Dividend investing is one of the most actionable, repeatable methods of building wealth over time.
Fortunately, there are many resources available to learn about dividend investing. Many of them are published by some of the most successful dividend investors in the business. These include books, websites, and even shareholder letters.
One particular example is the portfolios of large, institutional investors, made visible through the 13F filings required of institutional investment managers with more than $100 million in qualifying assets.
Warren Buffett oversees a $100 billion+ common stock portfolio which holds many dividend-paying companies through his company Berkshire Hathaway (BRK.A) (BRK.B). These holdings are detailed in a quarterly 13F.
13F filings are only a single source of investment knowledge. There are many others.
This article will provide seven tips to grow your wealth like the best dividend investors.
Invest in Companies With Long Dividend Histories
One of the best ways to grow dividend income is to invest in companies with proven histories of raising their dividend payments over time.
When companies successively raise their dividend payments, investors can benefit from a growing income stream even without contributing more capital.
A great place to search for these companies is the Dividend Aristocrats Index.
The requirements to be a Dividend Aristocrat are:
- Be in the S&P 500
- Have 25+ consecutive years of dividend increases
- Meet certain minimum size & liquidity requirements
If 25 years is not enough, then the Dividend Kings Index is even better.
To be a Dividend King, a company must have 50+ years of consecutive dividend increases – twice the requirement to be a Dividend Aristocrat.
Besides the obvious rising dividend payments, there are many advantages to investing in companies with long histories of steady dividend increases.
First of all, these companies tend to outperform the market in general on a total return basis.
The performance of the Dividend Aristocrats is compared to the S&P 500 Index below.
The Dividend Aristocrats have demonstrated meaningful outperformance over the broader stock market as measured by the S&P 500 over a long period of time (10 years).
Numerically, the Dividend Aristocrats have returned 10.14% per year compared to the S&P 500’s 7.62% per year over the past decade. This represents an outperformance of 2.52% per year (on average).
This outperformance over varying time periods can be seen below.
There are also many qualitative reasons why companies with sustained dividend histories make good investments.
Companies with 25+ years of steadily rising dividends must have a durable and sustainable competitive advantage.
Otherwise, when economic environments or consumer tastes undergo periods of change, the company’s profitability will be reduced. Without a competitive advantage, companies cannot withstand ‘shocks’ to their operations.
Lower profitability leads to dividend cuts, which triggers an automatic sell according to The 8 Rules of Dividend Investing.
Regular dividend increases are also a sign of shareholder-friendly management teams.
Companies that are committed to increasing dividend payments are also likely to exhibit other shareholder-oriented behavior, such as:
- High levels of insider ownership
- Candid communication with shareholders
- Reasonable executive compensation
- Stock buybacks
Stock buybacks in particular are discussed in the next section.
Believe in Stock Buybacks
Stock buybacks (alternatively called share repurchases) occur when a company purchases its own stock on the open market with the intention of the reducing the number of shares outstanding.
On a per-share basis, stock buybacks improve a company’s financial performance even if overall business performance remains unchanged.
The reason for this is because the denominator of per-share metrics is reduced. If the same amount of earnings are distributed among less business owners, then each owner’s share of the profits becomes proportionally larger.
The effects of stock buybacks on shareholder returns can be tremendous. The following table shows the financial performance of a company that:
- Grows earnings at 8% a year
- Trades at a constant price-to-earnings ratio of 15
- Uses 75% of earnings on share repurchases
Notice that even though the company’s earnings only grew by a factor of 4.6, the company’s stock price grew by more than a factor of 10.
Despite the obvious advantages of share repurchases, many pundits have been critical of stock buybacks, saying that they divert capital from the ‘real economy’.
They argue that money spent on share repurchases could be better spent on creating jobs, building infrastructure, and investing for organic business growth.
Warren Buffett, arguably the most successful investor of all time, has dispelled these claims.
In Berkshire Hathaway’s 2016 Annual Report, Buffett wrote extensively on his belief in the value-creating capabilities of share repurchases.
“As the subject of repurchases has come to a boil, some people have come close to calling them un-American – characterizing them as corporate misdeeds that divert funds needed for productive endeavors. That simply isn’t the case: Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital. (Call us if you have a candidate.)”
Source: Berkshire Hathaway 2016 Annual Report, page 8
In his shareholders’ letter, Buffett placed a notable caveat on share repurchases. The Oracle of Omaha justifies share repurchases only if company stock is repurchased below intrinsic value.
“For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”
Source: Berkshire Hathaway 2016 Annual Report, page 7
Companies reduce intrinsic value when they repurchase overvalued stock. It has the same value-destroying capabilities as buying overvalued companies for an individual’s investment portfolio.
Buffett also stated two scenarios in which repurchases should not occur, even when a company’s stock is undervalued:
“One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.
The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.”
Source: Berkshire Hathaway 2016 Annual Report, page 7
All-in-all, investors do well to invest in companies who repurchase their own shares at an attractive