An investment strategy is a framework to help provide clear long-term thinking. Do you know what investment strategy will work best for you? In this series, we will discuss several strategies to help you find out starting with Dividend Growth Investing (DGI).
The stock market is a tremendous long-term generator of wealth. The challenge is capturing your share of that wealth with a strategy that works for you.
The Right Strategy Helps Make Us Better Investors
The best strategy is compatible with your circumstances, temperament, risk tolerance, skill set, time constraints, and goals. It is essential to understand this and to clarify your goals to assure the strategy is aligned.
According to Dalbar, the average investor’s annualized returns of 4.0% over the past 30 years compare poorly to the stock market average return of 10.2% for the same period.
They cite several factors that contribute to this performance gap, and they all point to investor emotions and behavior as discussed here.
This is not to discourage you from investing but to encourage you to select a strategy compatible with you and in your comfort zone. This will help minimize emotions and investor behavioral mistakes that tend to occur more during turbulent market times when we need an anchor.
During strong market periods some investors chase performance. They see a company or strategy doing better and move to it just as it begins to peaks and then falls out of favor. This leads to underperformance even in good markets.
A strategy compatible with you helps anchor us in our comfort zone where we have more confidence in what we are doing. It provides a consistent framework and clearer vision from which to make sound investment decisions.
As we go through this series think about which one is the right fit for you.
Dividend Growth Investing
Dividend Growth investors purchase shares in companies with a long history of paying dividends to shareholders and increasing them each year.
The idea is to create a diversified portfolio of stocks with companies that are capable of paying increasing dividends for long periods.
These are typically well managed, financially healthy, shareholder-friendly companies. They often have strong brands names like P&G, Microsoft, and Texas Instruments with protective economic moats.
The dividend is also an essential indicator of the quality of a company. They typically have a history of stable returns on equity that indicates superior performance.
These companies show enough confidence in their future earnings to pay dividends due to stable or increasing sales, strong cash flows, and earnings growth.
As a result, Dividend Growth Investing often appeals to the more conservative and prudent investors seeking to minimize risk and with a long-range investment horizon.
A friend once made a strong case for Dividend Growth Investing when he explained: ”
A friend once made a strong case for Dividend Growth Investing when he explained: “Dividends are real; deposited into your account each quarter, and yours. They can’t be faked like a promise of great returns in the future.”
The Ideas Behind Dividend Growth Investing
1) Dividends Produce a Significant Source of Long-term Market Returns
Dividend-paying stock’s average annual return of 9% was significantly above the 2% yearly return for non-dividend paying stocks from 1972 through 2018.
Source: The Hartford Funds
From 1930 to 2018 dividend income contributed an average 43% to the total return of the S&P 500 Index.
Source: The Hartford Funds
The chart shows that dividends’ contribution varied greatly from decade to decade, but over the long term are significant.
And, while you are waiting for the share price to appreciate the dividends are paying you to wait.
2) DGI Provides Both Income and Capital Gains
Some investors desire recurring income through dividend payments. Others may prefer to reinvest the dividend to enhance long term capital appreciation and future income.
Those who prefer income, retirees, for example, receive regular dividend payments and continue to hold the shares for future payments. The dividend income remains constant in declining stock markets. This isolates the investor’s income stream from market turbulence.
While enjoying a consistent flow in dividend income, the growth of the dividend increases the price of the stock over time. So, the income investor benefit from both income and stock price appreciation as you will see in valuing Dividend Growth Investing stocks.
Those investors or savers who prefer capital gains over income can choose to reinvest the dividends through dividend reinvestment programs. The dividend payment provides additional cash to buy more shares for future income increases and wealth accumulation.
There are an estimated 650 dividend reinvestment plans, commonly called “DRIP” plans, in the United States. These plans enable investors to purchase additional shares or fractions of shares with their dividends payments. Many DRIP plans also allow investors to make cash payments directly into the plans to purchase shares.
3) Dividend Growth Investing Compounds Returns
Returns are further compounded by growing dividends. The reinvested dividends purchase more shares. And, the dividend increases on the increasing number of shares.
DGI compounding provides attractive returns, even if the share price does not rise for a while. That’s because the reinvested dividend purchases more shares at the lower prices. The increasing share count provides more dividend income in which to reinvest. Your dividend yield is increasing on a growing number of shares.
4) Dividend Growth Companies are Easier to Analyze
Josh Peters of Morningstar’s Dividend Investor Newsletter once wrote; “Dividends are not only a powerful tool for driving total returns, but they can represent a practical way of extracting returns from the companies in which one has invested. Rather than placing emphasis on buying and selling, this strategy prefers that companies do the bulk of the work in creating returns.”
This is a critical differentiator between Dividend Growth Investing and other styles of investing. The value investor has to determine, or find, the intrinsic value to know when to buy and when to sell. They do “the bulk of the work” to create their returns.
Growth investors must estimate future sales, earnings, and multiples, all of which are subject to many variables and work.
The Dividend Growth Investor; “prefers that companies do the bulk of the work in creating returns” as Peters explained.
I really like that distinction, especially for investors who choose to minimize the amount of time analyzing investments.
5) A Built-in Buy Low Strategy
Dividend investors who continue to reinvest dividends during stock market corrections and bear markets purchase more shares while the price is lower. It is a form of dollar cost averaging where more shares are purchased when they are cheaper and less when expensive.
This accumulation of more shares in down markets significantly increase investment returns over a long-term investment horizon. Purchasing more shares at lower prices enhance capital appreciation.
6) Management is Disciplined and Shareholder Friendly
Dividend Growth Investors benefit because a long history of dividend payments demonstrates managements willingness to reward shareholders. This is also an essential recognition of shareholders as the owners of the company.
The dividend commitment to shareholders imparts a necessary capital allocation discipline on the board of directors and management. It is paramount they maintain a healthy cash flow to support the dividend and avoid ever reducing it.
This, in turn, helps prevent marginal uses of capital such as questionable acquisitions, uncertain new ventures, etc. that could adversely impact the dividend.
Management discipline and shareholder focus also tend to attract longer-term focused shareholders. Thereby helping to reduce volatility in Dividend Growth Investment stocks.
The Dividend Growth Investing strategy targets companies that pay growing dividends over many years.
These companies are usually well managed and characterized by stable or increasing sales, strong cash flows, and earnings growth backed by stable returns on equity.
They are usually high-quality companies appealing to more conservative and prudent investors.
What We Learned:
An investor seeking income and capital appreciation over a long-term investment horizon should consider a Dividend Growth Investment strategy.
1) Dividends produce a significant source of long-term market returns
2) Dividend Growth Investment provides for both income and capital gains
3) Enhanced compounded returns can be realized through dividend reinvesting
4) Dividend growth companies are easier to analyze
5) The built-in buy low strategy can enhance returns further
6) Management is usually disciplined, good capital allocators and shareholder friendly
In our next article, we discuss finding Dividend Growth Investment ideas and how to evaluate them.