Hello everyone! This will be an updated post and in-depth breakdown for the Dividend Growth strategy. It is important to understand how companies need to be evaluated differently based on the investment philosophy you are pursuing. Now, investing in a dividend growth strategy takes time and patience, depending on your income goal, it can take awhile before a dividend portfolio can fully support enough cash flow to sustain your lifestyle without you needing to rely on a full-time or part-time job. But that is the exciting part, once you have enough income from the dividends you can retire or work a job that you perhaps find more exciting?
The dividend growth strategy is focused on building up a portfolio of high quality companies that not only pay out a dividend, but have regularly been increasing the dividend payout. The end goal is to create passive income to live off the increasing dividend payouts. So the focus is placed more on the cash flow for wealth rather than the stock appreciation (appreciation is just an added bonus).
NOTE: Dividend yield is not main focus. A common misconception is that a very high dividend yield is the most important measure, however, a yield that is considerably higher similar stocks in the same industry may indicate not a good dividend but rather a depressed price due to company issues. This price may signal an eventual dividend cut or elimination if the situation continues. Most dividend ETFs will filter out the top percentage of dividends yields for this reason.
The strategy here is on the dividend growth. If a company increases their payout overtime it is going to have an insane snowball effect when the dividends are reinvested (kinda like the snowball effect for paying off debt). Dividend growth investing uses the compounding effect of reinvesting dividends into the same investment to increase your future dividend payments. With each reinvestment, your shares grow slightly larger. With slightly more shares, your next dividend payment is slightly larger. With enough time invested in solid companies, the growth effect is amazing. This is why dividend growers are so important, they add more fuel to this compounding effect!
If you really want to see this effect visualized, check out the charts for Warren Buffets wealth. In 2018 alone, Berkshire raked in $3.8 billion in dividends – “a sum that will increase in 2019,” Buffett said in the annual letter. The great majority of the stocks in Berkshire’s portfolio are dividend stocks. And many of those stock are growing their dividend.
EVALUATING COMPANIES FOR THIS STRATEGY:
Since the focus of this investing is less on capital appreciation and more on the dividend growth we need to evaluate the following factors:
- Dividend payout ratio:
- Dividend payouts less than 50%-75% of its earnings in the form of dividends is generally considered stable.
- Does the company has the potential to raise its earnings over the long term?
- Dividend Yield:
- Ensure the company is paying a dividend and that the dividend yield isn’t too low to start.
- Watch out for dividend traps! Extremely high dividend yield for non-REITs can often signal an unsustainable payout! Look for companies in the healthier 3-6% range. (Do research after this ofcourse, this doesn’t immediately mean it is healthy)
- Dividend Growth Rate
- Look for companies that increase their dividend payout year after year.
- Free Cash Flow to Equity:
- This is simply what is paid out after expenses and debts have been paid. If a company has too much debt it can affect their ability to continue paying out and increasing their dividends.
- Debt to EBITDA ratio (Earnings before interest depreciation and amortization)
- A company with a lower ratio, when compared to similar companies, is more attractive. See AT&T vs Verizon!
NOTE: The companies are often broken into these categories based on how long they have increased their dividend:
- Challenger: 5+ years
- Contender: 10-24 years
- Champion/Aristocrat: 25+ years
- King: 50+ years
There are ofcourse many other factors. Consider the business, does it have a sustainable model (Coca-Cola & Pepsi)? Is its market shrinking (See oil companies)? Do you like the company and management?? For this type of investing (any type really), you need to know what you are investing into!
WHERE TO START AND KEY THINGS:
Many of the companies that should be looked for are ones we all recognize because they are so well established and have very wide market exposure. They have incredible staying power for these reasons, and very often have enough money to expand into new markets to remain relevant. This is their significant advantage over startups (many of which they just buy up anyways)
Let’s take PEPSI for example. Pepsico (NYSE: PEP) is a company in the Consumer Defensive Sector, its wide variety of iconic brands and products give it a very large global moat.
- Current Dividend Ratio: 2.89% (November 2020 based on share price of $141.75)
- Current Annual Dividend Payout: $4.09
- Average 3 Year Dividend Growth Rate – 8.60%
Looking at this we can see that PEPSI is not only paying a very nice dividend, but it is increasing it at an average of 8%! So even if you don’t buy more shares of the stock it will start to pay you more each year just for holding it. The next step from here would be to look into the financials. Essenitally we are just checking to ensure they are not burdened with too much debt, have sharply decreasing revenue, or payouts that exceed their current cashflow.
Other companies that would be good examples (just a few)
- AAPL – Apple – Challenger – IT
- MSFT – Microsoft – Contender – IT
- JPM – JPMorgan Chase – Challenger – Financial
- VZ – Verizon – Contender – Telecommunications
- JNJ – Johnson and Johnson – King – Healthcare
- MMM – 3M – King – Industrials
- IBM – International Business Machines – Aristocrat – IT
- KO – Coca-Cola – King – Consumer Defensive
ETFs are an excellent option, however due the large difference in strategies amoung them they will have to be discussed in a separate post. However some notable ones include: NOBL, SCHD, VYM, VIG, DGRO, and DRGW. (Amoung many many others)
ADVANTAGES AND DISADVANTAGES OF THIS STRATEGY:
- Dividends are not always guaranteed. In 2020, there we dozens of companies that cut their dividends due to financial pressure. At any moment, companies can decrease their dividend payout or completely get rid of it. However, many of the companies on the Dividends list maintained and increased their dividends during this time, this highlights the importance of investing in quality companies.
- Unless you are holding these stocks in an IRA you will pay taxes on them.
- When compared to index investing it decreases diversification since you’re really only invested into more “large cap” stocks. You’ll be missing out on the mid-cap and small-cap stocks
- Some say dividend payouts of the sign of a dying company. For some perhaps this is true, however a strong counter argument is this. If a company is well established and the payout for moving into a new market sector, or a new acquisition wouldn’t be favorable, a company can instead payout dividends to entice investors rather than potentially sacrifice company value just in the name of potential growth.
- You have to pay more attention to the companies you are investing into to ensure they remain healthy and can continue to grow and increase their dividend.
- Reinvesting dividends during sideways moving markets, bear markets, and corrections, purchase more shares with the dividend while the prices are lower. Later, when prices recover, the return is actually enhanced by the temporary fall in the stock price. Reinvesting dividends and accumulating more shares during corrections and bear markets greatly boosts dividend growth investing returns in the long run. This is a significant advantage of dividend stocks over growth stocks in less than ideal market conditions.
- Historically dividends have provided 43% of the S&P 500 total return from 1930 – 2017 (according to Blackrock). Dividends provide an ongoing return while waiting for capital appreciation.
- The snowball effect of dividend growth compounding can provide competitive returns regardless of whether the price of the stock increases in value or not.
- Creating passive income and preserving capital. Like all stocks they are an excellent hedge against inflation.
PERFORMANCE & FINAL THOUGHTS:
It depends on what timeframe you are looking at, if say we take from December 1999 – 2017 the S&P 500 Dividend Aristocrats Index outperformed the S&P 500 by 3.37% per year. But if we take other timeframes then the S&P500 is dominant. Beating the S&P500 over the long term is near impossible, but beating the S&P isn’t the goal of this strategy. This strategy is focused on passive income generation. Imagine if checks were rolling in every week during the COVID lockdowns even if you weren’t working?
Please supplement this post with your own research. Compare this strategy to general index investing and growth investing. Find what is right for you.
The hope is this post provided insight into this strategy and evaluating dividend paying companies.
Thankyou for taking the time to read!
There are many other sources to learn more about dividend focused strategies, in the brand new Moderator’s Collection for the sub there is a post titled ” My Complete Guide to Dividend Investing” written by u/Interriuso, it holds an incredible amount of useful links and information. Please check it out.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.