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Many people whom I meet have asked me, why I’m a dividend growth investor and what my purpose is. There are a few reasons why I chose to mainly invest my funds in this segment of companies within the stock market, and all these reasons will be discussed in depth in this article. But for a more all rounded understanding of the overall concept, I will share some of my personal dividend investing goals, rules and strategies before going into the factors that pushed me towards dividend growth investing.
I discovered how lethal inflation was a few years ago, and was amazed at how my savings were being bitten away, bit by bit over the years. Inflation is at about 2% currently, but banks now only offer a mere 0.1% or less for normal accounts. After finding out about the concept of dividend investing and its capabilities, I decided to use this method when investing, with a simple personal investing goal- which is to beat inflation and preserve wealth.
This has led me to formulate the current mission statement of my dividend portfolio, which is to provide myself with a steadily growing stream of predictable and reliable dividends. These dividends will either be reinvested into their respective companies, or reinvested into new holdings. I’m also planning to add a sum of money to the account every month for the purchase of new holdings, or undervalued opportunities. The reason I am seeking to continually reinvest dividends is due to the effect of compounding.
In terms of portfolio management, I plan to be an active manager. By “active”, I do not plan to trade actively. Instead, I plan to keep myself on top of the news, looking out for any signs that may not be favorable to me, and researching about new stocks that may be a good pick for my portfolio at the same time. Examples of some stocks I found while researching this way are Textainer (TGH) and Alliance Resource (ARLP).
I aim to remain diversified across industries, while maintaining a beta of below 0.7. Beta is a measure of volatility. With the general market beta being 1.0, I aim to have a portfolio 30% less volatile (on average) as compared to the general market.
I also require all the stocks in my portfolio to have grown (or at the very least, maintain) their dividends through the latest recession- which is the 2007-2008 recession. Even the best dividend companies may face trouble and decrease dividends at one point of time. But, I think they will have proven themselves to me if they had braved through the brutal sub-prime financial crisis with their dividends unscathed. Hence, all companies in my portfolio need to have at least 7 years in consecutive dividend increases at the moment (from 2007 or 2008, depending on the time of dividend increase).
For instance, oil major ConocoPhilips (COP) decreased dividends once during the 1980 oil crisis but has increased it ever since. It braved through the crisis in 1987, in 2000, and in 2007 without decreasing dividends. This means it qualifies this portion of my dividend portfolio “entrance test”.
Being a dividend growth investor focused on a steadily growing stream of dividend payments, the growth of the dividend over the past few years also means a lot to me. In terms of dividend growth, I require a company to keep dividends growing at a rate above 4% with the exceptions of slow-growing stable utilities and high-yielding REITs and funds. Since dividend growth is being driven from earnings growth, I also always ensure that companies in my portfolio are growing at a rate that is at least as fast as the economy (after all extraordinary one-time charges). Therefore, I also require every company in my portfolio to grow its earnings at a minimum of 2% yearly (based on the current US risk-free rate).
Companies also have to yield at least 2% when the dividend reaches my pocket. This means that US companies (30% withholding tax) need to have a minimum yield of 2.8%, and that UK or Swiss companies (15% withholding tax) need to have a minimum yield of 2.3%.
In terms of dividend sustainability, payout ratios (the dividend payment divided by earnings) for individual stocks also have to stay below 90%. This ensures that the dividend is safe from a cut, and that the company is not overpaying shareholders and under-investing in itself.
Now that I have made my dividend portfolio’s concept and rules clear, here are a few of the reasons why I chose dividend investing.
Due to the stringent picking of companies, and the strict selling rules as listed above, I am able to ensure that I have a steadily increasing income stream no matter how the market performs. The rule requiring all companies to increase or maintain dividends through at least the latest recession also increases the chance of having continually increasing dividends during the next recession.
One example of a company that has provided constant dividend increases for investors over the years is Johnson & Johnson (JNJ)- one of my favourite dividend holdings. As shown in the dividend chart below, Johnson & Johnson has been growing its dividends for as long as the dividend website’s data range (which is 1970-2014). In case you are wondering, Johnson & Johnson has increased its dividends ever since the Cuban Missile Crisis in 1962.
Partly due to this, I am able to ignore the daily gyrations in stock prices and focus on the larger picture. Here is a great analogy of the market that I would like to share: The fluctuations in market prices of high quality stocks can be likened to the movements of a person going up a staircase playing a yo-yo. The random movement of the yo-yo is the market price- and should not be focused on. Instead, we should be more concerned with the movement of the person up the staircase over time, creating value (and capital appreciation) for us over time.
The dividend growth companies that I am targeting are usually also the cream of the crop in the stock market. The fact that they are able to pay shareholders a part of their profits, and continually increase them over long periods of time suggests that the company in question has a strong, stable business model that is able to continually generate and grow earnings to the benefit of shareholders. Companies with strongly cyclical businesses, or experience a greater amount of uncertainty will definitely not be able to pay increasing dividends with such consistency over such long periods of time.
As the old adage goes, “Only time will tell”. When you are buying high-quality dividend-paying shares that have stood the test of time, not much can go wrong over the long term.
Since I actively reinvest previous dividends into new holdings or existing positions, I will benefit from the effect of compounding. Compounding, in dividend portfolio terms, is simply having more dividends generated from previous dividends since these previous dividends are consistently reinvested into more dividend-paying shares.
In fact, here is one famous quote by Albert Einstein:
“Compound interest is the eighth wonder of the world. He who doesn’t understand it, pays it”
Up till now, your impression of compounding might not be very clear. To show the true power of compounding, here is an example showing how important compounding is in a dividend growth investor’s portfolio.
Assuming that a certain company
All these numbers are very reasonable, since my dividend portfolio currently yields 3% after taxes, and has experienced dividend growth of 8% in 2014. The Dow Jones has also appreciated by 6.2% a year between 1960 and 2010.
The first table shows the amount dividends one would have gotten and the yield on cost if someone had bought $10,000 worth of shares in the company without reinvesting dividends.
That looks impressive, but the next table shows the amount of dividends one would have received if all the dividends were reinvested. There was no change in the other variables.
This looks even more remarkable as compared to the first example, and shows the power of compounding when you reinvest the dividends.
While the example is unrealistic in the sense that there will not be such a company for us to compound our money in, and considering that we will not live to invest that many years, this just shows the power of compounding when one reinvests all the dividends. If you add a certain amount of money to invest regularly (like I am doing), the effect of compounding will only be enhanced further.
In conclusion, there are many advantages of owning a portfolio of solid dividend growth stocks. This is applicable to you, no matter of your age. It allows all investors to experience long-term capital appreciation with a portfolio of rock solid world class companies with an above-average yield to boot.
This strategy is definitely suitable for younger investors just starting out in investing (like me). This method is more passive in nature, along younger investors to spend less time on their portfolio as compared to other methods of investing. The long term viability of investing in dividend stocks and the ability of taking advantage of the eighth wonder of the world (compounding) also makes the strategy a very attractive one.
On the other hand, this dividend growth strategy is also very suitable for older investors who are in their “distribution phase”. The stable (and growing!) dividends from these reliable companies give such investors the ability to live off their dividends without touching their initial capital.
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