I caught myself having investing ‘fever’ during my sophomore year in college. I worked hard throughout the summer, put my money into a stock and doubled it. Having a taste of success made me want to keep the ball rolling. I made a series of investments my senior year of college and as many of you know, I made many grave mistakes which I have since learnt from.
I refuse to pay a manager 1% to manage my portfolio so I made the decision to change my investing strategy. Unfortunately, there are an endless amount of ways to invest. Should I throw my money in an ETF or mutual funds? Should I be a growth investor or a value investor? The list goes on…
Luckily, I stumbled upon a blog called Dividend Diplomats which opened my eyes to dividend growth investing (DGI). I believe this method can contribute towards my quest for financial independence.
Dividend Growth Investing Explained
As legendary investor Warren Buffet once said, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
Dividend investors have a buy and hold mentality. If you want to sell stocks every time they decline, this is not the method for you. If investing in promising companies such as FB or AMZN appeal to you, this method is also not for you as these companies do not pay dividends.
The concept behind dividend growth investing is you buy and hold a dividend paying stock for a long period of time. Assuming the company continues to grow the dividend, your dividend income should increase the longer you hold the stock. This disincentives you from selling the stock which in turn makes you earn more dividend income.
Benefits of Dividend Growth Investing
The major benefit of dividend growth investing is the compounding effect. This concept is best explained using an example. Say you invest $100 in a company with a 3% dividend yield. You will receive $3 in dividends a year. However, the concept of dividend growth investing is that the company grows their dividend every year. If this company manages to raise their dividend by 5% per year for the next 10 years let’s look at the results. Without any growth you would have received $30 over the course of 10 years. Consequently, if the company managed to grow the dividend 5% a year you will receive $37.73 and have a yield of roughly 4.65% after 10 years. Ok… no more math I promise. If you put stock growth into this equation and use a dividend reinvestment plan (DRIP) these results may be far greater.
Another benefit is cash flow generation. Stocks that do not pay dividends generate one form of cash flow, capital appreciation or depreciation. Dividends stocks offer two: capital appreciation/depreciation and dividends. These dividends can either be reinvestment to generate more cash flow or used to cover expenses.
Other benefits to dividend growth investing is the low-cost nature of this style:
- You are not paying a portfolio manager to manage your portfolio
- Reduction in brokerage fees as you are selling stocks less frequently
- Dividends are taxed at a lower rate than stocks, see more information here
Consequences of Dividend Growth Investing
Like any investing strategy, nothing is perfect.
Dividends are not required to be paid by companies. They can cut the dividend at any point and have no obligation to pay you. Obviously, this will have a negative impact on this strategy. During economic hardships, companies that pay dividends tend to reduce the payout, or cut the dividend completely, to fund their current expenses.
I urge you, do not invest in a company that has a high dividend yield. These dividends usually get cut as the company cannot maintain the high payout ratio.
Evidence for Dividend Growth Investing
Few people realize that Warren Buffett, arguably the greatest investor, is primarily a dividend growth investor. Over 90% of his portfolio is invested in dividend paying stocks.
If that is not enough evidence right there let’s look at some quick stats.
- Since 1930, dividends have accounted for roughly 40% of the total return of the S&P 500 Index
- According to Sure Dividend, Dividend paying stocks have compounded total returns of 9.2% vs 2.3% a year for non-dividend paying stocks
There is a select group of corporations that have increased their dividend payments for 25+ consecutive years in a row. These corporations are called the Dividend Aristocrats. There are currently over 50 Dividend Aristocrats. Many of these are household names such as Johnson & Johnson and Wal-Mart, to name a few.
More importantly, the Dividend Aristocrats have averaged returns of 9.4% a year over the last decade versus 6.4% returns for the S&P 500. It is very rare to have an investment method outperform the market over a long period of time.
This historical evidence ultimately persuaded me to become a dividend growth investor.
I would like to highlight some important metrics and information I believe you need to know to be a successful dividend growth investor.
- Arguably the most important metric for a DGI is the payout ratio. This is the proportion of earnings paid out as dividends. Many investors argue this ratio should be 60% or less. Anything over 100% is a red flag and I urge you to be careful.
- Use a platform that has a dividend reinvestment plan (DRIP)- Reinvesting your dividends to purchase additional shares will compound growth far quicker than spending them every year. This is something I am personally in the process of setting up.
- Have a long term mentality – I think this is the hardest concept for most investors. Leaving money untouched for a long period of time is rewarding as a dividend growth investment. Resist the urge to sell when the market declines…heck I would use this as a perfect opportunity to buy even more of the stock.
- Quality trumps high yield – When I started this investment style I wanted to have the highest yield possible. Unfortunately many of these companies cannot sustain these payments which will have a negative impact on this investment style. I used the Dividend Aristocrat list to choose quality stocks as the core of my portfolio.
- Tax exception – Real Estate Investment Trusts (REITs) are required to pay around 90% of their earnings as dividends. These investments are taxed at your personal tax rate rather than the dividend tax rate.
Final Thoughts – How I hope to achieve financial freedom through Dividend Growth Investing
This article was more technical than others I have written but I did not want to short change you. Many people see investing as gambling but I hope the information provided showed you there is hope!
Dividend growth investing is not a get rich quick scheme. It will take years to compound wealth but if you have the discipline to buy and hold you will see your dividend income rapidly rise.
I believe you can find financial independence with dividend growth investing. Let me be clear, financial independence is different for everybody. For me it means being debt free and having enough passive income to cover all my expenses, and then some, so I can enjoy life however I want to. Through dividend growth investing I believe this can be accomplished.
For more information on dividend growth investing, I highly recommend you check out my blogroll to see how other bloggers are using dividends to achieve financial independence.
What are your thought on dividend investing? Do you believe this is a viable model? Are you ready to become a dividend growth investor?