Dividend Growth Investing – the hunt for long-term income

Choosing whether to invest in stocks that offer steady income or long term growth is a subject that usually divides investors – but an increasing number think that you can have both. 

At the heart of this apparent crossing of investing wires is a dividend strategy that combines a conventional focus on dividend yield with a strong emphasis on a company’s ability to grow its payouts over time. Find a company that can do that, the argument goes, and you’ll find a company with a rising share price too. 

While investment headlines tend to be dominated by the market’s high-growth stock successes, analysts claim that since 2000, sparkling individual stock performances have really just been exceptions in otherwise unremarkable market conditions. For the FTSE, like the S&P in the US, the 2000-2003 crash marked the start of a secular bear market that is still running. In over ten years there have been short periods of elation but for the most part the trend has been sideways and the performance has been negative. In terms of overall capital growth it was a lost decade. Ominously, some commentators think there could be a lot more of this so-so performance to come.  

One of the consequences of these conditions is that the hitherto unsexy world of dividends has got a hell of a lot more alluring for many investors. Low interest rates, uninspiring bond yields and stalled equities have given yielding stocks a magnetic attraction. My colleague Ed has been discussing this, together with the contents of a recent SocGen note in which the bank’s analysts have formulated an index of so-called Quality Income stocks that they believe offer safety and an inflation-busting yield. That index has outstripped all manner of yields, bonds and equities since 2000. However, as the analysts concede and critics would stress, that performance is no guide to the future.

It is that uncertainty over the future that has contributed to a surge in interest in dividend growth strategies. Dividend Growth Investing involves buying stocks that are committed to growing their dividends over time – and have a track record for doing just that. Rather than selecting shares with spectacularly high yields, the strategy takes a longer term view and incorporates the advantages of compounding through reinvesting dividends to meet its objectives. For investors that have an eye on retirement or meeting future financial requirements, Dividend Growth Investing is one option worth considering. While the requirements and definitions vary from investor to investor, Dividend Growth strategies tend to boast some common traits: 

A Focus on Yield

The issue of high yield – or what the company is paying out relative to its share price – requires some care. Particularly high yielding stocks are a well known red flag because of the risk that the market is pricing in an expectation that the dividend may soon be cut. To mitigate this risk investors can look closer at metrics such as dividend cover but while this is an excellent view on the past it offers a slightly more flimsy guide to the future. The good news is that studies have found that the very top yielding stocks are not actually the best performing. Out of 10, it’s those stocks that are ranked eight and ninth in the high yielding stakes that actually excel – you can read more about that here. Indeed, the SocGen researchers also concluded that “dividend yields which look too good to be true usually are”. 

A Growing Dividend

A growing dividend is not only an indicator of management confidence in the future cash flows of the company but, for the investor, it can also act as protection against inflation. In the US, finding a company that has consistently grown dividends is as easy as looking at the S&P 500 Dividend Achievers index, which comprises stocks in the S&P 500 that have not only paid, but have increased their dividends for 25 consecutive years. 

Look at this chart – it shows that in the ten years to 2011, the total cumulative return from the S&P 500 Index, including the reinvestment of dividends, was 32 percent. However, if you put cash solely into US companies that grew their dividends for at least 25 consecutive years, the total return was over 136 percent. 

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Source: M&G Investments - Mergent’s Dividend Achievers as at 31 August 2011; Datastream as at 30 September 2011. US companies with a 25-year track record of consecutive dividend growth 

In the UK it is a little trickier to track long term dividend growth streaks (Stockopedia PRO tracks dividends over six years). However, according to Indxis, which runs an equivalent UK Dividend Achievers index, consistent dividend-paying stocks produced an annualised return over the 12 months to January 31, 2012 of 5.32 percent, out-performing its MSCI benchmark by 3.81 percentage points. Over three years, the index produced a return of 21.86 percent, up 3.2 percentage points on its benchmark. Among the best performing long-term dividend growers were SABMiller, Diageo, Unilever, British American Tobacco, Tesco, Reckitt Benckiser, Vodafone, BHP Billiton, BG Group and AstraZeneca. Each of these stocks has increased its annual regular dividend payments for the last five or more consecutive years. 

But while Dividend Achievers is a handy guide, some analysts have pointed to shortcomings in relying to heavily on it in a Dividend Growth investing strategy. In particular, the S&P index is limited to large, very established companies, providing no exposure to smaller, faster growing, dividend payers. 

Reinvesting Dividends

Together with yield and dividend growth, proponents of Dividend Growth Investing stress the need for long-term reinvestment of dividends to take advantage of the huge gains that can be achieved from compound growth. This subject of compounding is a familiar one to investors but, just for the record, a recent note by investment giant BlackRock, UK equity investors who reinvested their dividends multiplied their money 15-fold in the last 45 years. Those who relied on capital appreciation alone would have an inflation-adjusted gain of just 95 percent. 

Dividend Growth vs. Capital Growth 

Choosing between capital growth and dividend income is an aged debate among investors. For those that prefer the pursuit of capital gains, the idea of scrutinising companies BECAUSE they pay dividends is often treated with suspicion. That is easy to understand in the context of headline-grabbing growth stock successes. The Irish pensioner that turned £400 into £720,000 by backing Dana Petroleum for 15 years presumably had little interest in whether Tom Cross would ever pay a dividend from all that North Sea oil production. However, for dividend investors with a focus on yield and long-term performance, there is every reason to expect capital growth as a by-product of the strategy. While Dividend Growth Investing means different things to different people and uses various metrics to achieve its objectives, the underlying focus on building long-term income could be a useful option for those that, until now, never looked beyond dividend yield.