So often, I discuss why I believe that dividend growth investing is the best, the simplest, the easiest, and the most stress free path to take along the journey towards financial freedom; yet, I realize that it’s been awhile since I’ve covered the “how” in regard to accumulating the dividend growth stocks that will build a reliably increasing passive income stream.
This is mainly because there isn’t a clear cut how-to guide to proper dividend growth investing.
There are certainly many ways to skin this cat. With regard to asset allocation (how diversified you choose to be), whether or not you prioritize yield or growth (which will likely have to do with things like your investing time horizon, your lifestyle’s expenses, your asset base, and your savings rate), and what your risk tolerances (which will determine which types of equities that you own).
So, unfortunately, I can’t provide a quick and easy, step-by-step guide on how to build a wonderful passive income stream here in this piece. There are simply too many variables at play. However, I do hope to provide a nice jumping point for the DGI journey regarding the most important things that investors need to consider.
The way I see it, constructing a dividend growth portfolio is a bit of an art and a bit of a science. Fundamentals remain incredibly important at all times; however, there’s always a balancing act going on between things like quality versus value, and what’s a reasonable premium to pay for varying growth prospects. What’s more, acceptable multiples and premiums are going to vary from sector to sector and from industry to industry, which adds another layer of complexity into the equation.
But, the good news is, I do believe there are a handful of useful metrics and trends that dividend growth investors should be familiar with, regardless of what type of equity they’re looking at during the accumulation process, which will not only help to reduce risk and booster return potential, but most importantly, ensure that long-term dividend growth prospects remain robust.
First and foremost, when looking for companies likely to generate reliable dividend growth, I start by looking at just that: dividend growth.
While it’s true that the past cannot be used to accurately predict the future, I do believe that a company’s historical generosity in regard to returning cash flows to shareholders is a great screen to use to whittle down one’s watch list.
There are hundreds of high quality companies in the market, which can be very daunting for those looking to begin single-stock investing. We have to narrow down our scope somehow and using proven dividend growth trends, whether that be 5-years, 10-years, 15-years, 20-years, etc, is a great way to do so.
To me, the best source for tracking historic dividend growth streaks is the Dividend Champions List. This is a free service we offer at Wide Moat Research. To sign up, you can click the link below!
Personally, the dividend growth streak threshold I like to use is 13 years. What this number means is that a company came into the Great Recession in 2008/2009 with a dividend growth streak and was able to maintain it through what may have been the worst financial crisis of our lifetimes.
What’s more, during that 13-year period, stocks that have maintained their dividend growth have cleared other hurdles related to the Fed’s monetary policy changes, geopolitical concerns, several different political administrations in the U.S. and their respective legislative victories (which have the potential to disrupt the competitive landscape in the private sector), and most recently, the COVID-19 pandemic which appears to be a once in a century type of biological event.
I should note that from time to time I’ll invest in companies that have dividend growth streaks shorter than 13 years (for instance, I own shares of a handful of blue chip technology companies that didn’t mature to the point where they began paying dividends until after the Great Recession).
The fact is, rules are meant to be broken and I don’t think a dividend growth threshold should be viewed as a concrete barrier during the due diligence process. But in general, I’m able to sleep well at night knowing that the companies I own have survived the last 2 recessions (2008/09 and 2020) with their dividend growth streaks intact, and this SWAN-type of investing is one of my highest priorities (life is stressful enough, I don’t think it makes sense to add more worries to one’s docket).
So, once I’ve established whether or not a management team is both generous and conservative enough to maintain sustainable shareholder returns over the long-term, I move onto the fundamentals.
At the end of the day, it doesn’t matter how generous a C-suite/Board of Directors is if a company doesn’t generate cash to return to its shareholder base.
With regard to fundamental analysis at a high level, when it comes to picking and choosing high quality dividend growth stocks, I think that investors need to start at the top.
What I mean is the top-line, or in other words, revenues.
Simply put, if a company is not able to generate reliable revenue growth over time, they’re likely not going to be able to pay a reliable growing dividend.
What’s more, I view strong revenue growth trends as a great way to track the width of a given company’s moat. Revenue growth equates to strong demand.
And, generally speaking, outsized demand for products/services implies a strong market position, which is the first step towards developing a defensible moat.
It’s true that dividend safety is generally gauged with various bottom-line, or profit related metrics. However, things like earnings-per-share (which tends to be the go-to metric income oriented investors track) can be manipulated by smart management and accounting teams with financial engineering measures (especially over short periods of time).
But, sales growth doesn’t lie.
Given the assumption that reliable sales growth equals strong demand, I believe it’s reasonable to also assume that margins are going to be strong (and increase over time). Therefore, the trickle down effect of strong revenues is likely to result in dividend safety and sustainable dividend growth as well.
Granted, while I start with sales growth, I certainly don’t ignore the bottom-line.
Sales growth is a key metric for tracking the viability of dividend growth moving forward. And, dividend growth remains my primary concern because of the fact that if I can determine dividend growth is likely, then I don’t have to worry about dividend safety (obviously an unsafe dividend is not going to be able to portray sustainable dividend growth prospects).
However, as a part of my due diligence process, I certainly don’t ignore bottom-line metrics. Simply put, if a company’s earnings and/or cash flows don’t cover its dividend, I am not going to invest in it – or, at least not as a dividend growth investment.
There is certainly money to be made making contrarian, deep value bets; however, that’s not the topic of discussion with today’s article.
Once I establish that a company has what it takes to grow its dividend due to strong operational success, I immediately move along to its balance sheet.
When it comes to predicting long-term dividend growth prospects, investors end up placing a lot of faith in management teams and their ability to continue to produce results that enable sustainable dividend growth.
That’s because it’s nearly impossible to accurately forecast sales, earnings, cash flows, etc, out more than a year or two (there are too many variables at play for long-term projections to be consistently accurate).
In short, we’re balancing speculation with trust in talent. Equities are risk assets, owning them involves speculation, and this is unavoidable. But, I think that a management team’s stewardship of its balance sheet can say a lot about their ability to help me meet my long-term goals.
It’s not just about trust in talent. The fact is, high levels of debt and the interest rate expenses associated with it are going to take away from a company’s ability to sustainably pay out growing dividends to shareholders.
In a similar vein, I also look at trends with regard to outstanding share counts. High interest rate expenses make paying growing dividends difficult over time. So does share count dilution (the more outstanding shares a company has, the more dividend payments it has to make).
With that in mind, I generally look to own companies that have shown a proven ability to reduce their share counts over time.
I know many income oriented investors are displeased when they see management using cash flows to repurchase shares, but the way I see it, a regularly falling share count plays a role in sustainable dividend growth prospects over the long-term.
And finally, after I make sure that a company checks the conservative balance sheet boxes, I begin to compare its performance to its peers.
So much of succeeding in the market is owning best-in-breed stocks.
If you can get ahold of blue chips at discounted valuations, that’s great. If you’re able to capitalize on situations where the highest quality stocks sell off to irrationally low prices, then you’re likely going to really accelerate your journey towards financial freedom. However, I don’t think waiting for steep discounts is necessary for success when you’re talking about best-in-breed companies because of their knack for posting reliable growth.
Simply put, time in the market is more important than timing the market.
I don’t think investors should make a habit of knowingly overpaying for stocks, regardless of how high their quality may be, but if you’re able to buy shares of the best companies in the world when they’re fairly valued, you will likely outperform the market.
So, getting back to peer/industry comparisons – I’m able to use these comparative metrics to ensure that I am accumulating shares of the best companies who are winning their respective competitions.
We all want to partner with winners, right?
I want to own the companies with the best recent growth results, the highest margins, the lowest debt, and the fastest growth prospects. Rarely does a single company in an industry come in first place in all of these metrics, and therefore, you’re going to have to prioritize which ones are most important to you when attempting to determine winners and losers (this gets back to the idea that too many variables are at play for there to be an optimized formula for investing). But, in general, when taking a look at industry peer groups there are obvious leaders, and these are the stocks I want to own.
I hope this article has provided useful food for thought. And, if you liked this discussion, I invite you to check out The Intelligent Dividend Investor, a monthly newsletter service I run here at Wide Moat research, which is 100% focused on building a dividend growth portfolio composed of the best of the best stocks in the market. This focus on quality meant that during the COVID-19 recession in 2020, the IDI portfolio maintained a perfect dividend growth record. The way I see it, if we can generate reliable passive income during a once-in-a hundred-year pandemic, then we are likely to achieve success in whatever economic environments the future has to throw at us. As a part of an IDI subscription, you not only receive a monthly newsletter, but can also access the actively managed portfolio, weekly portfolio updates, and real-time trade alerts – all for $79.99/year, which is a small price to pay to sleep well at night with your investments.
Nicholas Ward is a research analyst who currently writes for Seeking Alpha, The Dividend Kings, iREIT, and Forbes Real Estate Investor. Before that, he was Founder and Editor-in-Chief of The Dividend Growth Club, as well as the Income Minded Millennial. Nicholas has also contributed to Sure Dividend, Investing Daily, and The Street, where he covered stocks in Jim Cramer's Action Alerts PLUS Portfolio.
Nicholas holds a bachelor of arts from The University of Virginia, where he studied English and studio art. Prior to transitioning into the financial industry, he managed a vineyard in the foothills of the Blue Ridge Mountains.