Dividend Growth Investing

Dividend growth investing has always been popular with a wide range of investors, but its popularity has greatly increased since the financial crisis. The main idea of DGI is to buy the stocks of companies that have paid steady and increasing dividends for a period of years, usually at least 10 or more. These are usually large cap companies that are stalwarts of American business; frequently they sell consumer staples that are necessary regardless of economic conditions.

The reasoning behind dividend growth investing is that a company that has continually increased its dividend has a number of positive features:

1) The company’s results are likely to be stable and predictable, regardless of the business cycle
2) The management has demonstrated shareholder-friendly policies by returning cash to shareholders

DGI appeals to wide range of investors, but most often it’s used by investors in retirement or approaching retirement. These investors are interested in steady income. If the stocks are held in a taxable account, the investor has to pay current income taxes on the dividends received. For most people earning less than $411K, the rate will be 15%. (http://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New). For this reason, many advise holding a DGI portfolio within a tax-deferred account.

A few words of caution are applicable for new DGI investors as of 2015. Many of the companies popular with DGI investors are trading at historically high P/E multiples. For example, Colgate-Palmolive (CL) is currently trading at 27x trailing earnings. In comparison, the S&P 500 is trading at about 17x trailing earnings. At the current price, the expected return for CL is lower than its historical average. At 27x earnings, it’s definitely not a value stock. If you pay a historically high multiple, the tendency is for the stock to underperform the market over the course of the next several years.

Dividend growth investors would argue that they never intend to sell the stock, and thus aren’t concerned with short-term fluctuations in the stock price. The stock is purchased for income and they will hold it into perpetuity. This approach contrasts with total return investors, who are seeking to grow their balance over time through a combination of capital gains and dividends. Total return investors create income by simply selling the stock.

The danger for DGI investors paying a high multiple for a dividend-paying stock is that there’s no guarantee that a company will continue to grow. Generally, for large mature companies, the dividend is a function of earnings. If earnings increase over time and the dividend payout ratio is constant, the dividend increases over time. However, the company’s management can decide to change its dividend policy at any time, or they can be forced to change it by financial circumstances. There certainly have been companies in the past that were popular with DGI investors, but had to cut the dividend or even declare bankruptcy (General Motors and RadioShack are easy examples).

Many dividend growth investors like to build a portfolio of 20-30 individual stocks over time. The list of stocks that are popular with DGI investors is pretty small; it’s probably less than 100 companies. However, it still requires a lot of time and research to choose a company. An alternative to picking individual stocks is to buy an ETF that tracks dividend growth companies. One option is the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). The Dividend Aristocrats index is comprised of companies that have increased their dividend every year for at least 25 years. This ETF has an expense ratio of 0.35% so the fees are reasonable.