Vanguard closed its most popular dividend fund — Vanguard Dividend Growth Fund (MUTF:VDIGX) — to new money about a year ago. But if you’re not already in, you’re not exactly out of luck.
I have a backdoor way to duplicate — and even beat — its winning income strategy. We’ll talk specifics in a minute, including stocks to buy now. But first, let’s discuss this dividend investing strategy to appreciate why it works so well in all market environments.
In a world with no shortage of financial worries, the VDIGX is the surest long-term bet you can make with a single click of the mouse. It’s a dividend strategy that I plow 100% of my 401k contributions into. It always wins over time.
VDIGX owns the strongest business with ever-rising profits driving ever-rising dividends. As a result, it’s doubled the market’s return over the last 10 years:
Dividend Growth Doubles Up the Market
Funds like VDIGX are good options for investors who don’t have the patience or ability to buy individual stocks. But you have the know-how to build your own portfolio — and secure even better returns.
Plus, you and I have a big advantage over Vanguard. We don’t have to deploy $29 billion in assets! If we did, we’d be forced to buy mostly large cap issues.
Instead, we can take advantage of our nimble size to grow our capital and payouts more quickly by buying faster growing under-the-radar dividend payers.
We’ll talk about the sweet spot for firm size in a moment. Right now, let’s start with payout speed.
A Dividend Growth Strategy for Double-Digit Gains
Over the long haul, your stock returns will equal the current yield you’re netting today plus your annual dividend growth in the years ahead. It’s that simple.
Over time, investors tend pay the same current yields for certain stocks. For example, check out VDIGX’s top three holdings — Nike Inc (NYSE:NKE), Microsoft Corporation (NASDAQ:MSFT) and Costco Wholesale Corporation (NASDAQ:COST). For the last five years, their yields have been amazingly consistent:
But this doesn’t mean their prices have stayed the same. In fact, these stocks have soared higher by an average of 142% thanks to big dividend growth over the same time period!
Costco was the laggard with “only” 81% dividend growth over the past five years — though that doesn’t count two big special dividends paid in 2012 and 2015. Nike bumped its payout by 90% while Microsoft boosted its dividend by 97% over the five-year period.
Vanguard’s portfolio manager Donald Kilbride isn’t exactly performing brain surgery here. He’s simply buying good businesses that throw off enough excess cash that they can increase their dividends by double-digits annually. These payout gains translate directly to stock price gains — which is why dividend growers perform all other payout policies over the long run.
According to Ned Davis Research, since 1987, perennial dividend growers have returned 10.1% annually. They’ve outperformed static dividend payers, non-dividend paying firms and dividend cutters or eliminators.
Beware the Dividend Aristocrats, Though
Dividend aristocrats — companies that have raised their payouts for 25 consecutive years — are deservedly admired, respected and loved by investors. They’ve been dividend growers for decades.
That does NOT mean we should buy them, however. At least not now.
First-level thinkers pay up for past glories and multi-decade track records. But a storied shareholder past is no guarantee of future returns — especially if you pay too much for the privilege to own the company.
Let’s take four aristocrats – Kimberly-Clark Corp (NYSE:KMB), McDonald’s Corporation (NYSE:MCD), Sysco Corporation (NYSE:SYY) and General Mills, Inc. (NYSE:GIS). Their best growth days are behind them, though you’d never know it looking at their valuations. Here are their sales and dividend growth over the past five years, along with their current price-to-earnings (P/E) ratios:
|Company||5-Year Sales Growth||5-Year Dividend Growth||Current P/E Ratio|
|General Mills (GIS)||-7%||52%||21|
How can dividends skyrocket when sales stagnate? It’s not pretty. These has-beens have resorted to artificial measures. They boosted their payout ratios and debt levels to keep up appearances.
The surface-level tactics “worked” over the last decade: these four stocks performed good to great. While the S&P 500 returned 56%, they rang up returns ranging from 125% (Sysco) to 290% (McDonald’s).
But today they’re a decade older … 51% more expensive… and are paying out a higher percentage of profits as dividends today. Which means there’s less room for future dividend increases.
Oh, and other than especially beleaguered General Mills, their yields languish at multi-year lows today:
I prefer to buy my dividend growers when their stocks are cheap and their best growth is ahead of them. Today it’s difficult to find blue chip names that fit the bull right now. The Fed’s “low rates for longer” policy has inspired investors to bid up the popular names.
But the real growth isn’t with the stalwarts anyway — it’s with the up-and-comers. The stocks that Donald Kilbride can’t buy for VDIGX because he has too many billions to deploy.
The Right Size for 12% Annual Returns
The “sweet spot” size for individual investors like us is mid-cap stocks, or companies with market capitalizations between $2 billion and $10 billion. They actually form the biggest segment of the market, but you’d never guess that, because for most analysts and investors, stock investing begins and ends with the sacred cows of the S&P 500.
That lack of attention is fine by me, because it gives us a much wider field in which to find overlooked bargains than we’ll ever have in the large-cap universe.
Here’s something else few people know: Mid-caps have quietly delivered bigger gains than large- and small-cap stocks over the past 20 years.
It’s not even close. Here’s how the S&P MidCap 400 Index, with a median market cap of $3.5 billion, has performed compared to the S&P 500 and the S&P SmallCap 600 (with a median market cap of $1 billion) over the past 20 years:
Mid-cap dividend growers are the safest, surest way to get rich buying stocks. “Efficient market” proponents are dead wrong – you can bank 12%+ annual returns with this strategy – and outperform the great VDIGX easily. Click here and I’ll outline my dividend growth system for you in detail – and I’ll also share my 7 favorite buys today, including names, tickers and buy prices.