This is a guest post from DividendPower.org.
I am a big believer in the benefits of dividend growth investing. It is a way to build wealth over time through dividends, compounding, and capital appreciation. It is also a way to build a passive income stream. There are other investing strategies, but I find the simplicity of dividend growth investing appealing. One does not need access to real-time market data nor fancy algorithms to practice it. Furthermore, the cost of following this strategy has become very low since there are no trading commissions on stocks at most brokerages now.
Hence, a do-it-yourself or ‘DIY’ investor, like me, can be a dividend growth investor. But like anything else, a new investor thinking about practicing this strategy should research it. In this article, I discuss some of the benefits of dividend growth investing.
Definition of Dividend Growth Investing
The commonly accepted definition is that dividend growth investing is an investing strategy where one invests in a group of companies that increase the dividend annually for both income and capital appreciation. Another key aspect is that the dividends are reinvested to allow compounding to occur. Next, dividend growth investing should be done over longer time periods. Next, dividend growth investing requires one to diversify across sectors and industries. Lastly, the dividend has to be sustainable, or in other words, the dividend must be safe and driven by earnings growth rather than debt. The strategy of dividend growth investing has some benefits for DIY investors.
Dividend Growth Investing Has Higher Returns
Companies that pay and grow their dividend annually have over time consistently outperformed companies that pay a constant dividend or do not pay a dividend. Dividend growth stocks have also outperformed an equally weighted S&P 500 index.
This seems counterintuitive. Conventional investing wisdom is that high growth stocks that do not pay a dividend tend to outperform slow and steady dividend growth stocks. Headlines news seems to reinforce that with seemingly ever-rising stock prices for Amazon (AMZN) and NetFlix (NFLX), which do not pay a dividend.
However, research has shown that dividend growth stocks outperform non-payers as a group. The table below is reproduced from research by Ned Davis and Hartford Funds. He shows that $100 invested from 1972 to 2019 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. There will always be some individual stocks with disruptive business models, such as Amazon, that outperform dividend growth stocks as a group. But in general, other categories tend to underperform dividend growth stocks. In my opinion, this is probably one of the main benefits of dividend growth investing.
|Dividend Growers & Initiators||12.87%||0.92||15.61%|
|No Change in Dividend Policy||11.85%||1.13||17.92%|
|Dividend Cutters & Eliminators||10.88%||1.23||24.08%|
|Equal-Weighted S&P 500 Index||12.29%||1.00||16.98%|
Dividend Growth Investing Benefits from the Power of Compounding
Dividend growth investing makes use of the power of compounding. Compounding is a subject most investors should understand. In this context, it is the process in which the dividends are reinvested to purchase more shares. This reinvestment will lead to exponential growth over time because future dividends not only depend on the initial investment but also the reinvested current dividends. This continues each quarter. The longer the compounding period the greater the growth. It makes use of the time value of money. We can illustrate this concept with a simple example.
Let’s take 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 not too bad. 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 let’s reinvest it, and we would buy 0.75 shares assuming the stock price is the same. Note that this is a simplification for the purpose of this example. In the second quarter, we would receive $15.11 in dividends. This too, is reinvested, and we buy 0.76 shares. We now own $101.51 shares. That generates a dividend of $15.23 in the third quarter. The process continues. You should get the idea now. By using the power of compounding, we grow our initial principle by reinvesting the dividends.
How much does our initial $2,000 become after 10 years? We make two more assumptions that the dividend growth rate is constant at 5% per year and the stock price appreciates at a constant 5% per year. We then use many of the 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 $919.18 in dividends. 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.
Dividend Growth Investing Generates A Passive Income Stream
The third benefit is an important one when following a dividend growth investing strategy. The strategy generates a passive income stream that can be used in retirement. Theoretically, if done correctly over a sufficiently long period of time, dividend growth investing should be able to provide passive income without having to draw down the initial principle. This makes use of the power of compounding that we talked about in the previous section. 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 diverse basket of 20 to 30 dividend growth stocks or more, then the passive income stream can be thousands of dollars per year after 10 years or more. For instance, Felix has generated an annual passive income stream of over $10k per year by dividend growth investing directly in stocks.
Final Thoughts on the Benefits of Dividend Growth Investing
Dividend growth investing has become increasingly popular as investors have realized the benefit of dividend growth investing. There are several benefits, and I have outlined three of the major ones above. Further, dividend growth investing can be a path toward building wealth and passive income. But the strategy does require patience and realistic expectations. This is often difficult for some investors who want to invest in the next Amazon and see a 10-bagger quickly. There are risks with dividend growth investing. Dividends can be cut or suspended as has occurred due to the coronavirus. This will lead to a loss of income and usually a decline of the stock price. However, if you are interested in a systematic method that can build wealth and passive income over time, then the dividend growth investing may be the right strategy for you.
Biography: Dividend Power is a self-taught dividend growth investor. He is the founder and author of the Dividend Power investment blog. He writes about dividend growth stocks for the small long-term investor seeking to invest in dividend stocks for income and growth. His focus is on undervalued stocks with sustainable dividend growth and capital appreciation potential. His work has appeared on Seeking Alpha, Sure Dividend, ValueWalk, The MoneyShow, and other financial sites.