I am a dividend growth investor, and I am excited to explain a strategy that has helped me achieve financial independence.
This style of stock investing can provide retirement income to live on, and investing in stocks (rather than bonds) makes capital gains highly likely over the long haul.
What Is Dividend Growth Investing?
There are many ways to invest, and investors choose how they want to do it. Dividend growth investing is a strategy to invest by building, managing, and profiting from a portfolio of dividend growth stocks.
There are hundreds of companies that have raised their dividends every year for 5 years, 10 years, or longer. You may be surprised that some companies have ongoing, active streaks of annual dividend increases that have surpassed 50 years (known as dividend kings).
Dividends may be a little obscure to some investors, but they are simple to explain and understand.
Dividends are cash payments that a company sends to its shareholders.
Not every company pays dividends, but many do. For example, per CNBC, around 400 stocks in the S&P 500 pay dividends.
If they not only pay dividends, but raise them regularly, such stocks are candidates for a dividend growth portfolio.
How Does Dividend Growth Investing Work?
In dividend growth investing, the investor:
Identifies dividend growth stocks
Analyzes them to decide which ones to buy
Buys and accumulates the best ones
Collects dividends and decides what to do with them
Manages the portfolio
That’s it. A virtuous circle of five straightforward steps.
I believe in treating personal finance in a businesslike fashion. Here is my business model as a dividend growth investor:
Identify, accumulate, and manage a portfolio of high-quality stocks that reliably send growing dividends to headquarters.
"Headquarters" is my house.
This investing model allows me to collect income while I sleep. Better still, over time (and almost without fail) the income grows.
Even though income is prioritized, it is not the only attraction of dividend growth investing.
If the investor follows the business model reasonably well, the total value of the portfolio will generally rise over time, because that is what high-quality stocks historically do over long periods: They go up in price.
As seen below, snack and beverage giant PepsiCo's (PEP) stock price has tracked the company’s dividends higher over time, more than quadrupling since 1999.
Over short periods, of course, there are stretches where stock prices go down or stay flat. The market introduces price risk, so it is not guaranteed that the portfolio’s value will rise over time.
But when it comes to dividend growth, we do not have to hedge very much about the outcome.
With a portfolio of reliable dividend growth stocks, it is almost certain that the dividend income will rise every year.
Even if a few stocks in such a portfolio cut or freeze their dividends from time to time, the majority will increase their dividends enough to make the overall dividend stream rise on a near-continual basis.
That has been my experience in real life investing.
It is also the record of our three model portfolios (learn more about Simply Safe Dividends here), each of which has raised its dividend every year since their inceptions in 2015. The stock market fell in 2015, 2018, and 2022, but the dividend stream for each model portfolio went up.
Why Do Dividends Rise Over Time?
As shown in the display below, there are three reasons that the income from a dividend growth portfolio generally goes up.
1. Stocks increase their dividends
I mentioned earlier that there are hundreds of stocks that have raised their dividends for many years in a row. Here is an iconic example, PepsiCo (PEP).
Pepsi has increased its dividend for the past 50 years in a row. It has not skipped a year for half of a century. (Disclosure: I own PepsiCo shares.)
Dividend increases are controlled by the company. In that sense, the income is passive for you. Your only involvement was to buy the shares. For this reason, dividend income is often referred to as "passive income."
2. You reinvest the dividends
If you don’t need the dividend income right away, you can save or reinvest it. This often applies to younger investors who are building wealth and income for retirement.
Dividends are paid per share, so if you buy more shares in any dividend growth company, that will cause more dividend dollars to be sent to your account when those companies pay next time.
This process will result in compound growth in the dividend stream.
Compounding is sort of like money going viral. Compounding causes your income to grow at an exponential rate. In plain English, your income line not only rises each year, but it also curves upward faster and faster with each passing year.
The following graph illustrates dividend growth for a hypothetical stock – the stock yields 3% and raises its dividend 5% annually over 25 years.
The orange line shows income growth if the dividends are reinvested back into the stock. The blue line shows the income growth from the 5% increases alone, without reinvesting them.
Both lines start at 3%, which is the stock’s original yield. By Year 25, the reinvestor receives 19% of the original investment amount as that year’s dividend payout. The blue line shows that without reinvestment, the payment in Year 25 is about half that.
The difference between reinvesting and not reinvesting starts right away, but the gap really becomes dramatic around Year 11 and thereafter.
3. You adjust the portfolio
While dividend growth investors tend not to trade very much, most monitor and occasionally change their portfolios.
Sometimes, those changes increase the income. For example, say that a stock has risen "too high" in price. You might decide to trim it and substitute a stock with a more reasonable valuation and better yield.
That accomplishes two things:
It locks in some capital gains, turning them from "paper profits" into real profits.
Since you move the money into a stock with a better current yield, the income generated by that money goes up.
The point is that – in addition to the income growth from dividend increases and dividend reinvestment, you can sometimes manufacture further growth through simple portfolio management.
Pros and Cons of Dividend Growth Investing
Here are some positive aspects of dividend growth investing:
1. Growing dividends provide a reliable, increasing stream of income. This can be important, for example, to a retiree who wishes to use the income for living expenses. The dividends replace their former paycheck.
2. Dividends always provide a positive return, even when stock prices are going down. There is no such thing as a negative dividend.
3. Dividend payments provide a cushion to offset price declines. It is common for your dividend stream to go up even when the market goes down.
4. Dividends are far more reliable and predictable than stock prices. For investors living off dividends, this can make for less stress compared to a withdrawal strategy that relies on selling shares.
5. Dividend stocks offer the potential for price appreciation in addition to the dividends they pay. Dividend investors receive total returns just as other investors do. A well-diversified dividend portfolio should keep pace with the broader stock market over time.
6. You do not have to sell shares to access your companies’ profits. You retain all your shares even as your companies send some of their profits to you in the form of dividends.
7. If reinvested, dividends compound and grow faster than the dividend increases paid by the companies. That is because you purchase more shares, which then add to the dividends you receive.
8. Dividends are independent from the stock market. Companies pay dividends directly to shareholders; the market has nothing to do with the process.
9. Because dividends are independent from the market, the investor can ignore investing "noise." Shareholders are, in a sense, set free from constant concern about the stock’s price.
10. Dividend growth investors, being insulated from short-term price noise, are less likely to sell their shares in response to short-term difficulties. Indeed, many of us see price drops as good news, because they lower the prices on stocks that we want to buy.
And here are some negative aspects about dividend growth investing:
1.Dividend growth stocks, being traded on the open market, are subject to price risk. They can and do lose value in bear markets and downturns.
Fortunately, many dividend growth stocks have low price volatility compared to the average stock, so they tend to decline less in a downturn. We can see this for PepsiCo.
The 0.50 value for beta (circled) means that Pepsi’s price changes, on average, only half as fast as the average stock in the market.
This relationship held up during the 2007-09 financial crisis. While the S&P 500 lost 55% during this period, Pepsi shares fell only 35%.
2. A company can freeze, cut, or eliminate its dividend at any time. Dividends are not guaranteed. That is why we provide Dividend Safety Scores™ to help identify the safest dividend companies. Pepsi’s score of 93, seen above, means that its dividend is Very Safe and unlikely to be cut.
3. Outside of general market downturns, any individual company can suffer price setbacks no matter what the market is doing overall. All companies are subject to idiosyncratic risks associated with their particular sector, industry, or company conditions.
4. Many of the best dividend growth companies have passed their fastest growth stage. Therefore, when the whole market rallies, dividend growth companies do not usually lead the charge.
Dividend growth companies typically participate in general market upswings, but the price growth of leading-edge companies usually surpasses that of dividend growth companies during such rallies.
Of course, if you hold your dividend stocks in a tax-deferred account, such as a 401(k) or an IRA, the normal tax benefits of such accounts apply to the dividends.
6. Investors looking for a quick score in the market are probably going to be dissatisfied with the dividend growth strategy. Dividend growth investing works best for investors who invest for long term results.
This article is a broad introduction to dividend growth investing.
Dividend growth investing occupies a middle ground between "pure" income investing and investing primarily for growth in stock prices.
Dividend growth investing offers both reliable, growing income along with an opportunity to participate in the wealth-building that can come from owning shares of some of the strongest, most excellent companies available.
I encourage you to read other articles in our World of Dividends library, where we cover not only broad strategies and principles, but also specific ideas, stock research, and market commentary.