Investors are often lumped into one of three categories on the basis of their investment strategy. Some investors target stocks with rapidly growing earnings and revenue, regardless of current valuation, hoping to ride the growth train higher and higher to collect significant capital gains. Others seek to identify stocks which have underperformed, been oversold, and/or trade at significant discounts to certain measures of valuation, be it free cash flow, price to earnings, or any other measure. Lastly, some investors set out to earn annual income from their investments often turning to bonds. While investors who adopt strictly growth or strictly value investment strategies may be very successful in their niche area I prefer dividend growth investing, which in many ways offers the best of both worlds.
Dividend growth investors adopt a simple strategy that blends the best aspects of both growth and value investing together into a strategy, that when properly executed, can provide substantial long-term capital gains and significant annual income. For dividend growth investors, the plan involves investing in high-quality companies that pay and increase dividends annually when they trade at favorable valuations (Value investing). The high-quality companies that DGI investors are interested in should be able to grow earnings rapidly enough to maintain and grow the current dividend payment without burdening the operations of the company. If the company an investor identifies is able to grow its earnings at a high rate annually the investor should benefit from substantial share price appreciation over the lifetime of their holding (Growth Investing). Lastly the company's DGI investors pour their hard-earned dollars into pay and (generally) increase dividends on an annual basis, so the income stream continues to grow annually (Income Investing).
While growth, value and income investors may be able to produce and obtain substantial returns using their selected strategy, portfolios built solely around any one of these investment strategies are subject to increased market risks. Income portfolios usually involve substantial investment in bonds, which while great for providing consistent and reliable returns, with few exceptions, leave investors vulnerable to inflation. Growth investors looking to latch on to stocks with sky-rocketing earnings and growth are subject to several risks. First, with these high-risk high-reward opportunities there is often higher volatility associated with these stocks, and therefore growth investors are subject to greater losses during periods of market downturn. Secondly, as the pace of earnings growth slows and revenue levels off, share prices can suffer quickly and dramatically, retracing much of the gains a growth investor may have experienced. While there are exceptions to every rule, and the meticulous growth investor may do very well over their career, this strategy presents too much risk for my liking. Lastly, value investors are not immune to risk either. While value investors may be able to easily identify companies that are trading at significant discounts to historic valuations, or have experienced recent sell-offs, the challenge becomes determining why these stocks are at such low valuations and can they bounce back. Investors who fail to recognize that some stocks subject to low valuations and significant sell-offs may simply be bad companies and bad stocks can fall into value traps. These unlucky investors may find themselves climbing on to a sinking ship if they aren't careful.
Dividend growth investing seeks to balance these risks while continuing to grow an investor's capital and build an income stream. By building a high-quality portfolio of dividend growth stocks consisting of stable mature companies that have grown dividends for decades, like Procter and Gamble (NYSE:PG), Coca-Cola (NYSE:KO) and Johnson and Johnson (NYSE:JNJ), well established dividend payers that continue to grow rapidly, such as Nike (NYSE:NKE) and Costco (NASDAQ:COST), along with up and coming fast growing dividend stocks, like Phillip Morris (NYSE:PM) and Mead Johnson Nutrition (NYSE:MJN), DGI investors can reap much of the benefit from all three strategies, with a fraction of the risk. On top of all that, investors have the opportunity to reinvest their annual dividends in their current positions or others to grow their portfolios and increase their income even faster.