Dividend Growth - The Only Metric That Matters

 |  Includes: DES, DTD
by: The Dividend Guy

What if You Could Pick All Your Stocks Based On a SINGLE METRIC?

It's not true; investing can't be that easy. What if the only thing you would need to focus is a single metric and you could build a portfolio that beats the market? Nah! I don't believe in miracles and only believe in Santa since I have three kids that also believe in the Tooth Fairy .

However, if you focus your stock research around this single metric; you will be able to beat the market.

This is a metric that you know already and that I've been preaching about already; it is dividend growth.

Here's what I found in my stock market research:

Dividend Growth Stocks Beat the Market

It's not a surprise that dividend stocks beat the market over time as 56% of the S&P 500 returns come from dividend payouts. However, I was surprised to find that companies that increase their dividend systematically also beat the market without a doubt. Let's start with the Canadian market:

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As you can see, companies paying dividends beat the S&P TSX and those who raise their dividend do even better. As is the opposite, those who cut or pay no dividend are trailing behind. This could be easily explainable since the biggest dividend payers on the Canadian market are:

  1. Banks
  2. Oil Industry (Oil Income Trusts in the 2000s)
  3. Telecom

If you look at these 3 industries over the past 15 years, you will see how they did well… maybe it's just something about a few sectors. Let's look at the U.S. market to be sure…

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Interesting enough, the difference is smaller for dividend paying stocks versus the S&P 500 but it is still to the advantage of dividend investors! As you can see no dividend paying stocks did almost as good as the index. There are more pure growth stocks in the U.S. compensating with high investment returns. This graph represents a better picture of the eternal battle between dividend investing vs growth investing.

Why Dividend Growth is SOOOO Important?

The only metric of dividend growth is definitely not enough to convince any investor to dive in and purchase a stock. But the dynamic around a company that, year after year, increases its dividend can create great results.

When you think about it, the only valid reason why a company would raise its dividend is because the management team believes in its capacity to generate even more profits in the future. Since we are all looking for such investments, dividend growth should be the first bell to ring in our ears when we look for another stock to add to our portfolio.

If a company increases its dividend during several years, it also means that it makes more profit year after year. If profit doesn't follow the dividend growth trend, the dividend payment will become unsustainable. For example, if a company makes a profit of $10 per share and pay $1 in dividend, the payout ratio is 10%. If the company increases its dividend payout by $1 per share each year and doesn't increase its profit at all, in ten years, the payout ratio will be at 100% and nothing will be left in the bank account once the dividend is distributed. Therefore, if the dividend growth trend follows the earnings per share, you already have a great indication that the company is doing well.

The second indicator that you must combine with dividend growth is sales. It is one thing to increase your profit [EPS] but it can be some kind of accounting magic done over a few years. Sales may not follow exactly the EPS trend; after all, during a period of intense growth, a bigger part of the budget will be allowed for operations and marketing. Once these efforts are stabilized, the company will usually generate bigger profits. On the other hand, sales can stagnate for several years and major cuts combined with the sale of important assets can increase the earnings during several years. This is what I call accounting magic. This is why it is important to see if the dividend growth is supported by both growing earnings and growing sales.

What is the Most Important Thing to Do When You Look at Dividend Growth

The most important thing to do is simple: look at the trend. The trend in dividend growth combined with the trend in earnings and the trend in sales will give you the perfect trio to determine whether a company should be a good addition to your portfolio or not. Looking at 5-year growth data is a great start. But you must look at each year. Once you have pulled-out the stock from your screener, additional work is required to make sure you pick the right stock for the right reasons.

You want to pick a stock with constant growth, not just a big boom for a year or two during the 5 year period. Constant growth is found within a strong business model while a big boom could be some fluke or worse; accounting magic!

In the end, I believe that dividend growth is probably the best metric to follow at first when you look at a new stock. However, you need to dig deeper and verify the overall fundamentals before making your decision.