The Basics of Dividend Growth Investing

The Basics of Dividend Growth Investing

Dividend growth investing is a popular strategy, but like any investment approach, it's essential to understand the fundamentals before diving in. Let's explore the basics.

Basic Ground Rules for Do-it-Yourself (DIY) Investing

Before you even think about investing in the financial markets, financial professionals strongly suggest establishing an emergency fund. This fund should ideally cover at least three months of your normal household expenses. Its purpose is crucial: to cover unexpected costs or a sudden job loss without forcing you to sell your investments prematurely.

Why is this so important? Because a core tenet of building wealth through investing requires keeping your money invested in the market over the long term. "Time in the market" is arguably the most significant of the three key factors needed to build wealth:

1. Investment Contributions ($): The amount you regularly invest.
2. Return on Investment: The growth your investments achieve.
3. Time in Market: How long your investments have to grow and compound.

Continuously investing, even small amounts, and allowing that money to remain invested allows DIY investors to harness the power of "compound interest."

As Vanguard Founder John Bogle famously said: “Time is the most important contributor to wealth creation.”

What Makes Dividend Growth Investing Attractive?

Dividend Growth Investing is a strategy focused on companies that not only pay dividends but also have a history of increasing them over time. This approach produces several attractive attributes for investors:

• Regular Income Stream: Dividends provide periodic cash payments.
• Inflation Hedge Potential: The goal is for the dividend cash flow to grow over time, ideally outpacing the long-term inflation rate.
• Compounding via DRIP: Many investors utilize Dividend Reinvestment Programs (DRIPs). This automatically uses the received dividends to buy more shares of the stock, leading to compounded returns over time.
• Potentially Higher Risk-Adjusted Returns: Historically, certain types of dividend-paying stocks have offered strong returns relative to the risk taken (more on this below).
• Significant Contribution to Total Returns: According to a Hartford Funds study analyzing S&P 500 returns from 1960-2021, a remarkable 84% of the total return during that period was attributed to dividends (40%) and the effects of reinvesting those dividends and compounding.
• Tax Advantages: In the US, qualified dividends are typically taxed at lower long-term capital gains rates, which can be beneficial compared to ordinary income tax rates.

The appeal of receiving regular income from investments was succinctly captured by John D. Rockefeller: “Do you know the only thing that gives me pleasure? It's to see my dividends coming in.”

Dividend Growth Stocks Have Outperformed

Historical data suggests that companies consistently growing their dividends have provided strong returns relative to the risk involved.

As the data indicates, Dividend Growth Stocks have experienced the highest long-term returns per unit of risk compared to other categories analyzed.

Working Backwards: How Big a Portfolio Do You Need?

A common question is how much capital is needed to generate a specific income stream from dividends. You can estimate this using a basic formula:

Portfolio Size Needed = Desired Annual Income / Expected Portfolio Dividend Yield

For example, if you aim for $2,500 per month ($30,000 per year) and anticipate an average portfolio yield of 4%, the calculation is:

$30,000 / 4% (or 0.04) = $750,000 Portfolio Size

The table below illustrates how the required portfolio size changes based on the average dividend yield.

Looking at this relationship, a higher target dividend yield reduces the capital required to hit an income goal. However, pursuing significantly higher yields often involves taking on more investment risk. Conversely, a lower yield generally implies lower risk but requires a larger capital commitment.

Key Metrics Used in Dividend-Growth Picking

Whether you choose a Dividend-Focused ETF or prefer to select individual Dividend-Growth stocks to build your portfolio, several metrics are important for evaluation:

• Dividend Yield: Calculated as Annual Dividend per Share / Stock Price. This shows the annual return from dividends relative to the stock's price. Caution: A very high yield can sometimes be a warning sign, especially if paired with a high Payout Ratio.
• Payout Ratio: Calculated as Dividends Paid / Net Income. This indicates the proportion of company earnings being paid out as dividends. Many investors prefer payout ratios below 50%, suggesting the company retains enough earnings for future growth and has a buffer to maintain the dividend.
• Dividend Growth: Calculated as (Current Dividend / Prior Dividend) - 1. Investors look for a consistent history of positive dividend growth, indicating a company's ability and willingness to increase shareholder returns over time.
• Dividend Streak: This is simply the number of consecutive years a company has increased its dividend. Many dividend growth investors look for companies with streaks of 10 years or more, often referred to as Dividend Challengers, Contenders, Aristocrats, or Kings depending on the length of the streak.

The Chowder Rule: This popular metric combines current yield and past growth by adding the Current Dividend Yield + 5-Year Dividend Growth Rate. It provides a quick check for a potentially attractive balance between income and growth. General guidelines are:
*   If Dividend Yield > 3%, look for a Chowder Number of 12%+.
*   If Dividend Yield < 3%, look for a Chowder Number of 15%+.
*   For Utility companies (which often have higher yields but slower growth), look for a Chowder Number of 8%+.

Don't Forget Diversification

While focusing on dividend growth stocks, it's crucial to remember the importance of diversification. Building a portfolio concentrated in only one or two sectors increases risk. Fortunately, dividend-paying stocks are available across most market sectors.

Spreading your investments across different industries helps mitigate risks associated with any single company or sector facing challenges.

Final Thoughts

Building a portfolio focused on dividend growth requires patience and discipline. As legendary investors have noted:

"Investing in dividend-paying stocks is like building a fortress of financial security, one dividend at a time." - Peter Lynch

"I believe non-dividend stocks aren't much more than baseball cards. They are worth what you can convince someone to pay for it." - Mark Cuban

"I do not own a single security anywhere that doesn't pay a dividend." - Kevin O'Leary

While dividend growth investing offers compelling benefits, remember to start with a solid financial foundation (like an emergency fund) and always consider your own risk tolerance and investment goals.

‍