Advantages and Risks of Dividend Growth Investing

Advantages and Risks of Dividend Growth Investing

The advantages of dividend growth investing outweigh the risks. It is a way to build wealth over time by building a growing stream of dividends combined with capital appreciation. There are other investing strategies, but dividend growth investing is appealing since it is simple. One does not need access to real time market data nor trading algorithms to practice the strategy. It does not involve daily trading. Sometimes simple is best.

Additionally, the cost of following this strategy has become minimal since there are no trading commissions on stocks at most brokerages now. In fact, the costs of dividend growth investing may even be less than the costs of index investing.

The simplicity and low costs of a dividend growth investing strategy means that even a new investor can easily follow it if they put in the requisite time and effort. But if you are a new investor thinking about practicing this strategy then you should research dividend growth investing before trying it. In this article, I discuss and outline some of the advantages and risks of dividend growth investing.


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What is Dividend Growth Investing?

Dividend growth investing is an investing strategy where one invests in a basket of companies that increase the dividend each year.

The goal is to generate a growing passive income stream but also get some capital appreciation, i.e., a rising stock price. Another key aspect is that the dividends are reinvested in the same stock to allow compounding to occur over longer periods of time.

Next, dividend growth investing requires one to diversify across sectors and industries. You cannot own stocks only in a few sectors as it leads to excessive risk. For example, imagine if you owned a high percentage of energy or retails stocks during the COVID-19 pandemic. The adverse effect on your portfolio’s total value would be significant.

Finally, the dividend has to be sustainable meaning it must be safe from the perspective of earnings, cash flow, and debt. The strategy of dividend growth investing has some advantages for individual investors but there are also some risks since we are talking about investing in stocks.

Advantages of Dividend Growth Investing

Dividend Growth Investing Has Higher Returns

Companies that pay and grow their dividend annually have consistently outperformed companies that pay a constant dividend or do not pay a dividend at all over longer periods of time. Dividend growth stocks have also outperformed an equally weighted S&P 500 Index. 

This seems contrary to conventional investing wisdom where high growth stocks that do not pay a dividend are thought to outperform slow and steady dividend growth stocks. News headlines seem to reinforce that thought with seemingly ever rising stock prices for Amazon (AMZN), NetFlix (NFLX), Tesla (TSLA) and other mega cap stocks that do not pay a dividend.

Research and Backtesting

However, research has shown that dividend growth stocks in aggregate outperform dividend non-payers as a group. The table below shows that $100 invested in 1973 in dividend growth stocks outperforms the same $100 invested in dividend payers, or an equally weighted S&P 500 Index, or companies that do not pay a dividend, or dividend cutters by end of 2021.

Granted, there will always be some individual stocks with disruptive business models, such as Amazon, that outperform individual dividend growth stocks. But in general, other categories tend to underperform dividend growth stocks. In my opinion this is probably one of the main advantages of dividend growth investing. Dividend growth stocks on average generate higher returns with lower volatility over longer periods of time.

CategoryReturnsBetaStandard Deviation
Dividend Growers & Initiators10.68%0.8816.02%
Dividend Payers9.60%0.9416.78%
No Change in Dividend Policy7.08%1.0118.43%
Dividend Non-Payers4.79%1.1822.02%
Dividend Cutters & Eliminators-0.46%1.2224.96%
Equal-Weighted S&P 500 Index8.20%1.0017.64%
Source: Ned Davis Research and Harford Funds

You can see the difference in final dollar value for the six categories listed in the above table between 1973 and 2021 in the graph below. The final dollar value for dividend growers far exceeds that of just dividend payers, an equally weighted S&P 500 Index, companies that do not pay a dividend, and dividend cutters by 2021.

Returns by Dividend Policy
Source: Ned Davis Research and Harford Funds

Dividend Growth Investing Benefits from the Power of Compounding

The next advantage is that dividend growth investing leverages the power of compounding. Compounding in dividend growth investing is the process in which the dividends are reinvested to purchase more shares of the same stock. This reinvestment will lead to exponential growth over time because future dividends not only depend on the initial investment but also the reinvested dividends. This continues each quarter as dividends are paid and reinvested. The longer the duration compounding occurs the greater the growth. This is simply the time value of money. We can clarify this concept with a hypothetical example.


Example

Let’s take a stock of Company A that is trading at $20 per share in 2020 and pays $0.60 per share in regular cash dividends annually. This gives the stock a 3% dividend yield, which is decent and more than 1% greater than that of the S&P 500. For simplicity let’s say we buy 100 shares of Company A for $2,000 as our initial investment. In the first quarter, we would receive $15 in dividends. It does not sound like much.

But if we reinvest it then we can buy 0.75 shares of Company A assuming the stock price is the same. Note that this is a simplification for purpose of this example. In the second quarter, we would receive $15.11 in dividends. This too is reinvested, and we buy another 0.76 shares. We now own 101.51 shares. That generates a dividend of $15.23 in the third quarter.

The process continues each quarter. By leveraging the power of compounding, we grow our initial principle by reinvesting the dividends that in turn results in greater streams of dividends.

How much does our initial $2,000 grow to after 10 years? We make two more simplifications, the dividend growth rate is constant at 5% per year and the stock price appreciates at a constant 5% per year. We then use one of the many popular dividend growth and reinvestment calculators online. Our initial $2,000 has grown to $4,378.20. We now have 134.39 shares of Company A. The stock has paid us $919.18 in dividends, which was reinvested. Our annualized total return is 8.15%. Not bad for just investing in a stock and relying on the power of dividend growth and compounding.

An ETF

Now let’s take a look at a real example. The chart below shows the difference between the SPDR S&P500 Trust ETF (SPY) with dividends invested and dividends not invested over a 25 year period assuming a $10,000 initial investment. There is about an $18,000 difference in the ending total value. Over longer periods of time the difference in final dollar value is even greater. A dividend growth ETF will perform even better because of the higher dividend yield and dividend growth.

Leveraging Compounding
Source: Dividend Channel

Dividend Growth Investing Generates A Passive Income Stream

The third advantage is that dividend growth investing generates a passive income stream for retirement. Theoretically, if done correctly over a sufficiently long period of time, dividend growth investing should be able to provide passive income to live off dividends without having to drawdown the initial principle. This leverages the power of compounding that we talked about in the above paragraph. So ideally, if one follows a dividend growth strategy the passive income stream for each stock that is owned should grow with time. If you own a diversified basket of 20 to 30 dividend growth stocks similar to Company A in the above example, then the passive income stream can be thousands of dollars per year after 10 years or more. It’s fairly straight forward.

Dividend Growth Investing is Tax Efficient

Investing in dividend growth stocks is tax efficient in the case of qualified dividends. This is particularly true when compared to investing in bonds, money markets, savings accounts or CDs. These investments are taxed at the regular income tax rate, which is higher than the capital gains rate for the same tax bracket. This also means the income from dividend growth investing is taxed at a lower rate than your regular income.

Qualified dividends are taxed at the lower capital gains rate. There are three capital gains tax rates, which are 0%, 15%, and 20% depending on your tax bracket.

Dividend Growth Investing Provides Inflation Protection

A growing dividend provides a measure of protection for purchasing power in the face of rising inflation. The prices of many items rise over time and this compounds. So, your dollar today does not purchase the same amount as the same dollar a few years in the future. For example, the price of eggs has generally risen since 1980. In aggregate, this is measured by the Consumer Price Index (CPI). However, in many cases dividend growth rates exceed the growth of inflation over time. For instance in the trailing 12-months the CPI has risen only about 1.7%, which is clearly lower than the dividend growth rate of many stocks. So, if you are judicious and pick a basket of stocks with mid-to-high single-digit dividend growth rate this will exceed the rise in inflation in most years.

Risks of Dividend Growth Investing

There are risks with dividend growth investing or investing in any stocks for that matter. Stocks can lose value if the share price drops. Stocks are not insured so your original principal is at risk. In the worst case, a company can go bankrupt and you lose all your money. 

Dividends can be cut or suspended as has occurred due to the coronavirus pandemic. This will lead to a loss of income and usually a decline of the stock price. Companies are not required to pay dividends unlike interest on bonds. If a company does not pay interest on a bond, then the company is in default.

Next, past performance is not a guarantee for future performance.  A stock that was a successful dividend growth stock in the past may not be one in the future as the many dividend cuts or suspensions during the COVID-19 pandemic has shown. The calculated payout ratio or dividend-to-free cash flow ratio becomes too high, placing the dividend at a risk. Simply, earnings or free cash flow do not cover the dividend. In this case a company can use debt to pay the dividend or more likely the dividend is cut.

What Kind of Stocks are Dividend Growth Stocks?

So, what kind of stocks are dividend growth stocks. There are several hundred dividend growth stocks in the U.S. They are categorized by the number of years of they have continuously raised their dividend.

At the lowest level, stocks that have raised the dividend for five to nine years are known as Dividend Challengers. Stocks that have done so for between 10 and 24 years are referred to as Dividend Contenders.

Once a stock reaches 25 straight years of dividend growth it becomes a Dividend Champion. A stock may also be a Dividend Aristocrat at this point. However, only stocks that are in the S&P 500 Index with a minimum market capitalization of $3 billion and meet liquidity and sector weighting requirements can qualify as a Dividend Aristocrat.

At the pinnacle, stocks that have raised the dividend for 50+ years are known as Dividend Kings. This is pretty select crowd and as of this writing there are only a few dozen total. To put this in perspective that is out of about 6,000+ publicly traded companies. A stock that is a Dividend King can also be a Dividend Aristocrat and a Dividend Champion.

You can examine the lists at the links below. The lists are updated monthly.


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Bottom Line About the Advantages and Risks of Dividend Growth Investing

Dividend growth investing has become increasingly popular as individual investors have realized the advantages of dividend growth investing relative to the risks. Dividends clearly matter to investors. Investing is not risk free, but dividend growth investing has proven itself over time. If you don’t believe this point, read about the Secret Dividend Millionaires or one my Millionaire Interviews. These are real stories of ordinary people who used frugality combined with dividend growth investing and built wealth over time and achieved financial independence.

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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.

2 thoughts on “Advantages and Risks of Dividend Growth Investing

  1. Great info! Thanks for sharing!

    I love the part about using Dividends as a Passive Income Stream. If you are monitoring and reinvesting your dividends in the years leading up to retirement, then there are no surprises when you pull the trigger and decide to live off that income instead of reinvesting it. It takes the stress and unknowns out of the transition, and helps avoid doing something costly like an annuity.

    Great stuff!

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