Dividend Growth Investing’s central goal, for most investors, is to build an income stream that can substitute for a paycheck. Using myself as an example, I want to build a dividend stream that fills the gap between the income I receive from Social Security and a pension in retirement and my expenses.
To do that, I buy stocks that exhibit both a decent yield (my minimum is 2.7%) plus a history of growing that dividend every year (my minimum is 5 years in a row).
[ad#Google Adsense 336×280-IA]My universe for selecting stocks is David Fish’s Dividend Champions, Contenders, and Challengers.
Known as the “CCC,” this remarkable document catalogs every stock traded in the US that has raised its dividend for 5+ years (Challengers), 10+ years (Contenders), and 25+ years (Champions).
The CCC is my starting point for researching every stock that I buy.
Dividend growth investing has its critics.
One of the chief criticisms is that, by focusing on income, the DG investor forgoes sheer growth in wealth. Critics say that investors, especially younger ones, would be better off focusing on building their wealth until the time later in life that they need income in retirement.
Does that make sense? It certainly would if it were true that investing for income automatically consigns you to inferior total returns. But that presumption is not true.
Ned Davis Research [NDR] has been tracking the returns of stocks as a function of their dividend policy since 1972. This chart is derived from their research.
[Source. Copyright 2016 NDR. Chart illustrates the average annualized historical performance of S&P 500 stocks, grouped as shown according to their dividend policies, with monthly rebalancing. The returns do not reflect the deduction of any fees, expenses or taxes. Returns for stocks that paid dividends assume reinvestment of all income. Past performance does not guarantee future results.]
Various charts of NDR’s research over the years, which are widely available, have shown essentially the same thing. Stocks with consistent dividend increases, as an aggregated group, tend to show the highest total returns over long time periods. Non-dividend-paying stocks tend to show the worst.
The non-dividend payers, of course, include many fast-growing hot stocks. How can it be that they are outperformed by plodding, dividend-paying companies?
The answer lies in two factors:
1. Many hot “growth” stocks crash and burn. Investors don’t know, in the beginning, which hot stocks will be the ones that survive and prosper. Those that do, like Apple (AAPL), provide their investors with fabulous returns that no dividend growth company can match. But when you buy a basket of hot growth stocks, or pick out the ones that you think will be the best, the great returns from the best ones are often wiped out by the losses from the worst ones as the years go by. We saw this big-time in the dot-com crash of 2000-2002.
2. Dividend growth stocks provide dividends that can be reinvested. The compounding of those dividend re-investments provides “extra” return on top of the price-only returns from growth stocks that issue no dividends. Over long time periods, the relentless reinvesting and compounding can overwhelm the returns from all but the most successful non-dividend stocks.
My own Dividend Growth Portfolio illustrates how dividend growth investing can produce superior total returns.
You are familiar with the S&P 500 Index. It is often used as a benchmark for comparing performance. You can’t buy the index itself, but you can buy a low-cost ETF that mimics it. The most heavily traded security in the world is SPY, the S&P 500 ETF from SPDR. Here’s how my Dividend Growth Portfolio stacks up against SPY in total returns since I started my portfolio back in 2008.
The returns for both are with dividends reinvested. As you can see, my portfolio has never ended a year behind SPY. At the end of last month, my portfolio had increased in value by 95% compared to SPY’s 77%.
Obviously, that is a small data set for comparison. But check out the following table, which compares total returns over the past 10 years for a variety of common dividend growth stocks to SPY, Apple, and Warren Buffett’s Berkshire Hathaway (BRK), which pays no dividends.
You can see that nothing touches Apple. Its price gain of 836% accounts for 92% of its total return over the past 10 years. (Apple just instituted a dividend 5 years ago.)
But would you have guessed that lowly utility Consolidated Edison provided 31% more total returns than Berkshire Hathaway? Or that “slow growth” Kimberly-Clark delivered 55% more? Probably not, right?
Yet they are perfect illustrations of the power of reinvesting and compounding dividends. Reinvesting Con Ed’s dividends more than doubled its total return from price alone. AT&T’s total return was almost tripled by the reinvestment of its dividends.
It is often recommended that investors invest mainly in the S&P 500 to take advantage of its long-term growth. But it ends up nearly at the bottom of the table.
The purpose of this article is not to suggest that you should only invest in dividend growth stocks. Far from it. If you are fortunate enough to identify a rocket-ship stock and stick with it through its inevitable ups and downs, you will realize fabulous returns. Maybe you will get rich on one stock alone.
But if you want to devote a portion of your portfolio to building the income stream that you will need in retirement, without needing to convert a growth portfolio into an income portfolio just before you retire, consider dividend growth stocks and the dividend growth strategy. They work.
For more information:
DGI Lesson 4: The Power of Compounding
DGI Lesson 5: The Power of Reinvesting Dividends
DGI Lesson 9: Why I’ve Loaded My Portfolio with Dividend Growth Stocks
— Dave Van Knapp
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