The Prudent Investor

Letting Dividends Do Their Work

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Lessons Learned
The past twenty-five years have offered boom and bust.  There are lessons from the experience of these periods that apply to the current market problems.  These lessons offer long term hope in a time when that appears to be in short supply.
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There are numerous lists that track the length of time companies have raised their dividend.  Dividend Champions, Dividend Achievers, Dividend Kings and Dividend Aristocrats have similar names, but they have important characteristics that differentiate themselves from one another.
 

Dividend Investing Strategies – Dividend Growth

by George L Smyth

The dividend growth strategy allows for protection against volatility by relying on the growth of the company’s dividend to carry it through the wild and unpredictable swings of the market.  When interest rates shift and economic growth slows, affecting all in the stream, dividend growth can help balance the rocking boat.

The dividend growth strategy relies on the selection of companies that have a history of dividend growth.  There is a different strategy where one purchases high dividend yield stocks, and that will be the subject of a future article.  However, this strategy concentrates on not simply the maintenance of the dividend, but its growth over time. 

Simple maintenance of a dividend does not survive inflation.  The buying power of a fixed dividend eventually erodes, but if it is raised at regular intervals then it will have an opportunity to maintain its value.

The Strategy

The idea behind the dividend growth strategy is that companies that have grown their dividends in the past, and are expected to continue doing so into the future, offer a level of protection against market volatility and other risks to one’s portfolio.

Companies that are included within a dividend growth strategy have strong fundamentals, quality balance sheets, and a solid cash flow.  If a company does not have a comfortable cash flow then this could bring the dividend into question, thus jeopardizing the dividend’s future growth.

The importance of compounding is an important element of the strategy.  If one takes $100 each month and places it under their mattress for 20 years then they will have accumulated $24,000.  However, using a Future Value Calculator and assuming a 5% annual increase the result is a very different $41,103.  Compounding is the self-feeding elixir that lets dividends do their work, and dividend growth is the magic powder that charges that elixir.  The more the dividend grows, the more fuel there is to feed the compounding.

If one is investing for retirement then it is imperative to find an income stream that outpaces inflation.  Our friend with his money under the mattress has no income stream and as he begins to spend his savings, that savings begins to go away.  The person who has invested in companies whose dividend continues to grow will be able to draw from the investment without as much reliance on the principal.

Companies that regularly raise their payouts have an opportunity to outpace inflation, meaning that more of the dividend can go toward reinvestment.  The quality of the dividend, i.e. if the company is growing their dividend, maintaining it, or cutting it, has much to do not only with the dividend itself, but also the total return.

The Case for the Strategy

Ned Davis Research placed S&P 500 companies into five groups – Dividend Growers and Initiators, Dividend Payers, No Change in Dividend Policy, Dividend Non-Payers, and Dividend Cutters and Eliminators.  They examined the total return for these groups from 1972 through 2018 and their results highlighted the importance of dividend growth.

Without going into full detail of the study the important facts are illuminating.  One is that, as might be expected, the group of Dividend Cutters did the worst.  When a company cuts or eliminates its dividend the stock price takes a major hit.  Doing so is not only a sign of weakness, but is also an indication of the importance the company places on its owners.  The study found that over this 47 year period the group’s total returns remained essentially flat.  Allow me to say that again – over a 47 year time span there was virtually no return.  This is why investors flee with dividend cuts.

Companies that simply maintained dividend offered returns 90% higher than an equally weighted S&P 500 index.  This is an easy case for the consideration of dividend stocks in one’s portfolio.  Merely having and maintaining a dividend helps the company outperform the most commonly referred to index.

The group that surpassed all groups was the Dividend Growers and Initiators.  Beating the S&P 500 Index by nearly 275% speaks volumes for companies that grow their dividend.  Even more amazing is that this result was achieved with a lower beta, so not only was the return significantly better, but this was done with less of the market’s fluctuations.

Perhaps this is not a surprise.  After all, companies that regularly increase their dividend are strong enough to fund capital expenditures, pay their debt, and maintain excellent cash flows.  These mature and stable companies are the strong shoulders of the market, and like elder statesmen are given an elevated value.

These are also the companies that throw a wet blanket on the fire of the market.  They are not companies listed as the hottest and most likely to triple your investment this year, they are not companies bought by hedge fund managers, and they are not companies that will give you an attentive audience at the next cocktail party (do these even exist?).  These are companies everyone has heard of, they make the products you use, and they are the boring companies active investors ignore.  Bottom line is that they are the adults in the room.

This is why the dividend growth strategy is so powerful.  A portfolio that over the long term has an opportunity to not only clobber the S&P 500 and do so with less volatility offers a strong argument for inclusion in anyone’s basket of investments.  The fact that it does so without fanfare says something about the investing information we are accustomed to consuming.  Nobody wants to read articles about boring companies – flash and dazzle sell.

Building the Portfolio

The strongest of the dividend growth companies are contained within the list of Dividend Champions, which is comprised of companies that have increased their dividend every year for at least 25 years.  There are some in the list that have done this for over 50 years, which is true commitment to the investor.

The Dividend Champions is a great place to start one’s research.  Currently with more than 125 companies one can certainly select a group of stocks within this list that fit their requirements.  If somehow the list is exhausted then Dividend Contenders – companies that have increased their dividend every year for at least ten years – offer more than 250 additional choices.

The saying is that “Rome was not built in a day” – to which I would add “nor did it fall in a day”.  A portfolio of companies that offer growing dividends, greater total returns, and lower volatility takes time to build, but can be exceptionally stable, and over the long term, profitable.  While the buy and sell crowd chases the latest hot idea, slow and steady us is mantra of the long term investor.  After all, marathons are not won by the group that starts with the lead.

The importance of a buffer against volatility cannot be overstated.  The amount of stress one incurs when listening to the daily gyrations of the market is enough to unsettle the heartiest of souls.  Finding paths to smooth the roller coaster allows one to continue with a long term horizon, undistracted by events that over time will become meaningless.

The dividend growth strategy is one of the strongest strategies for building long term wealth.  It seems like the easiest thing in the world to select strong companies that fit the profile, yet in 2018 close to two-thirds of active large cap fund managers were unable to beat the S&P 500 Index, a trend of underperformance that reached its ninth consecutive year.  An update to this link is that in 2019 less than 30% were able to beat the S&P 500 after fees.

Actually, this is being gentle, since over the previous ten years 85% lagged and over 15 years over 90% were unable to match the index.  It is amazing to me that so many investors are willing to pay a premium to have a manager who is unable to basically do as well as average.  I believe that this has to do with wishing to be led my an authority figure in a subject of which one has no knowledge, but would anyone want a doctor or lawyer who consistently performs below average?

Do I need to note the caveat that not all dividend growing companies will outperform and past performance does not guarantee a positive future?  We all understand that, but we also all understand that when you have a chance to play with loaded dice then it is time to join in.  Selecting companies that have grown their dividend year after year, even through recessions, gives one an edge when working with a long term horizon.  That is the dividend growth strategy.



This website is maintained by George L Smyth