What is Dividend Growth Investing?

A couple of years ago I knew next to nothing about dividend growth investing.

I always thought that the way to make money with stocks was to be a trader. I also knew that as an ‘average Joe’ you would always be behind professional traders, hedge funds and the like.

Behind in terms of material information that influence stock prices, and behind in terms of speed of trade executions. Articles and books like Michael Lewis ‘Flash Boys‘ confirmed this idea.

Movies about ‘Wall Street’ and it’s lupine inhabitants reinforce this idea: investing is for fast guys wearing intimidating suspenders.

This all changed when I started with Dividend Growth Investing (DGI). After doing my research I found out that this approach to investing fit perfectly with my interests, personality and risk appetite.

My results with DGI so far can be seen by checking my Portfolio and Dividend Income.

Recently I have received some requests from readers of this blog to take a step back and talk about what DGI actually is - and why I choose it to be my investment strategy.

So here it is: my attempt to provide an introduction into the concept of DGI and why it has worked so well for me.

What are dividends?

Let’s take the example of a dividend paying company, say Caterpillar (CAT).

After a busy quarter of designing, constructing and selling those heavy yellow machines, the company has the happy realization that there is quite some cash left. All other responsabilities have been met: employees and suppliers have gotten their checks, money has been set aside for a new factory and the interest on their corporate debt has been paid.

So the (great!) problem that now arises for Caterpillar is what to do with that excess cash.

Well, since everybody else has been paid, that money will be disbursed to the owners of the company. And the owners of the company are - in the case of a public corporation - the shareholders. 

Buying just one share in Caterpillar makes you a shareholder. As such you have the right to vote during shareholder meetings and are entitled to your share of their profits. This share of the profits is called a dividend.

Not every public company chooses to pay dividends. Buying shares in Amazon, Google or Facebook, for example, will still make you part owner of those businesses, you just won’t receive a reward in the form of a dividend.

Most dividend paying companies do so every quarter, although there are also companies that pay every month, twice a year or just once a year. It’s really up to the company to set their dividend policy and then for you to decide whether you want to invest in them or not.

Taking the example of Caterpillar again - this is a case of a quarterly-paying dividend company (like most do).

Looking at the chart below, each bar represents a quarterly dividend pay-out. The most recently announced dividend is for the last quarter of 2017, set to be $0.78 (in purple).

So if you have bought 1 share of Caterpillar, you will receive $0.78 in the fourth quarter of 2017.

If you were to own 100 shares of the company than your dividend pay-out comes to $78. And if you own 11 million shares of Caterpillar (like Bill Gates does) then you are most likely not reading this article.

When do I receive dividends?

You receive a company’s dividend because you are entitled to it as the company’s (part) owner. But as stocks get traded - and therefore change ownership every day and even every second - it would be hard to determine who at which point owned the stock and is therefore entitled to the dividend.

Enter the ex-dividend date.

The ex-dividend date is used to determine who will receive the dividend for that period (in most cases the quarter).

Taking the example of Caterpillar again - the following key dividend dates appear when I pull up the information at my brokerage’s website (Fidelity). This is public information that you can find in other places as well, such as Seeking Alpha and Yahoo Finance.

Let’s go over these dates from left to right.

On 10/11/2017 Caterpillar announced that they will pay $0.78 in dividends per share to anyone who owns the stock one day before the ex-dividend date - 10/20/2017.

If you indeed have bought before or on that date, your ownership gets recorded on 10/23/2017 and you will receive your $0.78 per share by 11/20/2017. Then a couple of weeks later the company will announce the next dividend for the next quarter and the process repeats itself.

Personally I don’t cut it close with the ex-dividend date. I buy a stock whenever I find it to be undervalued and tend to hold on to it forever, collecting my dividends for decades to come.

How do I invest in dividend stocks?

If you want to invest in dividend stocks - or any other stock for that matter - you will need to buy them on the stock exchange.

There are many stock exchanges on the world, but the biggest and most famous is the New York Stock Exchange (NYSE) - sometimes referred to as Wall Street.  

Luckily you don’t have to actually drive up to to Wall Street and start shouting your buy orders - you can buy your stocks from your couch wearing sweatpants. The only thing you’ll need is a brokerage service.

There are many brokerages around with different fees involved, so it comes down to your preference. I value a trusted name and access to research reports so I landed on Fidelity.

But there is also E-Trade, T Rowe Price, Charles Schwab, etc. A overview can be found here: 

https://www.nerdwallet.com/investing/best-stock-broker-comparison

Why should I invest in dividend growth stocks versus other types of investments?

Your investing style is really up to you. If you feel comfortable with more risky type of investments such as options, junk bonds or crypto-currencies - by all means, go ahead.

But if you are like me - boring, factual and lover of the predictable - you might find that dividend growth investing (DGI) is your way to go.

The beauty of DGI is the compounding aspect. It works as follows: let’s say you bought 100 shares of Caterpillar and therefore you receive 100*0.78=$70.80 for the quarter. On a yearly basis this means you will receive four times that amount, $310.20.

Now instead of spending that money, you re-invest it again in more Caterpillar stock. At the current share price your newly received $310 will get you two additional shares in Caterpillar, and leaving you some spare cash to invest in other stock.

Because of your savvy reinvestment, in the following quarters you will receive dividends for not just 100 Caterpillar stock, but 102. The dividends you receive will therefore increase, which allows you to buy even more stock and so on and so forth.

It’s like the analogy of a snowball: you start small and need a lot of effort (time and money) to grow it into a sizable sphere. But once it starts rolling it picks up more snow on it’s own and just gets bigger and bigger over time.

Even better - many companies raise their dividends over time.

Have a look at the bar chart again featuring Caterpillar’s dividend. In Q2 of 2016 the company would have paid you $0.70 for each share you’d hold. But the next quarter they amped it up to $0.77 cents, a 10% increase. After that a minor increase followed to $0.78 cents.

These two things combined made the compelling argument for me to adopt a DGI strategy. Now in my third year of investing, it has certainly worked and paid off handsomely judging by the year of year growth of my received dividends.

The chart below should serve as the final mic drop. The blue line shows you what would have happened if you had invested $100 in the S&P 500 index on December 31, 1929. The yellow line indicates what would have happened if would have done the same, but with continuously reinvestment of all your received dividends.

The first startegy would have left your with a little under $6,000. Reinvesting your received dividends would have provided you with more than $142,000.

The $100 amount in this example shows you that you really don’t need a large sum to start investing.

In fact - have a look at the investment calculator below and play around with some inputs. Even the smallest amount - through the power of compounding - makes for a significant sum in a 20 or 30 year period.

https://www.daveramsey.com/smartvestor/investment-calculator/

Which dividend stocks should I buy?

You invest in dividend stock because you assume they will continue and grow their dividend payouts for decades to come. So how do you know which companies will do well in the future and therefore make enough money so that they can keep paying you?

Well.. you don’t. Nobody knows whether a stock is going to up or down or sideways. You are not able to predict where the stock price will be in 10 years, in 5 years or even the next hour. ‘Experts’ who claim to be able to predict the future of stock prices, oil prices or company performance are all guessing at best.

Or as Charlie Munger (Warren Buffet’s longtime friend and business partner) once said:

“I don’t let others do projections for me, because I don’t like throwing up on the desk.”

You do have a reliable resource in history though.

Companies that have paid a growing dividend for decades are likely to continue to do so in the future.

A great place to start looking for reliable dividend payers is the so called Dividend Champions, Contenders and Challengers (CCC) list. On this list you’ll find about 816 companies that have raised their dividends for at least the past five years:

• Dividend Champions: U.S. stocks that have grown dividends for the last 25+ consecutive years
• Dividend Contenders: U.S. stocks that have grown dividends for the last 10-24 consecutive years
• Dividend Challengers: U.S. stocks that have grown dividends for the last 5-9 consecutive years

One could argue that 816 options is quite enough. But not every company on this list is a smart buy at this moment. Some are pretty expensive right now, while others are fairly valued. Some can currently be qualified as undervalued dividend growth stocks - and those are the ones you want to put on your shopping list.

So how do you know whether a company is an undervalued dividend growth stock and therefore one you’d like to buy?

Analyzing stocks is both an art and a science and can involve many factors. There is definitely more to it but here are the main elements I typically take into account:

Whether company pays a reliable and growing dividend (i.e. if they are on the CCC list mentioned above). If not, I don’t bother investing in it given my adherence to the DGI concept.

The current dividend is expressed in the ‘yield metric’ - which is the yearly dividend divided by its yearly stock price.

Taking the example of Caterpillar again: the yearly dividend is $3.12 (four times $0.78) and the current stock price is $138. Dividing 3.12 by 138 makes the current yield 2.26% which is decent but not great. The target for my Portfolio is to have an average yield of no less than 3.5%.

The 5 year dividend growth comes to 8.45%, which is again decent. Based on these two factors alone I wouldn’t recommend buying Caterpillar at this moment. The share price has grown rapidly over the past year and last year would have been a better entry point. Luckily that leaves you with 815 other candidates to assess!

The current and historical Price/Earnings (P/E) ratio. A rule of thumb is that the lower the P/E, the better. You also want to compare a company’s current P/E to it’s five year average. If a company is currently sporting a low P/E as combined to that average, it could be a good time to purchase.

In the case of Caterpillar the P/E ratio is currently 95. Compared to a 5 year average of 56 that is high and based on that metric alone it’s not an opportune time to buy.

Pay-out ratio. This ratio expresses the dividends that are paid out as a proportion of the company’s cash flow. A low payout ratio is typically better - it indicates that the company has enough cash to pay and hopefully grow the dividend.

A high payout ratio might indicate that the company is struggling to maintain the dividend and might need to cut or lower it in the future. Payout ratios over 100% mean that the company is paying out more in dividends than it receives in income - which is usually an unsustainable situation. A rule of thumb here is to find payout ratios under 60%.

Ethics. This is a personal call but I try to limit my investments in company that have an out sized negative effect on our planet and its inhabitants. I therefore shy away from tobacco companies, fast food and factory farming.

As I said there are many more factors that can be taken into account before you decide to add a certain stock to your portfolio.

The most important element is reading. Ignore the noise (Twitter, CNBC, that guy at the bar who urges you to invest in stock X because it will be the new Facebook etc).

I really like the concept of a calm and contemplative approach to investing as expressed by Warren Buffett in his annual newsletters and recent documentary “Becoming Warren Buffett”. It has provided him with a net worth of over $80 billion.   

Apart from the CCC list a great resource to start evaluating which stocks to buy are the ‘Undervalued Dividend Growth Stock of the Week‘ and ‘Dividend Grow Stock of the Month‘ series on Daily Trade Alert.

I also publish regular watchlists on stocks that are on my buy lists - they can be found by clicking here.

Finally - have a look at Resources page featuring blogs and books that helped me start my investing journey.

What do you think about Dividend Growth Investing? What comments or questions remain for you? Leave a comment/reply to share your thoughts!

 

I am not a licensed financial advisor, tax professional, or stock broker.

Tallinvesting.com is for entertainment purposes only. Always do your own research or seek professional advice before buying or selling securities.