2,000,000 dividend investment portfolio, your annual dividend income would rise to $30,000 to $60,000. The greater your portfolio that consists of dividend stocks, the more you can count on this income.

Higher dividend yields of over 4% may grow dividends more slowly.  Don’t chase stocks carrying higher yields without doing some research.

6. Higher Return Potential

According to several studies, stocks that pay dividends tend to grow faster than those that don’t pay dividends. Dividend-paying equity has three sources to fuel total returns: dividend income, dividend growth, and price appreciation. Growth stocks without dividends are faster growers at higher valuations but tend to be more volatile without dividend income.

Dividend Growers Outpace Non-Payers

In a February 2020 study by Hartford Funds and Ned Davis,  average annual returns from March 1972 to the end of 2019 were 12.87% for dividend growers versus 8.57% for dividend nonpayers. Using these returns, a $10,000 investment in non-dividend paying stocks would have grown to $500,000, well below the $3.24 million in dividend growers over the 48-year timeframe.

Since 1926, over 40% of the US S&P 500 returns have come from dividends, with the rest contributed from price appreciation.

7. Portfolio Diversification

Investors should maintain a diversified investment portfolio among different asset classes. An investment portfolio with diverse growth stocks is not diverse. These stocks may provide higher returns, but they pose higher risks. Dividend-paying stocks are a welcome addition to diversifying your portfolio and can help balance non-dividend paying growth stocks. These stocks offer defensive protection in adverse market environments and generate income growth and long term price appreciation in profitable markets.

To diversify your investment portfolio, you need other asset classes–money markets, bonds, and real estate–besides stocks. However, in recent years, and especially in 2020, high yield savings accounts, treasury, municipal, and corporate bonds have been challenging places to find any income. Income generation is a priority for many investors.

Viable Alternative To Low Bond Yields

As such, we discussed dividend income as a viable alternative source to bond income. The Fed took aggressive action to expand the money supply due to the pandemic’s impact on our economy. These moves reduced already low-interest rates. We discussed these risks of extremely low-paying yields from debt securities for investors in this article. We consider dividend income from high-quality companies as a higher income potential compared to high-grade corporate bonds.

8. Provides Inflation Protection

Stock investments tend to outpace inflation. Inflation can dramatically reduce the purchasing power of your money over time. Saving money in bank accounts will do very little in protecting your money from inflation. The value of a bond may drop below what you paid for it if interest rates rise. Dividend investing provides better inflation protection than fixed bonds.

Many companies pay dividends above the rate of inflation.  Dividend growth stocks performed well in periods such as the 1970s when inflation was higher than currently.

We have had low inflation for such a long time that many investors forget the need to protect themselves from potential inflation in the future. The higher returns from dividend investing tend to outpace inflation reasonably well. They provide better inflation hedges than fixed-income investments unless you go to more risky high yielding bonds, which carry greater credit risk.

Seeking Dividend Growth Stocks

You want to find high-quality companies with vital track records in generating revenue and earnings. Companies carrying excess debt on the balance sheet may hamper the company’s ability to support or increase dividend payments.

New Dividend Payers

Some well-known growth companies offer dividends for the first time. Some companies initiate payments after a strategic achievement. Apple did not introduce its dividend until 2012 after CEO Steve Jobs passed away. The company had significant cash on its balance sheet, but Jobs didn’t favor distributions to shareholders. Other companies introduce dividends to compensate investors for slowing growth. High yields are a different kind of signal, not necessarily positive that you want to investigate further.

Free Cash Flow

Free cash flow reflects positive cash flow after capital expenditures point to a company that can handle sustainable dividend payouts. Companies in industries such as energy with high capital expenditures may have higher risks that can’t support dividends.

Some Ratios May Help Identify Good Companies With Dividend Safety

 

Is The Dividend Safe?

Dividend safety is essential if you are engaged in this kind of investing. However, a high dividend yield may be a red flag for a potential cut in the dividend rate. Review your stocks for these red flags. The calculation is straightforward: dividend yields are annual dividend per share divided by the current stock price. A dividend yield of over 8% would concern me. Like utilities or banks, may pay a higher dividend yield because there is less stock appreciation.

Reasonable Payout

A company’s payout ratio should be manageable for the long term. You can calculate the dividend payout ratio by dividing the annual dividend per share by the earnings per share. A 30%-40% payout is reasonable.

Healthy Dividend Coverage

The dividend coverage ratio (DCR) measures the number of times a company can pay its current dividend amount to shareholders. To calculate this ratio, divide a company’s annual EPS by its yearly dividend per share. A DCR over two is considered a healthy ratio.

How To Find Good Dividend Stocks

You can purchase dividend stocks individually. Do some research. You can buy select names that are part of Dividend Aristocrats, which is a great way to start investing. Alternatively, you can purchase low-cost index funds or exchange-traded funds that can readily provide a pool of high-quality dividend stocks. Buying mutual funds or ETFs would satisfy instant diversification, reducing the risk of potential dividend cuts or suspended dividends. If one or two companies do any paring of dividends in these vehicles, your pain would be minimal.

Here are a few ETFs and a Vanguard Mutual Fund to consider:

• Proshares S&P 500 Dividend Aristocrats ETF, symbol NOBL
• SPDR S&P Global Dividend ETF, symbol WDIV
• ProShares S&P Midcap 400 Dividend Aristocrats ETF, symbol REGL
• SPDR S&P Dividend ETF, symbol, SDY
• CBOE Vest S&P 500 Aristocrats Target Income ETF,  symbol, KNG
• Vanguard Dividend Growth Fund, symbol VDIGX

 

Final Thoughts

Investing is the best way to build wealth in the long term. There are many types of stocks to purchase and generate profitable growth. Dividend growth investing may provide three investment income sources –dividends, income growth, and price appreciation. To invest in these stocks, focus on high-quality companies with a transparent track record and financially disciplined management.

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