The Power of Investing in Dividend Growth Stocks

The Power of Investing in Dividend Growth Stocks

This is a guest contribution by Nick McCullum from 
Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically identify high-quality dividend-paying stocks trading at fair or better prices and suitable for long-term investment. 

Dividend growth investing is one of the most powerful ways to build long-term wealth.

With that said, it is not known for being one of the best investing strategies. Many self-directed investors chase value investing strategies or momentum investing strategies because of their ability to make a quick dollar when done right.

Dividend growth investing stands out for its ability to work well over long periods of time. This article will explain three reasons why dividend growth investing is a powerful way to generate wealth over the long run.

Dividend Growth Investing Can Generate Above-Average Returns

Dividend growth stocks are typically mature companies with stodgy, boring business models that have been in operation for many decades. This is the opposite of what comes to mind when many investors think of high returns; instead, they imagine internet stocks or maybe even deep value stocks.

Still, dividend growth stocks have delivered market-beating performance over long periods of time. For evidence of the strong historical performance of dividend growth stocks, one needs to look no further than the Dividend Aristocrats. The requirements to be a Dividend Aristocrat are:

  • Be in the S&P 500
  • Have 25+ years of consecutive dividend increases
  • Meet certain minimum size and liquidity requirements

The long-term performance of the Dividend Aristocrats is compared to the S&P 500 below.

S&P 500 Dividend Aristocrats Historical Performance

Source: S&P 500 Dividend Aristocrats Fact Sheet

It is clear from this data visualization that the Dividend Aristocrats have delivered meaningful outperformance over the S&P 500 over the past 10 years. The following table provides more granularity to this data:

S&P 500 Dividend Aristocrats Performance Details

Source: S&P 500 Dividend Aristocrats Fact Sheet

Through the 10-year period ending November 30, 2017, the S&P 500 Dividend Aristocrats have delivered annualized returns of 11.57% per year compared to 8.30% per year for the broader S&P 500 Index. This represents outperformance of 3.27% per year, which is fantastic given the length of this outperformance.

We believe that there are three main reasons why dividend growth stocks outperform the market averages:

  • First, a long history of steadily rising dividend payments indicates that a company’s management is shareholder-friendly, a characteristic that likely extends to other capital allocation decisions, enhancing long-term business performance.
  • Second, a company that pays a dividend has less retained earnings to fund organic or inorganic growth opportunities. This means that the company’s management team must be ultra-selective with its financial decisions, leading to better decisions over the long run.
  • Third, companies that pay rising dividends must have actual earnings and cash flows to fund these cash distributions to shareholders. This means that the universe of dividend growth stocks excludes companies that are (1) going bankrupt or (2) pre-earnings startups. In other words, the universe of dividend growth stocks excludes the riskiest types of businesses, which improves the results of groups of dividend growers like the Dividend Aristocrats.

The Dividend Aristocrats – a subset of the world’s best dividend growth stocks – have outperformed the S&P 500 by 3.27% per year over the past 10 years. Clearly, there’s something special about the performance of dividend growth stocks.

Remarkably, dividend growth stocks have outperformed the broader stock market while simultaneously generating less volatility, a concept we’ll explore below.

Dividend Growth Stocks Present Less Risk Than Some Other Investments

Traditional academic finance theory would lead us to believe that one must assume additional risk to generate incremental returns. In reality, this is not the case, with dividend growth stocks being one counterexample.

As evidence, we can again use the Dividend Aristocrats – elite dividend stocks with 25+ years of consecutive dividend increases. In the table below, the performance of the S&P 500 Dividend Aristocrats Index is compared to the performance of the S&P 500 Index through the 10-year period ending November 30, 2017. 

Risk in S&P 500 Dividend Aristocrats

Source: S&P 500 Dividend Aristocrats Fact Sheet

The table shows that through the 10-year period ending November 30, 2017, the Dividend Aristocrats generated annualized volatility of 14.08% per year while the S&P 500 Index generated annualized volatility of 15.08% per year.

What does this mean for investors?

Well, the high returns and low volatility of the Dividend Aristocrats results in excellent returns on a risk-adjusted basis (which is usually measured by the Sharpe Ratio). Through the 10-year period ending November 30, 2017, the Dividend Aristocrats generated risk-adjusted returns of 0.82 while the S&P 500 Index generated risk-adjusted returns of 0.55. This is remarkable outperformance by the Dividend Aristocrats.

It is very rare to find investment opportunities that offer outsized returns with lesser risk. Accordingly, investors should consider dividend growth stocks for their next conservative investment opportunity, particularly given their ability to allow their stockholders to sleep well at night.

Dividend Growth Stocks Allow You To Sleep Well At Night

It’s hard to overstate the impact that a sound temperament can have on your long-term investing success.

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffett

With that in mind, why not make it very easy to have a stable temperament while investing? Investing in dividend growth stocks allows you to do just that because you’re so familiar with their businesses.

For evidence, consider the following: some of the most well-known dividend growth stocks include:

  • The Coca-Cola Company (KO)
  • Wal-Mart Stores (WMT)
  • PepsiCo (PEP)
  • McDonald’s Corporation (MCD)

It is highly likely that you’re intimately familiar with each of these companies from the standpoint of a consumer. As an investor, this means that you will benefit in two ways:

  • You will have a far deeper understanding of their business model than someone who exclusively reads their financial statements and annual reports
  • You’ll know whether their competitive positioning will allow them to endure through future economic recessions

The consumer familiarity of many dividend growth stocks is an unintended but important benefit to investing in these types of companies. It allows investors to sleep well at night and continually implement their investing strategy regardless of what the broader stock market is doing.

Final Thoughts 

The power of investing in dividend growth stocks comes from three main sources:

  • The long-term outperformance of dividend growth stocks, as shown through the Dividend Aristocrats Index
  • The lower volatility of dividend growth stocks, also shown through the Dividend Aristocrats Index
  • Our usual familiarity with dividend growth stocks from the perspective of a consumer, which allows us to have confidence in their long-term business success

Each of these three factors allows us to successfully implement a long-term investing strategy that takes advantage of legal capital gains deferrals, rising dividend payments, and – most importantly – the power of compound interest. Indeed, some of the world’s best investors have used time to their advantage and generated billions of dollars of wealth in the process.

“Benign neglect, bordering on sloth, remains the hallmark of our investment process.” – Warren Buffett

To sum up, dividend growth investing has three characteristics that make it uniquely suited for long-term investors, which is why we believe that dividend growth investing is the most powerful strategy for investors looking to generate long-term wealth.

Access 5i's Model Income Portfolio of the top Canadian dividend companies, by signing up for a free 30-day trial here.

You can view Nick's other dividend articles and research at:

Why Dividends Are the Most Stable Form of Total Returns

Why The Canadian Banks Make Great Dividend Stocks

5i readers interested in Nick's newsletter can also try it free here for 7 days and receive $21 off by using the discount code "21off" (5i is not compensated for this endorsement, we simply like the research and think it's of value to 5i readers).

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