An income-focused stock selection strategy that involves buying stocks with a long history of increasing dividend payments (known as Dividend Aristocrats or Dividend Champions) and reinvesting any proceeds.
There is usually a strong Buffettesque focus on the quality of the franchise supporting the business to ensure sustainability of the dividend payment.
It's hard to pin down the exact origins of Dividend Growth Investing (DGI). Clearly a recognition of the importance of dividends goes back as far as Benjamin Graham, who wrote "The prime purpose of a business corporation is to pay dividends to its owners" and beyond, but the strong emphasis on consistent dividend growth is more recent. The thinking behind DGI harks back at least as far ex-Fidelity fund manager and investing legend Peter Lynch who wrote in his 1994 book Beating the Street:
“The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row. Moody’s Handbook of Dividend Achievers – one of my favorite bedside thrillers – lists such companies. Here’s a simple way to succeed on Wall Street: buy stocks from the Moody’s list and stick with them as long as they stay on the list.”
In recognition of companies with a 10 year history of increasing dividends, Moody's Investor Service (now part of Indixis) created its first Handbook of Dividend Achievers in 1983, while S&P's Dividend Aristocrats Index (25+ years of dividend increases) seems to have maintained since at least 1989.
One of the earliest books to focus on DGI in detail as a strategy was Roxann Klugman's title, "The Dividend Growth Investment Strategy" (published in 2001). Amongst other stories, this book described the investment strategy of Anne Schieber, a ex-government employee who built a $5000 lump sum in 1944 into $22 million by 1995 through dividend reinvestment & compounding. Miller Lowell also wrote in detail about DGI in his 2006 book, "The Single Best Investment: Creating Wealth with Dividend Growth".
As a more structured/populist school of investment thinking, Dividend Growth Investing seems to have emerged in recent years out of the blogosphere, via sites like David Van Knapp's Sensible Stocksand Dividend Growth Investor and the writings of others like David Fish, Chuck Carnevale and Norman Tweed on social finance site, Seeking Alpha. This article gives some interesting background on its emergence.
Given its recent history, it remains to be seen whether DGI Investing is just a low-interest-rate phenomenon but, so far, its popularity has been mostly confined to the US market (perhaps because many countries do not have the same degree of consistency in their dividend payment culture).
Dividend Growth Investing involves buying stocks that are committed to growing their dividends over time – and have a track record for doing just that. Dividend Growth Investors want dividends that are sustainable and regularly increased. These dividend should be from high quality businesses that are expected to grow profits over a long period of time by selling/manufacturing/distributing products that people want or need every single day.
Rather than selecting shares with spectacularly high yields (as with the Dividend Dogs), the strategy takes a longer term view and looks for companies whose culture supports the payment of dividends. The rationale behind this is that:
- Companies that can grow their dividends are generally more efficient allocators of capital over longer periods.
- Paying dividends is good discipline for management, as they have to ensure their strategies and actions reward shareholders.
- Dividend payers tend to be less volatile and provide protection against downside.
- Ongoing dividend payments incorporates the advantages of compounding through reinvestment
The DGI approach is intended as a long-term strategy whereby the investor reinvests dividends and buys more of its core holdings over time on price dips.
There tends to be more emphasis on the income stream generated by the portfolio, than the value of the portfolio per se. The idea is that, thanks to compounding through reinvestment of dividends, a portfolio of carefully selected dividend stocks should provide a sufficient income stream to live on in retirement, without the need to touch the principal.
Views on diversification differ amongst DGI investors - some people focus hard on diversification, while others hold a concentrated portfolio.
As DGI is a fairly broad church, it's not easy to say exactly what a typical set of quant. screening criteria might be. However, in this respect, this article by David van Knapp is a useful synthesis as is this one.
- Consistent history of dividend increases - What this means is debatable, of course, but typically the starting point will be the list of Dividend Champions (i.e. companies with a 25+ year record of maintaining or increasing dividends) on the DRiP Investing Resource Center website. There is no UK equivalent to our knowledge although Indxis has recently launched a UK Dividend Achievers index.
- Strong Historic Dividend Growth Rate: This usually involves either a minimum five-year dividend growth rate of 10% or more, or a 10-year dividend growth rate at the same level.
- A Minimum Dividend Yield: David Crosetti looks for 3% or better, Norman Tweed looks for yields beginning at 4%. If the current dividend yield of an existing holding drops below 3%, this might trigger a decision to sell and deploy the cash elsewhere (see below).
- Increased dividend payout yield (either in relattion to earnings per share or free cash flow): This is more controversial since some DGI investors target low payout ratios as a sign of sustainability. However, it ties in with a 2003 study by Robert D. Arnott which found, contrary to received wisdom, that expected future earnings growth is fastest when current dividend payout ratios are high and slowest when payout ratios are low. They noted that “our evidence contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster earnings growth".
Other more qualitative DGI criteria might be:
Does DGI investing beat the market?
The evidence as to whether Dividend Growth Investing delivers alpha is fairly mixed. While a number of its supporters have back-tested the performance of the Dividend Champions list, this work is based on a data-set that suffers from significant survivorship bias (as the Champions list does not show companies that cut their dividends or went bankrupt).
For US stocks, Kurtis Hemmerling has attempted to back-test the strategy without this bias for 797 companies from 1994 to the beginning of 2012. He found that this strategy delivered a CAGR of 7%, without taking into consideration dividends (which he estimated at 3-4%), i.e. an estimated total return of 10-11%. This compared favourably with a total return CAGR for S&P 500 of 7.71%."
Contradicting this, though, Larry Swedroe, along with the research team at DFA, analysed the returns from Dividend Growth in the US over a 30 year time period. His work found that, from 1982-2011, the top 20% of dividend growers had an average annual return of 12.5% and a standard deviation of 17.6%, whereas the index had an average return of 12.3% and a standard deviation of 17.7% (i.e. the difference wasn't statistically significant). You can read an interesting debate between Swedroe and a DGI supporter here.
One international study by Cass University of UK stocks, "Consistent Dividend Growth Investment Strategies" examined data for LSE from 1975-2006 (summarised here). It found that firms with in excess of 10-years consistent dividend growth (especially small-caps) returned considerably more than the equity market as a whole, with the additional benefits of lower volatility and smaller drawdowns.
What to watch out for
As blogger Financial Uproar writes, the proponents of dividend growth investing can sometimes appear somewhat myopic (and arguably even unbalanced) in their focus on dividend growth to the exclusion of other concerns:
"I like dividends too. The problem is with the almost singular focus on it. As long as a company is growing the bottom line and their investors get that yearly dividend hike, dividend growth investors are happy to buy, all other metrics be damned. Paying $10 for every $1 in assets? THAT’S ALL GOODWILL BABY! Buying at a 52 week high? WHO CARES, DADDY LIKES DIVIDENDS.
One thing to be wary of is that DGI literature tends to be rife with claims that dividends account for 90% of the Stock Return. There's lots of research highlighting the importance of dividend reinvestment - e.g. an Ibbotson study found that it made up 40% of total stock returns from 1926 to 2006 and studies shows that it can be as high as 90% in bear markets. However, the idea that dividends generally make up 90% of stock returns - apparently taken from Daniel Peris’ book “The Strategic Dividend Investor” - has been fairly comprehensively debunked as specious by Crossing Wall Street. As he writes:
"The hitch is that the claim is that 90% of returns are derived from dividends, not specifically dividends themselves. This is a bit of logical sleight-of-hand. The problem is that this sleight-of-hand doesn’t reveal any important truths. Instead, it makes a point which is ultimately irrelevant... Let’s take a stock that at the beginning of the year pays a 5% dividend. During the year, the dividend is increased by 10%. Let’s say that the stock also rises by 10% during the year. Well, Paris et al claim that the 10% stock rise is derived by the dividend payment since the shares are merely keeping up with the dividend. Ergo, the return derived from dividends is the 5% dividend plus the 10% stock increase. In other words, all of the stock’s returns (15% out of 15%) are derived from dividends".
When to Sell / Realise Profits
Views on when to sell differ amongst DGI investors. Some people actually sell positions when they feel that a company may be overvalued. van Knapp normally aims for 3% minimum current yield, otherwise he would look to redeploy the proceeds into other stocks with higher current yields. Some people claim to never sell unless there is a fundamental issue with the company and/or a stock suspends or reduces its dividend.
Rather than the typical 4% selling rule used for retirement planning, the thinking amongst DGI investors is that the dividend income generated naturally by the assets should be all that is removed from the investment account. On this view, price falls (or even a bad economy) should pose no particular threat, because there is little correlation between dividends and stock prices.
From The Source
While there's no one central DGI text, it's well worth referring to David van Knapp's book, "Top 40 Dividend Stocks of 20XX" (released each year since 2008) as that covers a lot of the thinking. This is available from his website. See also Roxann Klugman's title, ""The Dividend Growth Investment Strategy" (published in 2001). See also these articles from Seeking Alpha:
- The Rational Case For Dividend Growth Investing (Part 1)
- The Rational Case For Dividend Growth Investing (Part 2)
It's also worth referring to the Dividend Champions document maintained by David Fish on the DRiP Investing Resource Center. Known as CCC, this document lists US stocks that have consistently grown their dividends for at least five years (Challengers), 10 years (Contenders), or 25 years (Champions).
- Consistent Dividend Growth Investment Strategies
- DGI: The hunt for long-term income
- The dangers of dividend-paying stocks
- Don't rely on dividend strategies to pick stocks
- Are Dividend-Focused Strategies Viable For Investors?
- Can I Suggest An Alternative To Dividend Growth Investing?
- What are the lessons of Anne Scheiber's story?