The Dividend Growth Portfolio

Key Points

• A dividend is income paid out to shareholders that are owners of a company stock.
• Strong dividends are a relatively stable source of portfolio income and can be a strong indicator of the financial health of a company and are attractive to prospective shareholders.
• When investing in companies that are paying dividends, it is important not to fall into the “yield” trap where the dividend looks attractive but there are deeper issues with the company.
• GenVest prefers dividend growth companies, where the business is consistently growing its earnings- and as a result is consistently raising their dividend. 

What is a Dividend?

A dividend is a portion of a company’s earnings paid directly in the form of cash to eligible shareholders. These payments can be monthly, quarterly, or annually and all decisions in regards to dividends are controlled by the board of directors for a publicly traded company. 

In certain instances, usually after a highly profitable year or quarter, the board of directors could decide to issue a “one off/special” cash payment to shareholders inclusive of their standard dividend payments. 

You will actually need to purchase common stock shares of a company that pays a dividend in order to receive these cash payments making you a small owner in the company. Dividend payments share a similar structure to fixed interest payments made to bondholders.

Why Should Someone Invest in Companies Paying Dividends?

Investing in a company that pays a dividend can provide an investor with a reliable stream of passive income while still having the possibility of benefiting from an increase in the common stock price. This is what makes developing a Dividend Growth Portfolio an attractive and proven investment strategy historically.  

Much like fixed interest payments from bonds, common stocks that pay dividends have a yield referred to as the dividend yield. The dividend yield has an inverse relationship with the market price of the common stock. 

This is because the dividend yield is a ratio highlighting the cash flow for each dollar invested in a stock. 

Regardless of what direction the stock price might move in the market, the company will continue to make dividend payments so long as they remain financially stable or as the board of directors seems fit. 

Let’s break this down into a simple example below.

-The Home Depot Inc (HD) was paying a quarterly dividend of $1.50 which comes out to an annual dividend payment of $6.00. It has since increased, a GOOD SIGN. On 3/20/2020, HD was trading at $152.20 a share during the Covid Panic Selloff which would give you a dividend yield of 3.95%. 

Important note, your dividend yield is actually your return on investment which you can calculate by taking the annual dividend payment/ common stock price.

6.00/152.20=3.95%

 If you are building a portfolio of dividend paying stocks, chances are you have hopefully selected companies with sustainable growth rates that are financially sound and increasing their dividend annually. Not only will stocks that have a sustainable dividend growth rate protect your investments from inflation, over the long run stocks paying attractive dividends tend to appreciate in value historically.

A combination of dividend growth payments and capital appreciation (fancy way of saying common stock price increases) will be a useful tool in hedging against inflation and protecting the purchasing power of your hard earned dollars. 

What to Keep in Mind

The High Yield Trap

Investing into dividend paying stocks means you as an investor will most likely lean towards stocks with higher dividend yields or even companies paying really high dividend cash payments. This is not always wrong, but investors should be aware of high yield traps due to the inverse relationship between stock prices and dividends. 

If a company has a high dividend yield, it is important for you to check and make sure a decrease in stock price is not correlated to a negative outlook on the company’s earnings or their sector. Likewise, it is important to research and ensure a decent portion of earnings(retained earnings) are allocated into R&D to grow the company and so they can increase the dividend in the future. 

Think about it, you really are not able to grow a company if you pay out too much to shareholders at once in the form of dividends and you want the company to keep raising their dividend. You can get a good idea of this by looking at the dividend payout ratio. 

A general rule of thumb is to take a closer look at companies paying out 75% of their earnings. This does not mean you should not invest in the company, but it should warrant a bit more research. 

How Much Cash to Start?

A Dividend Growth Portfolio is best suited for those with a large amount of readily available cash. If you as an investor have between $1K-$250K, it could be more appropriate to invest your idle cash into the S&P 500, or an equity growth fund as expressed in the Blue Chip Growth Portfolio. This is entirely based upon your personal investment goals, time horizon, and risk tolerance.

A dividend portfolio is not a get rich quick strategy and could require more patience for capital appreciation but will allow you to earn dividend cash payments if you seek a passive income source. Most online discount brokers also give you the option to reinvest your dividends into your current holdings allowing you to obtain more shares of each stock position over time. 

The Portfolio Returns when dividends are reinvested have historically been superior to those when they are not. This strategy is often referred to as DRIP(Dividend Reinvestment Plan). Let Compound Growth do its thing!

Business Outlook and Diversification

Before purchasing stocks that pay dividends, it is important for you as an investor to be active and conduct sector research and conclude the business outlook is positive moving forward. This should give you comfort in knowing the industry of the company you have selected should remain stable allowing the company to make and possibly increase their dividend payments. 

It is more than just the industry outlook for the company however, it is also the company outlook that is important. 

The process of Equity Valuation is critical before selecting a company’s stock.  Likewise, it is also important to ensure your dividend portfolio is diversified across several different sectors in order to mitigate risk. 

While certain sectors such as energy and consumer staples have historically paid attractive dividends, all sectors hold dividend paying stocks and you must continue to maintain diversity in your portfolio.

Growth Story to Dividends

Companies growing their earnings way above the average market rate can only maintain this for a period of time until they along with several other competitors have saturated most of their market. This is pretty standard depending on what point a company is in their business cycle unless they are a highly innovative company that continues to grow revenue and scale their business accordingly.  

Thus, upper management or the board of directors concludes that operating profits and cash earned from the growth phase will be more rewarding to investors in the form of cash payments as opposed to fully being put into R&D. 

After the initial growth phase, this is also an attractive means by which to reward loyal shareholders and even attract more potential investors who seek passive income which can directly move the common stock price up in value over the long-term as the company grows the dividend.

Electing to pay dividends is a true indication of the strength of a company.  Their ability to increase those dividends will further justify this and also point to superior upper management. Depending upon the accounting principles used, earnings are a best estimate of a company’s quarterly profits. 

Since dividends are cash payments made to investors, they are either paid or they are not, which ensures the financial strength of the company to investors. To help with this a little bit more, check out What Dividends Tell Investors (DDM)

Conclusion

Selecting individual stocks for your dividend portfolio may seem daunting but should not stop you from starting one as you become more comfortable with investing. 

There are already several companies across different sectors of the economy you could begin to consider. Many of the names in a Blue Chip Growth Portfolio can also potentially overlap with a Dividend Growth Portfolio.

The key is to determine if the company can sustainably keep growing their earnings and as a result keep growing their dividend for shareholders. Like anything else when it comes to investing, conducting Equity Valuation is key to ensure you are purchasing the stock of a company at an attractive price.

Popular Dividend Growth Funds

1. Vanguard Dividend Appreciation ETF (VIG)
2. T. Rowe Price Dividend Growth Fund (PRDGX)
3. Schwab U.S. Dividend Equity ETF (SCHD)
4. iShares Core Dividend Growth ETF (DGRO)
5. Vanguard Dividend Growth Fund Investor Shares (VDIGX)