Investing in stocks with growing dividends is a proven strategy to build wealth. The method also works well to preserve wealth. If you have a sum of money you want to grow over the next five to 10 years, putting that capital to work with a portfolio of increasing dividend stocks will get you a long way towards achieving and hitting your financial goals.
I am not alone in recommending dividend growth as a path to build wealth. A couple of years ago, I attended a cocktail hour sponsored by Charles Schwab, where the purpose of the get together was for investors to meet money managers from the Schwab Advisor Network. I chatted with a couple of dozen managers there, and I was pleasantly surprised that the majority favored dividend growth investing as a primary way to preserve and grow client wealth.
The concept behind dividend growth investing is simple. If a company increases its dividend every year, for the dividend yield to stay level, the share price must appreciate matching the rate of dividend growth. A quick math example, if stock XYZ yields 4% and the company grows the dividend by 6% per year, the average annual return, over a period of years, will be the 4% plus 6%, or 10% compounding average annual total returns.
Returns from dividend growth investing will not be linear. Over the short to intermediate-term, stock prices of dividend stocks will follow the market cycle of up and downtrends. Yet, when you calculate longer term, five to 10 years or longer, total returns, what you earn from dividend growth stocks will end up very close to an annual compound growth rate equal to the average yield plus yearly average dividend growth.
In a nutshell, the dividend growth strategy for above-average total returns is simple to understand, and it works. The challenge comes with the large amount of research required to build a portfolio of dividend growth stocks.
For example, out of the 500 companies that are components of the S&P 500 index, 386 currently pay dividends. The S&P 500 accounts for about 10% of the total number of stocks trading on the U.S. stock exchange, so you can see the number of dividend-paying stocks climbs into the thousands. The first step to dividend growth investing requires you to start a list of dividend-paying stocks, listing current yields, and current dividend growth rates.
With a list of dividend growth stocks, the next step is to rank them by return potential. Initially, that potential will be the yield plus dividend growth formula. Once you have a list of stocks in which you might want to invest, it is time to analyze the businesses focusing on cash flow growth to sustain the dividend growth.
You can find dividend growth stock recommendations in the financial press. These articles typically point you towards popular stocks such as McDonald’s Corp. (MCD), Procter & Gamble (PG), and Visa, Inc (V). The problem with these stocks is that the popularity leads to low current yields combined with moderate dividend growth. These stocks will build wealth, but it will happen slowly. If you have a 30-year time frame, load up on blue-chip dividend growth stocks. If your time frame is more like five to 10 years, you need to dig deeper to find stocks that are less well known and that have higher return prospects.
My suggestion for getting started is to do enough research to find 15 to 20 attractive dividend growth prospect stocks. Buy these stocks to get your growth-focused portfolio off the ground. Continue to research and look for dividend growth investment prospects, and when you find one that looks better than what you own, replace one of your current holdings. This way, your research lets you continuously upgrade the return prospects of your portfolio.
There are attractive dividend growth stocks in every sector of the stock market. It would help if you strived to diversify your 15 to 20 stock portfolio across as many industries as possible. In my dividend growth focused service, the portfolio includes a drug manufacturer, investment management companies, banks, a public utility, REITs, and energy companies.
While there are dividend growth stocks in every stock market industry, there are a few sectors where dividend growth is more prevalent. Here are some types of stocks to check out first.
Equity real estate investment trusts (REITs) own commercial properties, and under the REIT rules, a company must payout at least 90% of net income as dividends. For dividend growth, there are specific sectors on which to focus. These are data center REITs, cell tower REITs, self-storage REITs, and industrial (warehouse) REITs.
Utility stocks are well-known for paying steady and growing dividends. Total returns from utilities won’t get you excited, but the stability through the full stock market cycle will. Closely related to the utilities are the Yieldco companies. The typical Yieldco owns a portfolio of renewable energy assets such as wind farms and large solar panel arrays. With most Yieldco stocks, you get both an attractive current yield and above-average dividend growth.
The financial sector has its share of dividend growth stocks. Subsectors to check out include regional banks, large life insurance companies, and money management firms.