Throughout my experience as a dividend growth investor, I have identified three types of dividend growth stocks. Each type of equities comes with a distinct set of yield and growth characteristics, which the enterprising dividend investor can use to their advantage.
In my dividend portfolio, I own all types of equities, in order to benefit from long-term growth and also to add some sustainable high income in case growth doesn’t turn out as expected.
The three types include:
1) High yielding stocks which typically grow distributions more slowly.
Most companies in this category include utilities, telecom, real estate investment trusts and many master limited partnerships. Many of these companies are natural monopolies over a certain activity such as electricity transmission in a particular area. There could be government regulation which ensures the monopoly status in a particular region, but also limits the amount of profits and returns on capital that companies could enjoy.
Others, as in the case of REITs, have properties which are already established, and would take a lot of effort from competitors to replicate that success. After all, the chances of a competitor building a new mall next to an established one are very low, as it takes time to build something and might be impractical to engage in a price war to compete for customers when you have steep upfront costs to foot. These companies generate stable streams of earnings, which do not grow quickly, but are dependable. This results in fewer dividend cuts during recessions. Because of their slow growth, such companies typically yield more than the market.
Examples of companies in the first type include:
2) Companies in the sweet spot.
These are dividend stalwarts, which generate strong earnings growth, and have average or above average yields. Some of these companies tend to satisfy everyday consumer needs for medicine, cosmetics, toiletries, food, gas etc. They tend to have strong brand names and wide moats which help these companies to charge a premium price to customers. The perceived qualities of these everyday products or services, make them a preferred choice for customers, who might be willing to go out of their way in order to find what they are looking for.
For example, consumers would prefer Tylenol to its generic version. Others loyally purchase Gillette shaving products on a regular basis, without hesitation. These repeatable purchases, multiplied by millions of consumers worldwide, lead to a diversified stream of revenues for the companies that sell those products.
These companies also invest billions in research to identify new product or services solutions for their customers, identify efficiencies to increase profitability and expand organically or through acquisitions.
Examples of the companies that will provide current yield with dividend growth include:
3) The third type of dividend growth stocks includes companies with strong earnings and dividend growth, which tend to have below average yields.
These are the companies that are in a growth stage, and they tend to reinvest most of their earnings back into growing the business. Such companies have the potential to deliver high total returns over time, and the rapid dividend growth from a low base could deliver double or even triple digit yields on cost after a couple decades. Some of these stocks are typically richly priced, which is why the best time to purchase them is during market declines.
Investors have to closely monitor these companies, in order to make sure that future growth can materialize. Otherwise, if growth slows down, shares that are trading at higher multiples could fall pretty quickly, even if earnings are still increasing.
Some of the companies on my dividend growth wish list include:
Full Disclosure: Long O, KMR, KO, JNJ, WMT, MCD, FDO, CASY, YUM