Dividend growth investing is a strategy that focuses on companies which regularly raise dividends. The strategy focuses on growth in dividends over a longer period of time that usually exceeds ten years. The typical dividend growth stock does not yield a lot today, but can generate very high yields on cost, that will definitely trump even some of the highest yielding stocks today.
The important tool that makes dividend growth investing is growth in earnings per share. Growth in earnings per share enables companies to increase dividends over time in a sustainable matter. A company that grows dividends for a period of time without corresponding earnings growth will eventually run out of room to boost distributions. I call these dividend stocks on autopilot, and try to avoid them whenever possible. I typically look for the annual rates of increase in dividends and earnings per share to be similar within a certain range.
As a result, dividend growth investors focus on the catalysts that can generate a higher net income for the corporations whose stock they are purchasing. Companies can earn more by selling more, increasing prices, streamlining operations, expanding in new markets, selling new products or acquiring and merging with other companies. Mergers and acquisitions can only lead to higher earnings per share if they result in synergies. We want growth in earnings per share after all, not just a growth in overall net income.
There is not a one size fits all approach, which is why some time needs to be spent learning about the company and determining where the growth will come from. For many consumer staples such as Coca-Cola (KO) or Procter & Gamble (PG), future growth will be positively correlated with the expansion in the number of middle class consumers in emerging markets of Asia, Latin America, Africa and Eastern Europe.
Strong pricing power of companies like Coca-Cola and Phillip Morris (PM) can also allow them to pass on cost increases to consumers, while increasing their profits. For other companies such as 3M (MMM), future growth could arise from a culture that focuses on innovation and bringing new products to market in order to generate growth.
Imagine a company which yields 2.50% today, but can grow earnings and distributions by 10%/year. The stock trades at $100 today, earns $5/share and pays a $2.50 dividend. The stock will probably yield around 2% – 3% over the course of an year, and would be usually ignored by investors who simply look at current yields. In approximately 14-15 years however, this company would likely still yield somewhere between 2% – 3%.
However, the stock would be earning close to $20/share and probably paying about $10/share in annual dividends. It would not be unreasonable to assume that the stock could be valued at $400/share. The investor, who had the vision to acquire this stock when it traded at $100/share, is now generating an yield on cost of 10%. If they reinvested dividends along the way, they would likely be earnings much more in dividend income. The rising dividend income also provides protection against inflation over time.
A few important things to note are related to entry price, diversification, and dividend reinvestment.
Having a strategy that provides a maximum entry price to pay for a stock helps in being a disciplined investor, who avoids getting carried away. I try to never pay more than 20 times earnings for a stock. At the end of the day, if you overpay by purchasing a company like Coca-Cola or Wal-Mart (WMT) at 30 times earnings, you might end up regretting the investment for a long time. You would likely receive a small yield as well. If you had the fortitude of selecting a great company with solid fundamentals and a rising earnings tide, it would eventually “bail you” out, as earnings growth would compress the P/E ratio. This would make the stock compelling again.
However, if for some reason the company stops growing, it might be dead money for a long period of time. Hopefully some of your other investments deliver better returns if that were the case.
This leads me to the next point on diversification. Dividend growth investors need to absolutely build a portfolio consisting of at least 30 individual securities, which come from as many industries that make sense. Investors who own less than 30 positions, and are heavily focused on a sector or two are just asking for trouble. A diversified portfolio of over 30 stocks provides a fail-safe mechanism to protect the portfolio income against a few bad apples. It can also protect investors against a wave of dividend cuts in a given sector. Investors in the financial sector experienced dividend cuts and eliminations across the board during the 2007 – 2009 financial crisis. Not every company in the financial sector cut dividends however, and the carnage was mostly focused there.
The good part about the strategy is that investors receive cash in their brokerage accounts from their dividend paying stocks. This allows them to have the necessary resources available for opportunities present during recessions for example. Not all sectors are attractive to invest in at all times. This is why building your exposure at the most attractive stocks across a variety of sectors over time is an effective way to deploy dividends received and new capital put to work.
Full Disclosure: Long KO, PM, WMT, PM, MMM