Dividend Growth Investing is Brilliant. It's such a brilliant and elegant idea it's amazing that it's not the basis for all investing ideas. In its purest form it's simply identifying and then buying stocks that grow their dividends over time. It's such a simple idea that it's often overlooked by investors who are searching for a more sophisticated and therefore complicated method of investing. Yet even simple ideas begin to get complicated once you try to execute them.
"And I had an old fashioned idea that dividends were a good thing."
-- James MacArthur, Actor, Investor
Here is how I implement this simple idea of dividend growth investing.
Looking for, and discovering, companies that increase their dividends annually is easy for me and for any other investor with an internet connection. There is little, if any, work involved in finding these companies. The work has already been done and is freely available on the net for everyone to see. Companies with a consistent record of improving their dividends each and every year are identified and segregated into categories or lists. These lists are based upon the number of years that the companies have been increasing their dividends. All an investor has to do is decide how many years of consistent dividend increases his investment strategy requires before acquiring a position in that company.
The Dividend Contenders List contains stocks that have been increasing their dividends for at least 10 years, the Dividend Aristocrats and Dividend Champions Lists contain stocks that have been increasing their dividends for at least 25 years, and the Dividend Kings List contains stocks that have been increasing their dividends for at least 50 years. Personally I prefer to begin my research with the list of Dividend Aristocrats. This list currently contains 52 companies but it's updated monthly because occasionally companies are added or eliminated from the list. After screening these companies for additional criteria I'm generally left with a sufficient number of companies to select from for my next acquisition. If, after screening, there aren't enough acceptable companies from the Dividend Aristocrats List, I'll move down to the Dividend Contenders List and look for additional candidates. With the limited funds I currently have to invest, the Dividend Aristocrats List generally provides a sufficient number of companies for my requirements.
Once I have a list of stocks that increase their dividends every year, I slim down the list by eliminating those stocks that pay a dividend of less than 2.5%. Of the ones that are eliminated that are close to my dividend yield threshold, I calculate the price point to which these stocks would have to fall in order for their dividend yield to increase to 2.5%. This provides me with a list of candidates that I could sell covered puts against and successfully enter a position that pays a dividend with my minimum yield expectation.
The next thing I look for is a company with a dividend that is increasing each year at a rate greater than inflation. Since inflation varies from year to year, I put more emphasis on recent dividend growth rates (1 year and 3 year) than I do on longer term growth rates (5 year and 10 year). I want to know that the dividend that I'm buying today will grow over time at a rate greater than inflation and therefore my purchasing power will increase over time as well.
I have an overall total annual expectation on my investments of at least 8% per year. This is a total return on my investments and is the sum of both dividends and price appreciation. Therefore a stock that pays a dividend of 2.5% would be expected to increase its stock price 5.5% to equal 8% total return per year. If a stock pays more than 2.5% in dividends, then that stock would need to appreciate proportionally less in order for me to obtain the minimum 8% total return. Obviously all of us would like more than 8% but this is the minimum expectation for all of my equities.
I'm also always looking to compound my dividends by reinvesting into shares of companies that have a total return of at least 8%. This would allow my portfolio to double every 9 years without any growth and even fewer years with added benefit of growing dividends. Add in any personal savings and the portfolio grows even faster.
"A large income is the best recipe for happiness I ever heard of."
-- Jane Austin, Author
Here's how I implement options into this strategy.
Since a company's dividends are paid out of profits, dividends won't grow very fast unless the company's revenues and earnings are also growing. Assuming that a company maintains a constant payout ratio, revenues and earnings will need to grow at 8% per year in order to increase dividends at this same rate. When they don't, dividends won't grow either. I always check to make sure that revenues and earnings are relatively consistent over time but I also know that there are other factors like profit margins, product development and seasonality that often play a role in sales and profits. This in turn will also affect payout ratios. All of these items have to be monitored at least quarterly to ensure that the shares of the companies that I own continue to perform as necessary in order for my portfolio to increase as expected.
Most dividend growth investors have similar requirements when it comes to finding companies that are worthy of investing in. Most dividend growth investors also hope and expect their investments to perform as expected which is to continue along this same growth path for years to come. Unfortunately there's no guarantee that this will ultimately happen. This is exactly why I monitor each company quarterly to ensure that they meet or exceed the same requirements that I expect of any new purchase. When these minimums aren't met, then it's time to move on.
So far these ideas are a pretty simple and straightforward method of looking at companies. I look at revenues, earnings, dividends, stock prices, payout ratios and growth rates. As long as they move forward in sync I maintain ownership and my wealth grows along with the companies themselves. It's also a strategy that lets me know at least quarterly if any of the companies in my portfolio are falling behind those initial buy parameters. If they do it results in a sell decision. This has been my investment strategy for a long time and it has done very well for me.
There is also a special category of companies in addition to the list of Dividend Aristocrats that I'm always interested in. This category is made up of companies that are either Master Limited Partnerships, Real Estate Investment Trusts, or Business Development Companies. These companies must distribute at least 90% of their profits to their shareholders. Each of these companies are also required to pass along 100% of their tax liability to their shareholders. In those case where one of these companies pays a dividend of at least 8%, I'm interested in looking further at their fundamentals to see if they surpass additional criteria I have for acquiring a position in any company. I normally don't expect the stock price of the companies in this category to increase from year to year but I also don't expect the stock price to fall either. If I can get an 8% return by way of the dividend alone, I'm happy for these stocks to maintain their present price from year to year. I'll settle with compounding the 8% dividend quarterly and annually. In some cases these dividends are paid monthly and the compounding occurs even faster.
If this is all I wanted to do then I think I'd have a successful investing career. But I also use options to enhance my dividend income. I use covered puts to enter into investments at the best price and hence receive the best possible dividend yield. I also use covered calls or outright stock sells if the stock price has gotten ahead of itself. One of the signals that a stock's price has gotten ahead of itself is when I see revenues, earnings and dividends improve in sync with each other while the yield begins to fall. This is an obvious result of the stock price advancing faster than the other parameters. It signals to me that investors have bid the stock up too fast and it's time to take some profits. One way that I do this is by selling covered calls against the stock and pocketing some of that price advance in anticipation that the stock will fall back over the duration of the call. Another way to monetize this is to sell the stock at the inflated price and then either wait for it to fall back and buy it again or sell covered puts to get back in and pocket the option premium. Either one of these two actions is acceptable. The only difference is the tax consequences associated with selling the underlying stock which may have been held for an extensive period and has a substantial capital gain versus selling short term options.
This strategy has been my investment strategy for a number of years and has provided me with a set of guidelines as I approach my buying and selling decisions. It's a simple strategy but I've learned over the years that simple strategies that can be written down, easily explained and are actually executable will be successful over time.