You've probably heard of the dividend investing strategy. It involves buying shares of companies that pay continuous quality dividends, then letting the shares sit there unless you want to buy more.
How does a dividend growth strategy work? A dividend-paying company that experiences growth year over year, are covering their expenses, and have continuously more cash flow than the previous year are candidates for dividend growth investing. These companies usually slowly increase the dividends they pay to shareholders due to their continuous growth.
Sub-Strategies for Dividend Growth Investing
Though techniques differ by practitioners, the gist of the dividend growth approach tends to involve some combination of the following:
- Building a collection of shares in great companies who increase their dividends at a rate equal to or substantially in excess of inflation each year
- Holding onto positions for long periods of time (often decades) to take advantage of deferred taxes, as it allows more capital to work for you, and for more dividends to be awarded to your family
- Diversifying across different industries and sectors so that your dividend stream isn't too reliant upon a single area of the economy
- Making sure the dividend growth is being financed by higher levels of real underlying profit, not debt
- Owning a collection of stocks from different countries so that you collect dividends in multiple currencies to reduce reliance upon a single government
If you need a visual picture of what a good dividend growth stock looks like, look at Swiss food giant Nestle, who has increased its cash dividend over the past few decades. An investor who never bought a single extra share of stock beyond the first purchase has had ever-increasing sums of money awarded them from their share of the coffee, tea, chocolate, and other products sold in nearly every country.
Going for the Biggest Stream of Net Present Value Dividends
Net present value is the summed value of an asset in the future, discounted to the present value of a currency. This is based on the idea that the money you have now is worth more in the future.
Imagine that you have a choice between buying two different stocks. Which would you prefer for your own investment portfolio?
- Stock A has a dividend yield of 3.00%. The board of directors has historically increased the dividend by 5% annually and the dividend payout ratio currently stands at 60%.
- Stock B has a dividend yield of 0.50%. The company is growing rapidly to the point that 20% jumps in diluted earnings per share (EPS) have not been uncommon over the past five years. The dividend is almost always increased accordingly. The stock currently has a dividend payout ratio of 10%.
If you follow the dividend growth investing strategy, you're probably going to opt for Stock B, all else equal. It may seem counter-intuitive, but you will end up cashing larger aggregate dividend checks by owning it than you will Stock A. This is because the net present value of Stock A is higher, giving you more money to work for you in the long run.
This will hold true provided the growth can be maintained for a long enough stretch of time. As the earnings climb, and the dividend is increased alongside profits, your yield-on-cost (dividend to the price paid) starts to overtake the slower growing company.
Yield-on-cost is a ratio used to gauge how much you paid for a stock compared to how much is paid in dividends. It is a measurement that has value for the individual investor, but not many others.
There will come a point at which the core business reaches its full potential and much of the surplus generated each year can't be intelligently reinvested. When that moment arrives, shareholder-friendly management will return the excess money to the owners in the form of dividends or stock buybacks.
Historically, businesses such as McDonald's and Walmart provide excellent case studies. In the early years, when these firms were marching across the United States (and later, the world), the dividend yields weren't very high. However, had you bought the stock, you would have actually been collecting a fairly fat dividend yield on your cost basis within 5-8 years depending upon the period.
Growth Is Indicative of a Healthy Operating Environment
Which situation would allow you to sleep better at night: owning a company that might pay you a smaller dividend today but is enjoying higher sales and profits each passing year, or a company that pays you a large dividend today and is seeing a slow, perhaps substantial, decline in its core business? If you feel there is a degree of added protection in the successful enterprise, you might want to consider this investing strategy.
There is some wisdom in this approach. In the United States especially, the board of directors is unlikely to raise the dividend if they believe they are going to have to turn around and cut it. Thus, an increased dividend rate on a per-share basis often represents a vote of confidence from the people who have some of the closest access to the income statement and balance sheet.
It's not foolproof, as even successful men and women who are qualified enough to get elected to such a prestigious position are not immune to self-deception when it suits their own interest. But it's a decent indicator more often than not.
Keep as Much of Your Income as Passive as Possible
Passive income generated from dividend growth stocks results in far more money staying in your pocket than many comparable investment assets. That's because qualified dividends are taxed at a lower capital gains rate than ordinary dividends, which are taxed as ordinary income.
Just as importantly, shares of stock held in ordinary, taxable brokerage accounts enjoy a stepped-up cost basis when you die and leave them to your heirs. That means if you bought $10,000 worth of Starbucks at its IPO and watched it grow to $750,000, your children are going to get the inheritance tax-free (provided you are under the estate tax limits), and the Federal and State governments will allow them to pretend like they paid $750,000 for it. That means if they sold it for $750,000 today, they'd owe no capital gains taxes.