DGI Lesson 3: The 5-Year Rule

Welcome back to this series of lessons about dividend growth investing!

Before we get started, let’s briefly review the most important points from the first two lessons.

In Lesson 1, What Is a Dividend? we learned:

• A dividend is a voluntary distribution by a company to its owners, usually cash.
• The company specifies the amount of the dividend, the record date, and the payable date, while stock exchange rules determine the ex-dividend date.
• The ex-date is important, because it determines who receives the next dividend. If you buy a stock before the ex-dividend date, you’ll get the next dividend. If not, the seller gets it.

Then in Lesson 2, Dividend Growth, we learned:

• The only requirements to be a “dividend growth” stock are that a company pays a dividend and grows it each year. Nothing about the size of the yield or speed of growth is implied.
• Dividends are independent from the market, because the companies themselves determine dividends. A company’s dividend can go up while its price is going down.
• Many companies increase their dividends every year. Some have been doing so for more than 50-60 years.

Now I want to introduce my first “rule” for dividend growth investing: The 5-Year Rule.

My “rules” are guidelines that I follow. They are not rigid. Over the years, they’ve served me well, but not every investor does things exactly as I do. You should think about them in the context of your own needs and investment styles.

As you learn more about the field, you can make up your own mind about what rules and guidelines are best for you.

The 5-year Rule simply says that a company must have raised its dividend for at least 5 consecutive years before I consider investing in it for a dividend growth portfolio.

The thinking is straightforward. Since the goal of dividend growth investing is to produce income that grows reliably, I want to select companies that have grown their dividends reliably.

Of course, no one can predict the future.

Any company can cut, freeze, or eliminate its dividend at any time.

But the past holds clues to the future.

Obviously, a company that has already raised its dividend for 5 years in a row has compiled a track record that suggests that it might continue to do so.

A 5-year track record is certainly not the only evidence you might seek, but it is an important part. It is so important to me that I use it as a hurdle requirement. If a company does not have at least a 5-year streak of raising its dividends, I consider it ineligible for consideration as a dividend growth investment. I won’t buy it.

Over the years, I have only made one exception to this rule. I bought Apple (AAPL) when its streak was 4 years. It was obvious that the streak would advance, and it has.

Apple’s streak is now at 6 years, and there should be a new increase for 2018 in a couple of months.

Five-year streaks are easy to identify. At the moment, there are more than 800 companies traded on U.S. exchanges that qualify under the 5-Year Rule. We know this from David Fish’s Dividend Champions, Contenders and Challengers document that is available here at Daily Trade Alert.

Let’s look at a few examples of stocks that pass this basic test. I own all of the following:

One reason that I like the 5-Year Rule is that the dividend charts of such companies look so beautiful. They are like staircases.

Those are exactly the way you want dividend charts to flow: Up and to the right, with no exceptions.

The increases keep marching up straight through recessions (the last recession is shown by the shaded band at the left) and other difficult events.

The 5-Year Rule is not foolproof. Nothing in investing is guaranteed, and no one can predict the future. As we learned in Lesson 1, dividends are discretionary. A company can freeze, cut, or eliminate its dividend no matter how long it has been paying one.

For example, several “Too Big to Fail” banks cut their dividends during the 2007-2009 financial crisis despite lengthy increase streaks. So I recommend further analysis beyond the 5-Year Rule, to buttress the case that a dividend is probably safe.

A company may cut or freeze its dividend not only during times of general economic stress, but also because of specific difficulties that impact only itself or its industry. For example, during the oil price drops a few years ago, Chevron (CVX) froze its dividend for almost 2 years until the price of oil recovered. The frozen period is circled below.

But as a company, Chevron was committed to increasing its dividend over the long term. So it made a tiny increase at the end of 2016, then in early in 2018 made a more substantial increase that (hopefully) signals the beginning of many annual increases to come.

To my way of thinking, a company that cuts its dividend has broken a link in a chain. Perhaps it becomes easier to break that link again for lesser reasons next time. I want companies that are clearly devoted to keeping their dividend growth streaks alive and have the financial strength to do so.

The 5-Year Rule helps me identify stocks that are likely to keep increasing their dividends. In most cases, longer streaks are even better. Some investors demand 10 years, or even 20 or 25. Again, however, nothing that has happened in the past guarantees the future.

Key Takeaways from This Lesson:

1. The 5-year Rule is an investing guideline that a company must have raised its dividend for at least 5 consecutive years before a dividend growth investor considers it probable that it will continue to do so.
2. A company’s existing dividend growth streak is a track record that gives insight into its ability and intention to continue raising the dividend each year.
3. The track record is not foolproof. No one knows the future, and even companies with long streaks sometimes freeze or cut their dividends.
4. For that reason, other due diligence is required to increase confidence. Many investors require longer streaks like 10 or even 25 years of consecutive annual increases.

— Dave Van Knapp

Click here for Lesson 4: The Power of Compounding

This lesson was updated 3/12/2018