Companies generate profits that are also referred to as “net income.” They can take those profits and either reinvest them in the company (as tech growth stocks do) or pay them out as a cash payment to shareholders, what we call “dividends.” One might think companies can only pay dividends if they are profitable, but that’s not true. A company may not be profitable, but it can take a loan and still pay dividends. (Chevron, among others, has done this before.) One might think companies can only grow dividends if profit increases, but that’s not true either. If you are only paying out a small portion of your profits in dividends and your profits decrease, you can still keep increasing your dividends because you have a buffer. The portion of your profits that you pay out in the form of dividends is referred to as the “dividend payout ratio.” Dividend paying stocks with a low payout ratio have a larger buffer that allows them to increase dividends even if profits fall.

When you hire an employee, you look at their CV, a track record of their past performance. You believe that their historical performance is indicative of their future potential. That’s the same approach we take when looking at dividend growth stocks. If you have a track record of increasing your annualized dividend every year for a longer period, say 25 years, that means it is highly likely that you will continue to do so. That’s because you are setting an expectation with your investors, and you don’t want to disappoint them.

Therein lies the entire premise of dividend growth investing. If a company shows us their CV which shows a track record of increasing dividends every year, then we believe it is likely that they will continue to do so. This is why dividend growth investing is so appealing to retirees. You can buy a bond that provides you with a fixed payment every quarter, or you can buy a dividend growth stock that increases its quarterly dividend payment every year, helping offset inflation. As for the risk of a stock blowing up Enron style, simply hold enough stocks to reduce company-specific risk. If you have an equally weighted 30-stock portfolio, and one of your dividend growth stocks goes bankrupt, you only lose 3.33% of your capital. The risk is quite low.

The Time Horizon of Dividend Growth Investing

We backtested our own dividend growth portfolio using various time horizons to show how the incremental increase in dividends makes a huge difference over time:

  • If you invested $10,000 25 years ago, your current portfolio would be worth $123,012. This corresponds to a compound annual growth rate (CAGR) of 10.5% versus the most popular S&P 500 SPY ETF’s 7.6% for the same period.
  • The same investment made 20 years ago would have resulted in a CAGR of 8.3% versus the S&P 500 SPY ETF’s 3.8%.
  • The same investment made 10 years ago would have resulted in a CAGR of 9.8% versus the S&P 500 SPY ETF’s 10.6%.

As you can see, it’s about time in the market, not timing the market. The longer the time frame, the more impact growing dividends have on your portfolio’s value. We’ve invested in our own dividend growth strategy with an indefinite time horizon, and plan to live off of our increasing dividend income while benefiting from stock price appreciation over time.

Benefits of a Dividend Growth Investment Strategy

  • Passive income: regular and increasing dividend payouts provide passive income that grows over time to outpace inflation.
  • Low risk: large, reputable companies are able to pay and increase their quarterly dividends continuously because they have stable revenue streams. This stability translates to lower volatility, and consequently, lower risk.
  • Increasing dividend payments in perpetuity: barring extreme market events, stocks in a dividend growth portfolio will aim to continuously increase their dividend payouts to keep their prestigious status as dividend champions. Stocks in our own portfolio have been paying and increasing dividends for 41.5 years on average.
  • Resilience: as dividend growth stocks aim to increase dividends in perpetuity, they need to become resilient to economic cycles and weather inevitable recessions. The longer the history of continuous dividend increases and the bigger the company, the more likelihood it will be able to weather a recession. Stocks in our own dividend growth portfolio have successfully navigated five major global crises and a handful of local ones while continuing to not only pay, but increase dividends.
  • Long-term investment horizon: Investing for the long term means little time is spent managing your portfolio. After initially selecting which DGI stocks to hold, investors only need to take action if a stock ceases to increase its dividend payments.
  • Dividend reinvestment: if a dividend growth investor doesn’t need a regular income stream, reinvesting dividend payouts is a surefire way to accelerate the rate of both capital appreciation and dividend payout growth. If you invested $10,000 25 years ago (as in our previous example), and reinvested your dividends, your current portfolio would be worth $237,111 – almost double the value than without dividend reinvestment.

Dividend Growth Stocks as a New Asset Class

A dividend growth strategy is like a new asset class. It combines the benefits of bonds and equities, providing a regular income stream, but with increasing payouts. Unlike bonds, increasing dividend payments eliminate the effects of inflation. Dividend growth stock prices follow the broader market, so our capital appreciates over the long term. Downturns do not affect dividend payments. Instead, they provide a buying opportunity for investors to increase their future dividend payments at a discount.

We believe DGI stocks represent an entirely new asset class where the benefits outweigh the risks. With most investing strategies, emotion gets in the way of rational thinking. That’s why we developed a calculator that provides an objective way to measure the ability of a stock to provide us with increasing income over time.

How to Invest in Dividend Growth Stocks?

While there are numerous lists of dividend growth stocks on the web, there isn’t a tool that allows a DGI investor to compare stocks to find the best ones to hold. It’s not just about picking stocks with the highest dividend yield, or stocks with the highest dividend growth rate, it’s about finding stocks that are most likely to keep paying and increasing their dividends over time, even in the face of market turmoil. That’s why we developed Quantigence, an objective stock selection tool that helps us determine which stocks maximize the benefits of a dividend growth investing strategy while minimizing the risk of not being able to increase the dividend as time goes on.

Not all dividend champions manage to keep their track record of increasing dividends. When comparing the list of dividend champions in January 2008 to the list of champions in August 2020, we found significant turnover. Since 2008, 70 dividend champions have lost their title out of 139, and 67 new dividend champions were born. With this kind of fluctuation, it is important to select the most stable companies to be included in a DGI portfolio. Over and above the benefits of an objective dividend growth investing strategy, the Quantigence methodology has additional benefits:

  • It facilitates objective stock selection by removing emotion from the investment process.
  • It increases performance by selecting only the best dividend growth stocks available. In financial lingo, this strategy provides superior risk-adjusted returns – larger returns in exchange for lower risk.

The following chapters of the Quantigence methodology will walk you through the steps of how to build your own resilient dividend growth portfolio. First, let’s talk about the “universe” of dividend stocks that we will use to construct your portfolio.