In the opinion of this humble blogger, dividend growth investing is a great way to build wealth over time. Dividend growth investing is a branch of value investing, that focuses on buying shares of companies with a consistent history of raising dividends. As I was putting together the initial content for this blog, it dawned on me that readers green to the idea of financial independence, dividend growth investing, or investing in general might be kind of lost by all the terms thrown around. In this primer, I presume that you know nothing and start at the very beginning.
What is a stock?
A stock is a share of ownership in a corporation. A very small share. By owning stock in a company you voting rights (you can vote for various members of the board of directors) and are entitled to a dividend payout (if the company pays dividends). Stocks are liquid and can be bought and sold major exchanges, and the price of a stock fluctuates over time according to the whims of the market. While stocks entitle you to certain benefits, you are not liable for corporate malfeasance. In other words, the company can screw up and make terrible mistakes, but you won’t be held responsible. That liability rests with the actual employees of the company.
Beginning to invest in stocks is very easy. Simply open up an account with an online brokerage company, deposit some money, and off you go.
How do stocks make money for investors?
Stocks can make money for investors in two ways, capital gains and dividends.
1. Capital Gains - Capital gains are fancy term for a stock being worth more than you bought it for. So if you buy a stock for $20 per share and then the price rises to $22 per share, you’ve made $2 per share in capital gains. That’s a 10% return. And just as there are capital gains, there are capital losses.
Capital gains only become real once you’ve sold the sock. Before that, they’re nothing but a number on paper. A number that is incredibly labile and goes up and down every day based on such factors as:
- Changes in business fundamentals - As the company becomes more profitable, the value of the company and thus the stock price should rise over time. When the fundamentals are strong, the stock price just slowly keeps on trucking upwards. There are plenty of jumps and falls along the way, but the overall trend is upwards. Of course the reverse is also true, if the company could be better run by a sack of potatoes, then the fundamentals will decline over time and drag the stock’s price with them.
- Market forces - The market is ruled by what economist John Maynard Keynes called animal spirits. Which is a very nice euphemism for short sighted speculators and computer algorithms all trying to make a quick buck or just chasing the latest fad. The market is all powerful, it can launch a worthless company into the stratosphere based on a vaguely worded press release, or crush a Blue Chip with a century of performance for missing an earnings target by a penny. Yes, despite the utter gobs of money involved, Wall Street has the overall maturity level of pack of teenage girls at a Justin Bieber concert. But these speculatory forces tend to be ephemeral, and sooner or later there’s a reckoning with the fundamentals and the stock price goes back to something more in line with the company’s business performance.
- Stock buybacks - This one takes us all the way back to Economics 101 with some simple supply and demand. As a company buys back it’s outstanding stock, the amount of shares in the market decreases. As supply decreases, assuming constant demand, the price of the stock should rise. Should the company decide to issue more shares (which can be done in order to raise additional capital), then the stock price should decline due to greater supply.
2. Dividends - A dividend is a portion of the company’s earnings paid to it’s shareholders. Dividends are usually cash, but they can also come in the form of stock or property. Dividend payouts can be one time events, or they can occur regularly. Dividends are often paid quarterly, but they don’t have to be – monthly, semiannually, or yearly dividend payments also exist.
Dividends are entirely optional (*). A company can pay or not pay. Dividends can also go up, down, or remain flat.
Unlike capital gains, cash dividends are real. You don’t have to wait to sell the stock in order to enjoy your dividends. If you own $10,000 worth of stock and you receive $350 (3.5%) in dividends, the money is yours to spend or save as you see fit. And the stock is still yours too, since you didn’t have to sell it in order to collect that dividend.
Let’s say that a company pays you $350 every year that you are a stockholder. That’s not a bad deal. You basically get a $350 return on your investment each year for doing nothing. In addition to paying a regular dividend, the stock’s price may increase over time, leading to capital gains. Many stocks that pay regular dividends are stable, profitable companies with solid fundamentals. If they weren’t, it would be very difficult for them to regularly part with wads of cash. It is common for companies paying regular dividends to see their stock prices increase over time as well. Kind of a win-win situation (regular dividends plus capital gains).
What are dividend growth stocks?
Some companies choose to grow their dividends every year. They are able to do this because their earnings steadily increase over time. Dividend growth is often a hallmark of a stable and successful company. The kind of companies that value investors like to buy. Companies with a substantial history of dividend growth are referred to as dividend growth stocks.
Dividend growth and the rate of growth are two different things. Let’s revisit our previous example of a $10,000 investment that provides a $350 (3.5%) dividend payment. If this company raises it’s dividend by 1% per year, at the end of 10 years you will receive $386.62 per year in dividends. On the other hand, if the company grows it’s dividend at a rate of 10% per year, a at the end of 10 years you will receive $907.81 per year in dividends. Either way, it’s still a dividend growth stock, but the latter example is a much better investment than the former. Growth rates are mad crazy powerful and you best respect!
Dividend growth stocks are further classified by the number of consecutive years that they have been able to grow their dividends.
- Aristocrats - Stocks that have raised dividends for at least 25 years
- Champions - Stocks that have raised dividends for at least 25 years (Same as aristocrats)
- Contenders - Stocks that have raised dividends for 10-24 years
- Challengers - Stocks that have raised dividends for 5-9 years
Who should and shouldn’t be a dividend growth investor
Personally, I think that everyone should be a dividend growth investor. But this style may not be for you. Dividend growth investing (and value investing more generally) isn’t flashy or exciting. Dividend growth stocks are companies like McDonald’s (MCD) and Coca-Cola (KO). Tried and true, they make products that people buy every day. You won’t find flashy new companies with still to be determined business models, and without a solid history of profitability, like Zynga (ZNGA) or Facebook (FB). Given their recent performance, this might be a blessing. No fancy IPOs either. Just companies that have a consistent history of bringing home the financial bacon and sharing it through dividends. What you gain in stability, you lose in potential water-cooler banter.
Disclosure: I am long MCD and KO. See the portfolio for my current holdings.
(*) Exceptions to this rule include master limited partnerships (MLPs) and real estate investment trusts (REITs). These are unique business structures, with mandatory dividend payouts, that we’ll discuss in later posts.
Readers: Share you thoughts on dividend growth investing. What do you like about it? What don’t you like about it? Do you have another investment strategy that is working for you?