Is dividend growth investing better than investing in the broad-based index funds?
Answer: Yes
Why invest in dividend stocks?
1.Compounding. According to Albert Einstein, compounding is the 8thwonder of the world. So, if you invest in dividend stocks and reinvest those dividends your gains grow and grow. Here’s an example by just how the stark the compounding effect is on the S&P 500: 40% of the total return of the S&P 500 from 1995 to 2015 was attributed to reinvested dividends and the power of compounding.
2.To protect you from yourself: According to BlackRock the world’s largest asset manager, the average retail investor has woefully underperformed the market. Most of this under performance is due to excess trading and trying to time the market. Having a steady stream of dividend income mitigates this need. The average investor generated an annualized return of 2.1% over the last 20 years compared to annualized returns of 8.2% and 5.3% from stocks and bonds, respectively. Sitting on your hands would have been better for the average investor.
3.They Make Up a Large Percent of Market Return: From 1930 to our current market, dividends accounted for about 42% of the S&P 500 Index’s total return, according to the Hartford Funds. In certain periods, dividends even accounted for well over half of the market returns.
4.Outperformance over time. So, these dividend stocks sound pretty good. How do they compare to non-dividend stocks? They crush them to a tune of an extra 2.5% return per year with less risk (measured by standard deviation).
Also, you may note that dividend growth stocks beat dividend payers and all other categories. There is a specific set of stocks known as the dividend aristocrats that have raised their dividends for 25 straight years. There is a subset of this list known as dividend kings who have raised their dividends for 50 straight years! They are a great place to start.
Should I focus on dividend yield or dividend growth?
So, we’ve established dividends are good. Dividend growth is even better. Shouldn’t you just shoot for the highest yielding dividend stocks? Well actually no. The highest yielding dividend stocks have actually underperformed the S&P. This is most likely due to the fact they have to stretch themselves to pay a high dividend. Also remember the dividend yield equation (dividend / stock price). If stock price is going down, dividend yield is going up. There might be a reason why.
So, what is a reasonable dividend yield to target? It’s different for every industry and sector. For example, REITS have to payout 90% of their earnings as dividends which naturally make their payouts higher. Still it seems the 3-6% range is the sweet spot.
Now that you have your dividend you also want to make sure the company is growing them year over year. This generally indicates the company is stable and growing its business (because they can payout higher and higher dividends) and also helping you naturally compound your assets if you reinvest.
How do I find safe and reliable divided stocks?
Simple Answer:
Start with the list of dividend kings and aristocrats then diversify across sectors.
Longer Answer:
Look for companies paying in the 3-6% dividend sweet spot we mentioned earlier then investigate each one deeper.
- The Business model: Does the firm have competitive advantages? (quality management, moat, strong long-term growth runway)
- Cash flow: is it growing and comparable to the competition (created by business model and preferably under long-term contract)
- Payout ratio: what is like compared to the competition (relative to the industry)
- Balance sheet: do they have a low amount of debt for the industry and do they receivable favorable rates and terms on their debt? Do they have a strong credit rating by the major rating agencies?
How do dividend stocks preform during a recession?
Pretty freaking well. Below is a chart showcasing the performance of the dividend aristocrats vs the S&P 500 over the last two recessions. They outperformed by 22% in 2001 (the tech bubble) and 15% in 2008 (the great financial crisis).
Summary:
Dividend growth stocks will help your portfolio growth quicker than stagnant dividend stocks, and non-dividend stocks. They also help protect your downside when a recession comes along. If you don’t create a portfolio solely of dividend growers, I hope we’ve made the case for you to at least start adding a few to your portfolio mix.
You can always ask us for help at info@commonfinancialsense.com
