As a dividend growth investor knows, it’s not exactly a secret that the U.S. stock market has been one of the greatest long-term wealth generators in history.
In fact, between 1871 and 2015 the S&P 500 has recorded a compound annual growth rate, or CAGR, of 9.1%, increasing a staggering 285,436.41 times in value.[ad#Google Adsense 336×280-IA]However, as with most things in life, actually reaping the potential rewards is much harder said than done.
For example, according to BlackRock (BLK), the world’s largest asset manager with $5 trillion in assets under management, the average retail investor has woefully underperformed the market over the past few decades.
As seen below, the average investor generated an annualized return of 2.11% over the last 20 years compared to annualized returns of 8.19% and 5.34% from stocks and bonds, respectively.
Despite the market putting up very solid growth over that time, most investors ended up treading water, after accounting for inflation.
But there is great news for those who seek to harness the incredible power of the stock market to build long-term wealth and achieve financial independence over time.
Learn five ways that being a dividend growth investor can help you reach your financial goals and make you a better long-term investor. By keeping a steady hand and staying disciplined, investing in dividend growth stocks can provide a stable, growing income stream that can fund your needs, desires, and retirement over time.
1) Dividends are a Major Source of Long-term Market Returns
The first argument for being a dividend growth investor is simply the historical importance of dividends to a portfolio’s total return. Most investors alive today have mostly known a stock market in which share price appreciation was the underlying goal. However, historically 52.3% of all the returns the S&P 500 has ever generated for investors have been due to dividends.
There is a lot of different data out there about the contribution dividends have made to the market’s total return, so it can be helpful to turn to multiple sources. Morningstar conducted a study several years ago and found that the dividend income component of total return amounted to 42%, 36%, and 31% for Large Cap, Mid Cap, and Small Cap stocks, respectively, from 1927 through 2012. Dividends are clearly important.
And as you can see in the chart below, at certain times, including recently, dividends accounted for over 100% of market returns. This can happen when stock prices stagnate or decline over a period of time yet dividend income continues rolling in.
This makes intuitive sense if you think about it like this. If you own a growth stock (i.e. one that doesn’t pay a dividend), then the only way you can earn a return is through share price appreciation. And as we all know, the market can be gut-wrenchingly volatile.
So say you bought Alphabet (GOOGL), which pays no dividend. Over several years the company grows, and the share price rises with it. But if, right before you need to sell to meet a certain goal, such as funding the down payment on a house or paying for your children’s college education, the market falls off a cliff, such as it did during the Nasdaq crash, or 2008-2009, then most, if not all, of those capital gains can vanish very quickly.
You could even end up losing 5 to 10 years of unrealized profits in a few months, and if you have to sell? Well, then you gained nothing for all your patience and saving over that time.
But with a quality dividend growth stock? Well, you are getting a growing income from your investment, which you can then reinvest into more shares, either into the original company or some other undervalued dividend growth stock.
That creates what I like to call “hyper-compounding” in which an exponentially growing dividend results in an exponentially growing income stream, that is buying an exponentially growing number of shares, which also paying exponentially growing dividends.
In other words, as a dividend growth investor, the dividends that you accrue are tangible and permanent benefits that no crash can undo. And if you reinvest it into quality dividend growth stocks over time, then even if the market crashes you are still much better off over time, if for no other reason that your growing dividend income stream can be reinvested at much lower, post-crash prices that lock in a higher yield on invested capital.
2) Dividend Growth Stocks Outperform the Stock Market over Time
While it may seem counter intuitive, companies that consistently pay and grow their dividends tend to outperform non-dividend stocks, further increasing the appeal of being a dividend growth investor.
The table below measures annual returns from 1972 through 2004 and shows that all dividend payers returned 10.1% per year, beating the S&P 500’s annualized return of 8.5%. To be fair, however, it’s true that this period was marked largely by falling interest rates since the early 1980s. This might have made dividend-paying stocks more attractive.
The chart below covers a much longer period of time, from the 1920s through the end of 2014. As you can see, dividend payers went on to meaningfully outperform non-payers.
How is that possible, when theoretically growth stocks are reinvesting all their earnings and cash flow back into their businesses?
The answer lies in long-term focused, conservative management. For example, a company like Facebook (FB), which is growing around 50% per year and is generating excellent 28% returns on invested capital, may seem like a much better choice than a boring dividend growth stock.
And for a while that may be true. But at some point Facebook is likely to reach a point where its scalable ad-focused business model reaches a point of saturation. Or to put it another way, they attract all the ad sales revenue that companies are willing to give it and struggle to find incremental growth opportunities.
At that point, the company will still be generating rivers of profits and free cash flow.
But in order to grow? Well, management may have to look broader than its core business, the one that is generating those high returns on invested capital, to keep increasing revenue, earnings, and cash flow.
That kind of diversification can be a good thing, but it also poses a big risk because it can result in management making poor capital allocation decisions, such as making big splashy acquisitions that it might overpay for and end up writing down for huge losses later.
But a dividend growth stock? Especially one that has a solid long-term track record of growing its dividends over 10, 25, or even 50 consecutive years (the so called “dividend achievers”, “dividend aristocrats”, and “dividend kings”)?
Well such companies have not just proven themselves proprietors of stable and growing businesses over time, but management must also be more conservative, both with its balance sheet (how much debt they take on), as well as what growth investments it decides to make.
After all, if you are paying out 50% of profits or free cash flow to dividend-focused investors each year, then you have to be far more selective (i.e. careful), with what acquisitions or investments you make.
You can’t just throw money around because if you mess up, then you could put the dividend at risk, which could send the share price (stock options, and vested share grants make up the majority of executive compensation packages) cratering.
Simply put, a commitment to paying dividends places more discipline on management teams to invest in their highest-returning, most promising projects.
3) Dividend Growth Stocks can Help Ensure a Safe Retirement no Matter How Long You Live
Perhaps the biggest reason most people invest is to ensure a good standard of living in retirement. Dividend growth stocks can certainly help with that goal. For example, many people are familiar with the 4% drawdown rule, which says that you should sell 4% of your portfolio during retirement to live off.
This rule was the brainchild of William Bengen, who in a 1994 study determined that a 60% stock, 40% bond portfolio could support a 4% withdrawal in perpetuity. Or to put it another way, if you were to just own a S&P 500 index ETF and a broad bond ETF, then selling 4% of the portfolio each year would offset the annual asset sales with portfolio growth and ensure that you never run out of money, no matter how long you live.
However, a 2008 study by Jack Gardner found that, if you were to only stick to the 100 highest-yielding dividend stocks in the S&P 500, the long-term outperformance of this portfolio would actually allow you to increase your annual portfolio withdrawal to 5% and still maintain the portfolio in perpetuity. His findings were so impressive that even Mr. Bengen endorsed his conclusion, that a higher-yielding dividend growth portfolio could indeed allow you a better standard of living during retirement.
Of course, the true Holy Grail of financial and retirement planning is to hopefully build up enough of a portfolio so that one can live off just one’s dividends. That way you never have to sell a single share to cover expenses, and you truly can be free of any concerns about short-term price fluctuations.
Academic studies have shown that a good long-term rule of thumb for total returns (which include dividend reinvestment) is yield + dividend growth. In other words, all you have to do to achieve long-term wealth and income is to consistently save and invest in a high-quality diversified dividend growth portfolio that yields around 4% and grows the dividends by 6% per year.
Of course, the earlier you can put your money to work for you, the more glorious the effects of hyper-compounding become, as you can see in the above table. But the point is that dividend growth investing is an almost infinitely flexible investing style that can be tailored to almost anyone’s needs, risk tolerances, and time frames.
And best of all, as the staggering annual dividend sums above show, not just can dividend growth investing help you achieve your financial independence, completely from dividends alone, but if you are diligent, consistent, and disciplined enough in your investing approach, you can achieve dividend streams that you can live off (if you start early enough).
The remainder can be reinvested back into the portfolio, ensuring exponentially more income over time and potentially creating a multi-generational perpetual income trust you can pass on to your children and grandchildren.
Dividend stocks also have retirement appeal because they have exhibited lower volatility over time. As seen below, dividend-paying stocks (blue line) have almost always had a lower three-year standard deviation than non-dividend payers (gray line) since 1927. Focusing on stocks that score high for Dividend Safety can further reduce volatility, help avoid dividend cuts, and provide a safe, growing income stream.
4) Embracing a Dividend Growth Investor’s Mindset can Help You Avoid the Biggest Cause of Market Underperformance
The single biggest enemy of long-term market returns is human emotion. Thanks to a well-studied psychological principle called “loss aversion”, it is extremely difficult for most investors to even match the market, even if they are only investing in low cost index ETFs such as the Vanguard S&P 500 ETF (VOO).
Why is that? Simply put, it hurts twice as much to lose a dollar as gain a dollar.
This partially explains why we have market booms and busts in the first place. As the chart below shows, when markets are climbing people get excited, and often greedy, piling into stocks only after the vast majority of gains have already been made.
Then, when the inevitable and healthy market correction, bear market, or crash happens, they freak out and end up selling at far lower prices.
Basically human nature makes market timing the biggest danger to achieving your long-term investing goals. According to BlackRock, unfortunately, up to 60% of clients’ holdings are sitting in cash today. Worldwide, BlackRock’s research suggests that investors are holding more than $50 trillion in cash!
While holding gobs of cash provides a level of comfort, timing the market has proved to be a fruitless endeavor over the years. Remember that bull market returns are often highly concentrated. In Ralph Wanger’s book A Zebra in Lion Country, a University of Michigan study that looked at market returns from 1969 to 1993 found that missing out on just the market’s best 90 trading days would have resulted in 20 times worse total returns. Or to put it another way, the market’s top 1% of trading days accounted for 95% of total returns over this 24 year period.
Even more shocking? He referenced another study that found that between 1926 and 1990, missing out on the market’s top 7% performing months would have netted a total return of ZERO over this 64-year period. Which just goes to show that to truly succeed in the market and benefit from the magic of hyper-compounding, you need to have your money working for you at all times and as long as possible.
So how can being a dividend growth investor help? Simply put, you need to think of your portfolio as a business, with a long-term emphasis on maximizing long-term cash flow and value.
Just as Nike (NKE) and Coca-Cola (KO) don’t try to time the global economy by shutting down their businesses during times of economic/market/interest rate uncertainty, the same should apply to your portfolio.
Think of it like this. By focusing on your long-term portfolio income and the growing dividends of your individual companies, you can calm yourself and constantly be reminded what matters in the long-term: cash flow.
Did Deere and Company (DE) just disappoint on earnings? So what!? A growing global population means that demand for food, and thus farming equipment, is very likely going to rise over time, and so a temporary downturn in a cyclical industry is not just irrelevant for long-term investors, but potentially a great chance to buy a great blue chip dividend stock on the cheap.
After all, John Deere hasn’t cut its dividend in decades and has in fact grown the payout at a 9.7% CAGR for the last 20 years. In other words, because you are a long-term business owner, concerned only with the safety and long-term growth prospects of Deere’s dividend, you aren’t concerned with a few bad quarters or a market crash.
The company has proven itself to be able to reward patient dividend growth investors though numerous business and interest rate cycles, so any correction, bear market, or crash is probably just a chance to buy one of the world’s best farming equipment makers at an even better price and lock in a higher yield on invested capital.
Which brings me to another important fact, one that dividend growth investing can help you appreciate. No matter what the market is doing, or what kind of lofty valuations it may currently sport, something is always on sale for a prudent dividend growth investor.
Whether it is energy stocks during the worst oil crash in over 50 years, REITs thanks to rising long-term interest rates, or biotech/pharmaceutical stocks during the election, the market is almost always irrationally negative over something.
So if you are worried that buying now at close to record highs is just setting yourself up for a loss, dividend growth investing can give you a long-term, value oriented, contrarian mindset that can keep you from trying to time the market, and thus set yourself up for far better returns over time.
5) Being a Dividend Growth Investor can Help You Earn a Return No Matter What Stock Prices are Doing
When you adopt a long-term, value-oriented dividend growth mindset, it becomes so much easier to grow your wealth and income over time. Take some of Warren Buffett’s advice:
“Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.” – Warren Buffett
And that’s not just from an overall portfolio perspective either. Take one of the Real Estate Investment Trusts, or REITs, in our Conservative Retirees dividend portfolio: Omega Healthcare Investors (OHI). This is a seemingly undervalued skilled nursing facility (SNF) REIT which, due to market concerns over the ever present risk of changes in government healthcare policy, was recently yielding 8.5%.
When you dig into the company’s fundamentals, you find what appears to be an industry blue chip, with a conservative management team, strong balance sheet, and one of the most impressive dividend growth streaks across all REITs.
But despite the company’s opportunities, there is a chance that Wall Street will never value Omega at close to its intrinsic value. However, as long as management continues to execute well and the dividend remains safe, a dividend growth investor can hope to make a reasonable, if not solid, return.[ad#Google Adsense 336×280-IA]That’s because, if Omega’s shares remain cheap, then I can always reinvest the dividends back into ever more undervalued shares, each of which is paying a growing dividend.
In other words, through the power of hyper-compounding, whether Omega ever appreciates in value isn’t necessarily a concern, because either way, capital gains or an exponentially growing income stream, Omega is likely to be a long-term wealth builder thanks to the power of compounding.
This example applies to virtually all dividend growth stocks, which, because they increase their payout to owners over time, help to separate long-term total returns from the vagaries of the market.
Remember that as long as the company’s underlying investment thesis remains intact (i.e. it’s able to grow its dividend sustainably and securely over time), it’s pretty hard to lose in the long-term…unless you allow your own emotions to get in the way of an exponentially growing income stream by selling for an emotional short-term reason.
At the end of the day, building wealth through the stock market is incredibly easy to do…in theory. The trouble is that human nature, impatience, unrealistic expectations, and taking advice from the wrong people (with different goals and time frames then you) can result in massive overtrading, high costs, and terrible underperformance over time.
But investing in dividend growth stocks can help you to avoid all of these pitfalls because they can help you to see your portfolio as not just a collection of digital symbols and randomly changing numbers on a computer screen, but real pieces of quality businesses.
In other words, being a dividend growth investor can potentially change your mindset from a short-term trader / speculator / gambler, and into a true investor; a business person whose portfolio represents a tangible cut of global corporate profits.
And in this way, dividend growth stocks can help you to avoid the silly, meaningless, and potentially harmful day-to-day movements of the market, which no one truly understands no matter how many PhDs they may have or how nice their Manhattan corporate office may be, and instead focus on investing for the long-term.
That is how regular people can get a piece of the American dream and achieve the kind of exponential increases in both income and wealth that can make you financially independent and help you live the life you and your family deserve. Whether you invest in dividend ETFs or individual dividend growth stocks, the key is to get started and stay disciplined to maximize the benefits of being a dividend growth investor.
Simply Safe Dividends
Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).
Source: Simply Safe Dividends