Last Updated on November 24, 2023 by Prakash Kolli
The benefits of dividend growth investing outweigh the risks. The strategy is a way to build wealth over time through dividends, compounding, and capital appreciation. It is also a way to make a passive income stream and live off dividends.
There are other investing strategies, but the simplicity of dividend growth investing is attractive. An investor does not need access to real-time market data or elaborate algorithms to practice it. In addition, dividend growth investing does not involve detailed technical analysis for trading. Furthermore, the expense of following this strategy has become very low since there is now no trading commission on stocks at most brokerages.
Hence, a do-it-yourself (DIY) investor can become a dividend growth investor. However, a new investor thinking about practicing this strategy should research it. This article discusses some critical characteristics of the dividend growth investing strategy.
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Definition of Dividend Growth Investing
Dividend growth investing is often defined as an investing strategy in which investors buy companies that increase the dividend annually for passive income, dividend growth, and capital appreciation.
A critical aspect is that the dividends are reinvested to allow compounding over time.
Third, dividend growth investing should be followed over more extended periods. Shorter periods expose a dividend growth portfolio to more volatility. In addition, shorter periods do not allow sufficient time for compounding and growth of the passive income stream.
Next, dividend growth investing requires an investor to diversify across sectors and industries. Diversification is known to reduce risk. However, an investor focusing on one industry will likely suffer dividend cuts and suspensions during recessions or industry-specific challenges. For example, many Energy sector companies cut their dividends during the worst months of the COVID-19 pandemic.
Lastly, the dividend must be sustainable. In other words, the dividend safety metrics like payout ratio, dividend-to-free cash flow ratio, earnings per share growth, leverage ratio, interest coverage, etc., must permit future dividend growth.
Finally, dividend growth should be driven by earnings growth rather than rising debt. Companies using debt to pay dividends eventually struggle to continue their increases.
Popularity of Dividend Growth Investing Has Grown
The dividend growth investing strategy has grown in popularity since the dot-com crash of 2000 – 2002. Many high-growth tech stocks that did not pay a dividend punished some investors during the dot-com era. This caused many investors to reassess their portfolios and switch to strategies besides growth.
Its popularity has only accelerated since the Great Recession from 2008 to 2009. During the Great Recession, many passive income portfolios struggled when financial companies and real estate investment trusts (REITs) cut their dividends due to the sub-prime mortgage crisis.
Today, dividend growth investing continues to gain followers. There are even index funds tracking the Dividend Aristocrats, which are stocks in the S&P 500 Index that have raised their dividends for at least 25 consecutive years and meet other requirements.
Furthermore, numerous dividend growth investing blogs and personal finance sites are dedicated to the strategy. The number seems to grow each month as more small investors realize the benefits of the dividend growth investing strategy.
Some blogs chronicle the personal journeys of dividend growth investors. These often include portfolios and monthly buys, and dividend payments. Other blogs are more formal, including stock overview, dividend safety analyses, and valuation.
Dividend Growth Investing Has Higher Returns
Over time, companies paying and growing their dividend each year have consistently performed better than companies that pay a fixed dividend or do not pay a dividend at all. Additionally, dividend growth stocks have outperformed an equally weighted portfolio of stocks in the S&P 500 Index.
This point seems the opposite of everyday perception. Conventional thinking is that high-growth stocks that do not pay dividends tend to outperform dividend growth stocks. During the past several years, headline news seemed to reinforce that with seemingly rising stock prices for growth stocks that do not pay a dividend.
However, the recent market correction in late 2021 and into early 2022 demonstrated the volatility of growth stocks. The tech-heavy S&P 500 Index has had its worst start since 1939 and third worst start. Some popular growth stocks are down nearly (-50%). On the other hand, dividend growth investing strategies have performed better.
Furthermore, research has shown that dividend growth stocks outperform dividend non-payers with lower volatility in aggregate.
The table below is from research by Ned Davis and Hartford Funds. He shows that $100 invested from 1973 to 2021 in dividend growth stocks performance far exceeds a $100 invested in dividend-paying stocks or an equally weighted portfolio of stocks in the S&P 500 Index. Companies with no dividend or dividend cutters & eliminators performed far worse with lower average annual returns and higher volatility.
Some individual stocks will consistently outperform dividend growth stocks for a period. However, other categories tend to underperform dividend growth stocks over time.
Dividend Growth Investing Has Less Volatility
Next, dividend growth investing reduces risk. This fact is apparent from the table above. The trailing beta, or volatility, of dividend growth stocks, is much less than the other categories. Recall that beta is a measure of risk that indicates the stock price or portfolio volatility relative to the broader market. A beta of 1.0 means that the stock has the same volatility as the broader market. Importantly, dividend growth stocks have a beta lower than companies that do not pay a dividend or even an equally weighted portfolio of stocks in the S&P 500 Index.
Standard Deviation and Beta
Additionally, the standard deviation of returns is much lower for dividend growth stocks than in other categories. Note that standard deviation measures the range of the returns from the mean. The greater the standard deviation, the greater the range and thus volatility.
This point makes intuitive sense. According to Stock Rover*, the 1-year beta of Amazon (AMZN) is 1.46. This value means that the stock is more volatile than the broader market. On the other hand, the trailing 1-year beta of Coca-Cola (KO), a well-known dividend growth stock and a Dividend King, is 0.42. Hence, this value means Coca-Cola is much less volatile than Amazon relative to the broader market.
Problems with Volatility
Volatility is an essential consideration because investors’ emotional reaction to it leads to poor long-term returns. As a result, most investors perform worse than the benchmark indices. This poor performance occurs even though the broader market or the S&P 500 Index generates total annualized returns of 8% to 12% over more extended periods.
The problem is when highly volatile stock prices decline, investors may need cash, or there are margin calls. Hence, investors must sell stock at low prices to raise some money locking in paper losses.
Alternatively, they may not be able to stomach the ups and downs of volatile stocks. In investing, this is referred to as “loss aversion,” which means psychologically, a loss feels worse than a gain of the same magnitude. As a result, some investors end up buying high and selling low. This action is a recipe for wealth destruction. In addition, loss-averse investors may become risk-averse.
Dividend Growth Investing and Compounding
Dividend growth investing leverages the power of compounding. Compounding is a subject almost all investors understand. In dividend growth investing, it is the continual process in which dividends are reinvested to purchase more shares. This reinvestment will eventually lead to exponential growth because future dividends depend on the initial investment and the reinvested current dividends. This process continues quarterly. The longer the compounding period, the greater the income stream from the dividends will snowball. A dividend growth investing strategy uses the time value of money concept.
An example can illustrate this concept.
For instance, we look at a hypothetical Company XYZ trading at $20 per share in 2022 and paying $0.60 per share in regular cash dividends annually. These numbers give the stock a 3% dividend yield. For simplicity, we purchase 100 shares of Company XYZ for $2,000 as an initial investment. In the first quarter, we receive only $15 in dividends, which is not much.
However, this amount is reinvested in a dividend growth investing strategy. Thus, we buy 0.75 shares assuming the stock price is the same as the initial purchase, in order to simplify the example. In the second quarter, we receive $15.11 in dividends. This amount is also reinvested, and we buy 0.76 shares again assuming the same stock price for simplicity. We now own $101.51 shares paying a dividend of $15.23 in the third quarter. The process continues each quarter.
The initial principal grows by reinvesting the dividends and using the power of compounding.
In investing, the Rule of 72 indicates that the dividend income will double in about 23.5 years. However, if the dividend grows annually, the income will double at a faster rate.
A dividend growth stock will increase the dividend by a fixed amount each year. So, if Company XYZ increases the dividend by $0.01 per quarter, then the new annual dividend will be $0.64 in the next year. In turn, this generates more dividends that are reinvested each quarter. This process results in exponential growth.
How much does the initial $2,000 become after ten years? To complete this example, we make two additional assumptions; first, the dividend growth rate is 5% per year, and second, the stock appreciates 5% per year. Next, we use one of the free online dividend growth and reinvestment calculators. The initial $2,000 investment has grown to $4,378.20 dollars and 134.39 shares of Company XYZ. The stock has paid $919.18 in dividends that were reinvested. The annualized total return is about 8.15%, which is a good value and only assumes a low growth rate for capital appreciation. Additionally, it does not assume additional money is invested in Company XYZ, an unlikely scenario.
Dividend Growth Investing Generates a Passive Income Stream
A dividend growth investing strategy generates a passive income stream for investors that can be used during retirement. Theoretically, if the strategy is followed over a sufficiently long time, dividend growth investing should be able to provide a passive income stream without having to draw down the initial principal.
This point uses the power of compounding discussed in the previous section. So ideally, if one follows a dividend growth strategy, the passive income stream for each stock owned should grow with time. For example, if you own a diverse basket of 20 to 30 dividend growth stocks or more, the passive income stream can be thousands of dollars per year after ten years or more.
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Final Thoughts on a Dividend Growth Investing Strategy
Dividend growth investing has become increasingly popular. There are several essential benefits to the strategy, and the main one is higher average annual returns with lower volatility. Furthermore, dividend growth investing can be a path toward building wealth and passive income.
However, the strategy does require patience and realistic expectations. This point is often difficult for some investors who want to invest in the next Amazon or Tesla (TSLA) and quickly see a 10-bagger or 100-bagger.
In addition, there are risks with dividend growth investing. For example, dividends can be cut or suspended, as has occurred due to the COVID-19 pandemic. However, if you are interested in a systematic method to build wealth and passive income over time, dividend growth investing may be the right strategy.
Disclosure: Long KO.
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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.