Among the more successful approaches to long term investing, dividend stocks provide a steady income stream as well as the ability to reinvest without paying fees. When evaluating dividend stocks to add to their portfolios, wise investors look for a long history of continual dividend payments and a steady stream of dividend increases. When you use this approach as your guide, it is referred to as dividend growth investing. Why does dividend growth investing work so well? Here are some thoughts on the subject.
Why Does Dividend Growth Investing Work So Well?
We have three simple answers to this question. They have to do with intrinsic stock value, outperformance of the market as a whole, and income protection in times of overall market decline.
Intrinsic Stock Value of Dividend Growth Stocks
First of all, steady dividend growth over the years is a result of a company making more money each year. A steadily increasing income stream indicates a strong intrinsic stock value. And a company with an intrinsic stock value in excess of its market price is always a good investment.
The market has a recurring tendency to be overly greedy when times are good and excessively fearful when times are bad. This fact can make the current market price of a stock an inexact predictor of underlying value in the coming years. A company sells a product that everyone needs and uses and has been successfully making money with that approach for decades or even more than a century. We refer to the likes of Coca Cola, Exxon Mobile, Colgate Palmolive, Procter & Gamble, and Eli Lilly and Company. These are investments with strong intrinsic value as they will endure and prosper over time.
The ability to steadily increase dividends over the years and decades is a sign of the intrinsic value of an investment and a guide to successful long term investing.
Market Performance Characteristics of Dividend Growth Stocks
Strong companies with high intrinsic value not only may pay increasing dividends over time but they tend to increase their share prices as well. Intelligent Income has a useful chart, courtesy of Ned Davis Research, in their article, 5 Reasons to Be a Dividend Growth Investor.
While it may seem counterintuitive, companies that consistently pay and grow their dividends have historically outperformed non-dividend stocks, further increasing the appeal of being a dividend growth investor.
[From the end of 1972 to the end of 1973,] companies that consistently grew their dividends during this time performed the best of any group and delivered the lowest volatility (standard deviation).
And, here is the chart showing that over a longer time frame, dividend growth investing provides the best returns.
A 10% return on investment, with dividends reinvested, will result in a doubling of value every ten years. This is a big part of why dividend growth investing works so well.
Dividends as Asset Protection in Down Markets
While dividend growth stocks outperform other dividend stocks and stocks that do not pay dividends, they also provide protection when the entire market is down. Intelligent Income again provides us with a useful graph courtesy of Hartford Funds. This shows us how much dividend income has contributed to total stock market returns over the years.
As we can see, steady and increasing income from dividends provides a significant return on investment over the years. When the stock market is languishing, dividends can provide a majority of returns, such as in the 1040s and 1970s. And, in the first decade of this century, when the market ended up lower than when it started, dividends provided the only income for someone who bought in 2000 and sold before the market recovered from the crash! And, we know that while the percent return of dividends is lower in years with a surging stock market, we also know that over time dividend growth stocks tend to outperform the rest of the market.
Criteria for Choosing Dividend Growth Stocks
We found an interesting article on Wallet Hacks about building a dividend growth investment portfolio. It is a first person account of how the author chose this approach and the criteria he uses to pick investments in this subset of stocks. He mentioned that Warren Buffett bought Coca Cola when it was low in 1988 and today gets a 45% dividend based on his original investment!
Buffett acquired shares of Coca-Cola in 1988. Back then he wrote “We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.” (1998 letter)
The point of investing in companies that steadily increase their dividends is that you too can replicate Buffett’s success.
An easy approach to investing in dividend growth stocks is to pick a fund that simply does the investing for you. The author mentions Vanguard Dividend Appreciation Index Fund Investor Shares (VDAIX) although Fidelity and others offer similar products. The advantage is that you only need to make one investment and not several. And, you are getting a decent mix of blue chip dividend stocks such as Coca-Cola, P&G, Pepsi, Microsoft, J&J, Wal-Mart, IBM, Medtronic, CVS, and 3M.
Alternatively, you can choose your own stocks. In this case, choosing companies that have paid dividends for decades and have been increasing them for a quarter of a century or more is a good place to start. Then, to make sure that a great company is not starting to fade from the scene, look for “dividend coverage.” This is earnings per share divided by dividends per share. A good coverage is 2 or more. In other words, the company is paying out less than half of its earnings in dividends and is not simply jacking up the dividend in order to disguise a failing business!
And, when should you buy these companies? Because you are not trying to time the market and are relying on long term appreciation of stock price and dividends, you can simply invest a set amount every month, quarter, or year as your cash flow allows, using intrinsic stock value as a guide.