My investment strategy is all about finding the right dividend growth stocks that fit my entry criteria, include stocks for as many sectors as possible and then reinvest dividends selectively. Some readers have expressed concerns with this strategy, particularly since to many investors dividend investing is synonymous with chasing high dividend yields.
Dividend investing is more than just including a few quantitative indicators about a certain stock or sector. It is also about understanding the big picture. Some novice investors focus exclusively on yield, which leads to investment decisions which do not take into account risks that the investor might face. I have written several articles on the dangers of chasing yield here and here.
I see several dangers of focusing on just one quantitative indicator. I used yield as an example for this article, but focusing only on dividend growth and projecting it into the future without understanding whether it is sustainable, is just as dangerous.
Stocks with higher current yields typically do not grow distributions at a rate that meets inflation, if they even raise distributions. As a result, investors who purchase such equities and spend all of their income would suffer from the reduced purchasing power of their dividend income.
Investors, who only focus on yield, might miss the boat on total returns as well. It is great to find a company yielding 6% - 8% today. It would take a company yielding 3%- 4% today growing distributions at 12% per year at least 6 years to reach a yield on cost of 6%-8%. Retiree’s who focus on dividend investing for current income might ignore dividend growth investing for this particular reason – they simply do not feel they have the time to wait. But if the only return comes from the distributions, while the value of the stock stagnates or even goes down, then investors would have lost purchasing power of their principal for the sake of higher current yield.
Qualitative characteristics are important as well. Deciding whether a strong dividend growth stock will continue paying higher dividends into the future requires a healthy dose of guesstimation. I typically look for companies with durable competitive advantages, where shifts in technology would not lead to product obsolescence for several decades into the future. For example, companies like Coca Cola (KO) have a strong brand name, synonymous with quality that carries a certain level of expectations, which customers are willing to pay a premium price for. Other companies like that are able to pass on price increases onto customers. Check my analysis of Coca Cola (KO). McDonald’s (MCD) is another company that fits this criteria.