Ten Critical Tips For Dividend Growth Investors by Sure Dividend
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 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, 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