Wednesday, April 8, 2015

The Value of Dividend Growth

Many investors who invest for income focus exclusively on yield, in order to build the necessary income stream to support them in retirement. While yield is one factor to consider, successful dividend investing is the outcome of focusing one’s attention to quality stocks that can grow earnings and dividends over time, and purchasing those at attractive valuations. Unfortunately, over the past century, inflation has been eating away the purchasing power of your dollars. As a result, companies that can grow distributions over time are much more desirable for income investors, since they will maintain purchasing power of their distributions without the need to reinvest these distributions. Companies that can grow revenues and earnings over time are much more likely to reward their investors with consistent dividend raises.

The value of dividend growth is most evident when someone attempts to reach a target level of dividend income. Investors in the accumulation stage, who focus on yield alone, can only rely on new fund additions and dividend reinvestment to grow their income. Dividend investors who focus on dividend growth in addition to dividend reinvestment and addition of new funds have a third tool to aid them in their goals. As we saw in actual examples I showed before, high yields, growing dividends and dividend reinvestment can result in turbocharging of dividend growth.

For example, let’s assume that an investor has a $100,000 portfolio in dividend stocks yielding 3% with no dividend growth. Their dividend income would be $3,000/year. However, if a second investor had purchased dividend growth stocks yielding 3% that also grow distributions at 6%/year with his funds, and didn't add any money, his projected dividend income would have grown to $3,180/year. In order to have generated the additional $180 in annual dividend income at 3%, the first dividend investor would have had to add $6,000 simply to keep up with the second investor. Over time, the second investor would generate higher income than the first one, who has to keep adding money simply to keep up. If the second investor also reinvests distributions and adds new money, they can reach their investment goals much faster.

The types of quality income stocks that can generate both earnings and dividend growth include:

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has raised distributions for 45 years in a row. In the past decade, Altria has managed to boost dividends by 11.60%/year. The stock currently sells for 18.30 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.

T. Rowe Price Group, Inc. (TROW) is a publicly owned asset management holding company. This dividend champion has raised distributions for 29 years in a row. In the past decade, T. Rowe Price has managed to boost dividends by 16.60%/year. The stock currently sells for 16.90 times forward earnings and yields 2.50%. Check my analysis of T. Rowe Price for more information about the company.

Johnson & Johnson (JNJ), together with its subsidiaries, researches and develops, manufactures, and sells various products in the health care field worldwide. This dividend king has raised distributions for 52 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.80 %. Check my analysis of Johnson & Johnson for more information about the company.

Emerson Electric Co. (EMR) provides technology and engineering solutions to industrial, commercial, and consumer markets worldwide. It operates through five segments: Process Management, Industrial Automation, Network Power, Climate Technologies, and Commercial & Residential Solutions. This dividend king has raised distributions for 58 years in a row. In the past decade, Emerson Electric has managed to boost dividends by 8.10%/year. The stock currently sells for 15.10 times forward earnings and yields 3.40%. I last analyzed the company on this site a couple years ago. I need to post my updated analysis soon.

While all of these companies are great, another important factor of long-lasting success in dividend investing is diversification. By owning at least 30 individual stocks representative of as many industries that make sense, investors would lessen the risk that a few bad apples can decimate their retirement portfolio.

Full Disclosure: Long MO, TROW, JNJ, UTX, EMR

Relevant Articles:

Dividend Champions - The Best List for Dividend Investors
Dividend Kings List for 2015
Rising Earnings – The Source of Future Dividend Growth
The Perfect Dividend Portfolio
Successful Dividend Investing Requires Patience

16 comments:

  1. Guilty. I built my portfolio largely on high yield (supplemented with options writing) to get to my FIRE date (5OCT12) as soon as possible. Now that I am in the promised land, I go with more dividend growth and insurance companies when I have new money to deploy.

    ReplyDelete
    Replies
    1. Why insurance companies in particular? :-)

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  2. DGI,
    Did you mean to include a short blurb about UTX? I see it listed in your holdings, but not the article. Otherwise, your analysis is sound.
    KeithX (long JNJ, UTX)

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    Replies
    1. Hi Keith,

      Yep, I had UTX on my mind. Nice company I hold also.

      Delete
  3. Dividend growth is important but the entry yield is equally as important for me, ideally most of the companies in my portfolio need an entry yield of at least 2-3%.

    If you invest in something with a 1.5% yield and an estimated 10% growth it takes over 7 years just to catch up with the entry yield of a stock with a 3% dividend yield. And when you reinvest the dividend and if the second stock can grow its dividend at a low-single digit rate it takes very long to tip the scale in your favor.


    Ideally you need quality firm with a good entry yield and high dividend growth, like some of the ones you listed :)

    ReplyDelete
    Replies
    1. There are three stages of dividend growth: http://www.dividendgrowthinvestor.com/2013/03/three-stages-of-dividend-growth.html

      I think there is a trade-off between yield and growth, as you have mentioned. It is good to have companies across the spectrum ( high yield, med yield, low yield), since they each play a role in your portfolio over time. Diversification is important - but you should also not ignore long-term capital gains potential.

      Delete
  4. You put down some of the best dividend growing stocks up there. I totally agree. dividend growth is the by far the most important qualities that I look for when purchasing individual stocks. Thanks for sharing.

    Cheers,

    BeSmartRich

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    Replies
    1. Ahh, thanks. Actually, David Fish maintains the most thorough list of dividend growth stocks that every dividend growth investor uses. He is the one who received the least amount of credit.

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  5. Couldn't agree more with you on that! I've been trying to make many investors understand the importance of the growth rate and growth in general with mixed successes! ;-) I don't mind accepting a lower yield (3%) if growth is there to stay. They have to go together.

    Cheers!

    Mike

    ReplyDelete
    Replies
    1. There is a tradeoff between yield and growth.I think some investors focus on yield too much - case in point investors in T or VZ. However, I have come to realize that different investors have different goals and objectives. I think you and I prefer medium to lower yield but higher growth companies, because we (believe) we have decades ahead. If I was 70, I would likely focus more on REITs or telecoms than I am today.

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    2. Yes DGI, you're probably right about the age point! ;-) I sometimes don't get why young investors focus more on yield than growth sometimes! But hey! Like you said, different people, different strategies!

      Cheers!

      Mike

      Delete
  6. Really good article. The possibility for steadily increasing dividends is why I favor dividend stocks to bonds. Curious--is forward p/e the most important valuation metric for you? I know a lot of people use it. I feel like using it can be dangerous at times, though, because analysts rarely predict future downturns, but I do see the value it can have.

    ReplyDelete
    Replies
    1. If you look at analyses I have done, I look at a lot more than forward earnings. This is why I linked to those reports - please check those out. While forward earnings could be wrong, they generally provide a direction/trend in which earnings are expected to go. In the case of companies like XOM or CVX, they look cheap based on trailing EPS But based on forward EPS they look expensive.

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  7. Absolutely like the dividend growth rate and its compounding effect year after year, although I don't do DRIP.

    ReplyDelete
    Replies
    1. I reinvest dividends selectively. You might like this post: http://www.dividendgrowthinvestor.com/2009/07/reinvest-dividends-selectively.html

      and this one:

      http://www.dividendgrowthinvestor.com/2014/01/the-only-reason-for-automatic-dividend.html

      Delete
    2. How do you address your cost basis on reinvested dividends? Seems to be a tax nightmare. Thanks.

      Delete

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