As a dividend growth investor knows, it’s not exactly a secret that the U.S. stock market has been one of the greatest long-term wealth generators in history.
In fact, between 1871 and 2015 the S&P 500 has recorded a compound annual growth rate, or CAGR, of 9.1%, increasing a staggering 285,436.41 times in value.
However, as with most things in life, actually reaping the potential rewards is much harder said than done.
For example, according to BlackRock (BLK), the world’s largest asset manager with $5 trillion in assets under management, the average retail investor has woefully underperformed the market over the past few decades. As seen below, the average investor generated an annualized return of 2.11% over the last 20 years compared to annualized returns of 8.19% and 5.34% from stocks and bonds, respectively.
Despite the market putting up very solid growth over that time, most investors ended up treading water, after accounting for inflation.
But there is great news for those who seek to harness the incredible power of the stock market to build long-term wealth and achieve financial independence over time.
Learn five ways that being a dividend growth investor can help you reach your financial goals and make you a better long-term investor. By keeping a steady hand and staying disciplined, investing in dividend growth stocks can provide a stable, growing income stream that can fund your needs, desires, and retirement over time.
1) Dividends are a Major Source of Long-term Market Returns
The first argument for being a dividend growth investor is simply the historical importance of dividends to a portfolio’s total return. Most investors alive today have mostly known a stock market in which share price appreciation was the underlying goal. However, historically 52.3% of all the returns the S&P 500 has ever generated for investors have been due to dividends.
There is a lot of different data out there about the contribution dividends have made to the market’s total return, so it can be helpful to turn to multiple sources. Morningstar conducted a study several years ago and found that the dividend income component of total return amounted to 42%, 36%, and 31% for Large Cap, Mid Cap, and Small Cap stocks, respectively, from 1927 through 2012. Dividends are clearly important.
And as you can see in the chart below, at certain times, including recently, dividends accounted for over 100% of market returns. This can happen when stock prices stagnate or decline over a period of time yet dividend income continues rolling in.
This makes intuitive sense if you think about it like this. If you own a growth stock (i.e. one that doesn’t pay a dividend), then the only way you can earn a return is through share price appreciation. And as we all know, the market can be gut-wrenchingly volatile.
So say you bought Alphabet (GOOGL), which pays no dividend. Over several years the company grows, and the share price rises with it. But if, right before you need to sell to meet a certain goal, such as funding the down payment on a house or paying for your children’s college education, the market falls off a cliff, such as it did during the Nasdaq crash, or 2008-2009, then most, if not all, of those capital gains can vanish very quickly.
You could even end up losing 5 to 10 years of unrealized profits in a few months, and if you have to sell? Well, then you gained nothing for all your patience and saving over that time.
But with a quality dividend growth stock? Well, you are getting a growing income from your investment, which you can then reinvest into more shares, either into the original company or some other undervalued dividend growth stock.
That creates what I like to call “hyper-compounding” in which an exponentially growing dividend results in an exponentially growing income stream, that is buying an exponentially growing number of shares, which also paying exponentially growing dividends.
In other words, as a dividend growth investor, the dividends that you accrue are tangible and permanent benefits that no crash can undo. And if you reinvest it into quality dividend growth stocks over time, then even if the market crashes you are still much better off over time, if for no other reason that your growing dividend income stream can be reinvested at much lower, post-crash prices that lock in a higher yield on invested capital.
2) Dividend Growth Stocks Outperform the Stock Market over Time
While it may seem counter intuitive, companies that consistently pay and grow their dividends tend to outperform non-dividend stocks, further increasing the appeal of being a dividend growth investor.
The table below measures annual returns from 1972 through 2004 and shows that all dividend payers returned 10.1% per year, beating the S&P 500’s annualized return of 8.5%. To be fair, however, it’s true that this period was marked largely by falling interest rates since the early 1980s. This might have made dividend-paying stocks more attractive.
The chart below covers a much longer period of time, from the 1920s through the end of 2014. As you can see, dividend payers went on to meaningfully outperform non-payers.
How is that possible, when theoretically growth stocks are reinvesting all their earnings and cash flow back into their businesses?
The answer lies in long-term focused, conservative management. For example, a company like Facebook (FB), which is growing around 50% per year and is generating excellent 28% returns on invested capital, may seem like a much better choice than a boring dividend growth stock.
And for a while that may be true. But at some point Facebook is likely to reach a point where it’s scalable ad-focused business model reaches a point of saturation. Or to put it another way, they attract all the ad sales revenue that companies are willing to give it and struggle to find incremental growth opportunities.
At that point, the company will still be generating rivers of profits and free cash flow. But in order to grow? Well, management may have to look broader than its core business, the one that is generating those high returns on invested capital, for keep increasing revenue, earnings, and cash flow.
That kind of diversification can be a good thing, but it also poses a big risk because it can result in management making poor capital allocation decisions, such as making big splashy acquisitions that it might overpay for and end up writing down for huge losses later.