Why Dividend Growth Matters
When the market sells off, investors flock to safety. This often means defensive, dividend plays. There is a perception that when buying income-oriented equities, investors sacrifice growth. In other words, you can’t have your cake and eat it too.
Well, I’m here to tell you that you don’t have to forsake growth when looking for yield. Dividend growth investing allows investors to receive reliable passive income while maintaining alpha generating growth potential.
The Miracle of Compounding
There is a bit of an urban legend floating around that says when Albert Einstein was asked about the most powerful source in the universe, he responded by saying that “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.”
As wonderful as this quote is, I’ve yet to confirm whether or not Einstein actually said it. Regardless, the sentiment is surely correct and worthy of such a smart man, as the following chart shows:
Here’s a more practical example using Johnson and Johnson (NYSE: JNJ), which is one of the most famous dividend growth income (DGI) companies. One thousand dollars invested in JNJ shares 20 years ago would be worth $3,487.11 today. This represents an annualized rate of return (ROR) of 6.5%. When you add in the dividends received over that same period of time, we see that one’s investment is worth $4,368.79. This equates to a 7.7% ROR.
However, if an investor really fueled the compounding process by reinvesting the dividends throughout that 20-year period, their investment would be worth $5,642.37 today. That’s good for an ROR of 9.1%, which beats the 6.7% return of the S&P 500 by a wide margin.
Time is an investor’s most precious asset in the market. The earlier one starts the compounding process the better off they’ll be. The difference between compound and simple interest is that the compounded variety goes parabolic. In the case of dividend growth investing, we see that in the later years of one’s portfolio’s lifespan, yields on cost can rise to truly epic proportions.
Simply put, once a company’s market cap becomes large enough, it’s difficult to move the needle with mergers and acquisitions or research and development. Furthermore, sometimes it doesn’t make sense for companies to expand outside of their core competency. Losing focus can mean lost market share and eventually, smaller profits.
Instead, management teams often maintain their intense focus on success within their market niche and use free cash flow to reward their shareholders. This allows them to maintain their valuation multiples once growth begins to slow. This is all a part of the maturation process of a high-quality company.
It takes 25 years of consecutive annual dividend increases for a stock to become a dividend aristocrat. These aren’t exciting start-up companies. However, that doesn’t mean that their returns can’t be above average.
Some of the most popular names in the stock market today, like Apple (NSDQ: AAPL) and Starbucks (NSDQ: SBUX) have recently decided to pursue the DGI path. Now, they’re up-and-coming superstars in the dividend growth space.
For a company to have a dividend increase streak that spans multiple decades, it must not only have a generous management team, but also a strong history of operational success. Dividends can’t grow sustainably without rising earnings to match. Rising earnings are derived from sales growth, which comes from broad and persistent demand in the market inspired by constant innovation.
Sure, some of the classic dividend growth companies, like Coca-Cola (NYSE: KO), Proctor and Gamble (NYSE: PG), or Altria (NYSE: MO) seem like stodgy stock selections compared to hip technology names. However, when you look at a long-term performance chart of these companies, it doesn’t take long to realize that there’s a reason that so many investors swear by them. Their success might not make headlines, but that doesn’t make it any less significant.
I don’t take back what I said about time being an investor’s most precious asset. However, I do admit that there are two sides to that coin. In a healthy economy, we expect to see low single-digit inflation occur annually. This might not seem like much, but it does have a cumulative negative effect on your buying power.
For those who rely on passive income in retirement, the purchasing power their income stream is about all that really matters (financially speaking). This is the problem with cash stashed under a mattress or even stagnant yields on bonds or equities. Over time, inflation will win out. However, this isn’t the case for an income stream that is growing annually.
It gives me great peace of mind knowing that just about every month my portfolio generates more passive income than it did during the same period a year prior. Not only do I receive regular payments from the many dividend growth companies that I own, but they give me regular raises as well.
Over the past five years, my passive income has posted double-digit growth annually. I don’t know about you, but I certainly don’t receive such generous raises at work. The only thing better than reliable income is reliably increasing income. This is what a dividend growth strategy offers, which is why it’s my chosen path towards financial freedom.
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