What is Dividend Growth Investing?

If you spend any time on the financial side of Twitter, you are bound to have come across an investing strategy called “Dividend Growth Investing”. Although not as flashy as options trading or Bitcoin trading, it promises good returns to the patient investor. This post explores dividend growth investing and my take on it.

Dividend Growth Investing Defined

FinancialExpert.co.uk defines dividend growth investing as “an active investing strategy which involves buying and holding a portfolio of shares…by looking for companies with a track record of paying reliable and growing dividends year on year”.

The first thing to note is that it is an active strategy. You will need to research and evaluate individual companies and choose how much to allocate to them.

Secondly, it is a buy and hold strategy. If you choose wisely, there should be no need to sell your investments. That isn’t to say that a share you purchase should never be sold, but selling should be a rare occurrence using this strategy.

Thirdly, we are looking for companies with a history of dividend payments and dividend growth. The amount they pay per share in dividends should grow each year.

The Case for Dividend Growth Investing

Passive Income: Dividend growth investing provides one of the most important elements necessary for financial independence, passive income. Passive income is exactly what it sounds like, income you get without working for it. Granted, there is a bit of work involved in finding and buying stocks, but once this step has been taken you should receive cash from the dividend for the rest of your life. When looking for passive income, there is always some work involved at the outset. Whether it’s purchasing a rental property, setting up a dropshipping business or affiliate marketing, most if not all forms of passive income require an initial effort.

Inflation Hedge: Dividend growth investing can also act as an inflation hedge. We have not covered inflation yet on this blog, but the basic premise is this. Over time, the prices of goods generally rise. A basket of goods may cost €100 today, but in a year, they could cost €102.50. This would represent an inflation rate of 2.50%. Due to inflation, your money now has less purchasing power. If you were to put your €100 in a savings account, you would effectively lose money as the rate of inflation is higher than the interest rate on savings accounts. To combat inflation, we need our money to glow at a rate higher than inflation. Inflation is covered in more depth in the next section.

Dividend Stability: Dividend returns are relatively stable in comparison to the overall stock market. Companies pay a set dividend each year, regardless of their stock price. The stock price can fluctuate wildly, but unless the dividend is cut it will remain at the stated amount. During good years, the return from the dividend can add to the capital gain in the stock. During poor years, the dividend gain gan offset some of the losses.

Dividends and Inflation

Inflation isn’t static, it can increase and decrease. If you buy a stock today at €100 paying €4 a year in dividends, your yield will be 4%. While 4% sounds great unless the dividend is raised every year you may lose out to inflation. Let’s assume the company behind the stock you bought doesn’t increase its dividend. Whatever happens to the stock price, your dividend will remain at €4 per year, your yield on cost will not fluctuate as the price you purchased at is fixed and the dividend amount isn’t changing, in real terms, your return is €4 per year.

Now let’s assume inflation is steady at 2% per year based on our €100 basket of goods, and assume you are using the dividend and not reinvesting it.

Year One:

  • Return = €4
  • Inflation = €2 (€100*2%)
  • Real Return = €2
  • Total Real Return = €2

Year Two:

  • Return = €4
  • Inflation = €2.04 (€102*2%)
  • Real Return = €1.96 (€8 – (€2+€2.04))
  • Total Real Return = €3.96

Year Five

  • Return = €4
  • Inflation = €2.16
  • Real Return = €1.84
  • Total Real Return = €9.59

Year Ten

  • Return = €4
  • Inflation = €2.39
  • Real Return = €1.61
  • Total Real Return = €18.10

As you can see, each year your €4 dividend is worth less and less in real terms. By the end of year 36, inflation would have completely wiped out your yearly dividend return. I know this is a long time, but we have used a relatively conservative inflation rate of 2%. If inflation was 3% per year, your dividend return would be wiped out in only 11 years! So what can we do to combat inflation?

Beating Inflation With Dividends

There are three options for beating inflation when it comes to dividends. They are DRIP (Dividend Reinvestment Plan)Dividend Growth, and the best one is a combination of the two.

DRIP is a fantastic way to capitalise on the power of compounding. By using your dividend to purchase more of the stock, you are ensuring your next dividend will be even bigger! Most brokerage platforms will let you automatically allocate your dividends into a DRIP plan, but be aware of the tax implications. In Ireland, you owe income tax on the dividend if you receive it in full or if you re-invest it automatically, there is no difference. Different countries have different tax regimes so make sure you know your countries policy before committing to a DRIP plan. Let’s look at an example using the same numbers from above, assuming the stock stays at €100 and does not increase its dividend (€4).

Year One

  • Return = €4
  • Inflation = €2
  • Real Return = €2
  • Total Real Return = €2

Year Two

  • Return = €4.16
  • Inflation = €2.04
  • Real Return = €2.14
  • Total Real Return = €4.14

Year Five

  • Return = €4.68
  • Inflation = €2.16
  • Real Return = €2.52
  • Total Real Return = €11.26

Year Ten

  • Return = €5.69
  • Inflation = €2.39
  • Real Return = €3.30
  • Total Real Return = €26.12

By reinvesting your dividends, your total real return after 10 years would be 44.3% higher than not reinvesting them. Fast forward to year 36 where inflation has wiped out your dividend, using a DRIP your dividend in year 36 would have been €15.78, or €11.78 after inflation. Bear in mind, these are relatively small starting numbers, the more you invest and reinvest the bigger the difference becomes!

Dividend Growth

So what if you decide you need the income from the dividends and can’t afford to reinvest it? It is worth looking for stocks that have a history of increasing their dividends. Using the same numbers as above, this is what your returns would look like. For this example, we have assumed the company increases its dividend by 5% annually.

Year One

  • Return = €4
  • Inflation = €2
  • Real Return = €2
  • Total Real Return = €2

Year Two

  • Return = €4.20
  • Inflation = €2.04
  • Real Return = €2.16
  • Total Real Return = €4.16

Year Five

  • Return = €4.86
  • Inflation = €2.16
  • Real Return = €4.70
  • Total Real Return = €11.69

Year Ten

  • Return = €6.21
  • Inflation = €2.39
  • Real Return = €3.82
  • Total Real Return = €28.41

An even better return than reinvesting your dividends (total real return 56.96% greater than no growth), but this will be dependant on the rate at which the company increases its dividend. Fast forward to year 36 where inflation has wiped out your dividend, using a DRIP your dividend in year 36 would have been €22.06, or €18.06 after inflation

DRIP and Dividend Growth

Now for the nuclear option. Assuming we use the same figures as above, the results of DRIP combined with dividend growth can be staggering.

Year One

  • Return = €4
  • Inflation = €2
  • Real Return = €2
  • Total Real Return = €2

Year Two

  • Return = €4.37
  • Inflation = €2.04
  • Real Return = €2.34
  • Total Real Return = €4.34

Year Five

  • Return = €5.69
  • Inflation = €2.16
  • Real Return = €3.53
  • Total Real Return = €13.63

Year Ten

  • Return = €8.83
  • Inflation = €2.39
  • Real Return = €6.44
  • Total Real Return = €39.46

After ten years, your total real return would be a staggering 118.01% more than a no growth and no reinvestment approach. By year 36, your dividend would be €87.07 with inflation running at €4.00 resulting in a real return for year 36 of €83.07. Instead of losing your entire dividend in real terms, you are now receiving 83% of your initial investment as a real return. Again, take these figures with a pinch of salt. They are meant to provide an illustration only, the odds of you finding a stock that meets these criteria and inflation running at exactly 2% per year is zero.

Dividend Growth Investing Considerations

I toyed with the idea of titling this section “Dividend Growth Investing Pitfalls”, but I believe considerations is more apt. These are things you should bear in mind rather than be afraid of.

Firstly, dividend growth investing is an active investing strategy. If you don’t have the time to invest in researching individual stocks, this method may not be for you. There are funds that specifically target dividend growth (VDGIX), but these are also actively managed and would not fit the investing profile of someone only interested in index investing. Active investing versus passive investing is a subject of its own, but if you don’t have a keen interest in the markets and researching them, passive investing will probably suit you more.

Secondly, dividend growth investing is a long term approach to investing. Sometimes people associate active investing with short term investing. As we can see from the examples above, the longer you stay invested (and reinvested) the greater the benefits are. Selling a position should be a rarity when using this strategy.

Thirdly, dividend growth investing can be oversimplified by some proponents of it. It is important not to chase yield above all else. Sure, a 7% dividend yield may look great, but if the companies fundamentals aren’t strong they won’t be paying that dividend for long. Some people invest only on the basis of length of dividend and a history of dividend growth. This approach may work for you, but I would recommend adding in some extra criteria to make sure the company you are investing in is strong.

Parting Thoughts

Dividend growth investing is not the be-all and end-all. As with most investing strategies, you will come across investors who believe the only way to success is their way. This is not the case. There are many ways to profit in the markets. Dividend growth investing can be a fantastic approach for those looking to increase their income and grow an additional revenue stream. For this reason, it is often pushed by people pursuing financial independence. For me, my dividend growth portfolio is only a small part of my overall investing approach.

If dividend growth investing is an approach that you think may work for you, you can see some of my criteria and updates here. As always, it is important to do your own research before investing in any securities.

The Stoic Trader

Posted in Income Portfolio, Investing and tagged , , , , , .
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