In the current interest rate environment, individual investors are understandably on the hunt for income. Naturally, many of them turn to dividend investing to generate a steady stream of income, especially in retirement.
A 10-Stock DRIP Portfolio to Get Rich Slowly
However, the problem is that the way most people approach dividend investing is to fall into the yield trap. A stock that pays an above-average yield seems attractive and presumably solves the income problem. But does it?
Focusing on stocks that pay the highest current dividend yield is akin to telling a teenager to drop out of school to work flipping burgers so they can earn an income at that point in time. Wouldn’t they be better off INVESTING in their FUTURE so their income has the greatest potential to grow?
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The fact is that dividend-paying companies produce three, not two forms of return: stock price appreciation, current dividend yield, and something else far more valuable but often overlooked: the possibility of future dividend growth.
Current yields are tempting and could produce income streams in the short-term, but it’s not sustainable.
This is not an opinion, but rather a proven fact. To wit, my colleagues and I at Reality Shares looked at Bloomberg data, between 1992 and 2016 and found, on average, the companies with the highest dividend yields historically underperformed the broad equity market on a total return basis. Conversely, companies with the lowest dividend yields historically outperformed the broad equity market.
(Image credit: Getty Images)
Certainly, this data is not meant to discourage you from dividend investing, but rather, it should make you rethink your dividend investing strategy. As the following chart shows, nearly 40% of the total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding.
(Image credit: Getty Images)
This is not just a domestic phenomenon. MSCI research found dividends were the largest contributor to global equity returns, accounting for 93% of total return over the 20-year period from December 1994 through September 2015.
(Image credit: Getty Images)
Dec. 1994 through Sep. 2015. Source: MSCI. Past performance does not guarantee future results.
If you break it down further, dividend yield accounted for only 29% of total return, whereas the growth of dividends represented nearly 65% of the performance over 20 years.
(Image credit: Getty Images)
Go for the Dividend Growth
While the allure of a high-yielding stock can be attractive, investors need to remain disciplined and should instead focus on the stocks that are committed to growing dividends. Not only has the dividend growth component contributed significantly to historical total returns, but further research from Ned Davis confirms dividend growers and initiators have historically outperformed all other categories of stocks (over a span of 40+ years).
(Image credit: Getty Images)
So, what is going on here? Remember what Albert Einstein said about the power of compounding: “Compound interest is the eighth wonder of the world. He who understands it earns it . . . he who doesn't . . . pays it. Compound interest is the most powerful force in the universe.” This is the key to unlocking the magic.
But here’s what even the most ardent dividend growth investors get wrong ...
In This Case, Size Really Does Matter
The magnitude of dividend growth actually matters even more so than whether or not a stock grows its dividend. Even among all the brilliant dividend-focused investors, most people miss this. Instead of simply being satisfied with companies that grow dividends, investors should be asking how much they grow dividends.
Companies that grew their dividends the most historically outperformed the broad equity market, and those companies with little to no dividend growth actually underperformed the broad equity market (on a total return basis). The following chart illustrates how the stocks with the highest dividend growth rates have historically outperformed the S&P 500 by nearly 9%, and it emphasizes the relevance of the level of dividend growth.
(Image credit: Getty Images)
Remember that investing, for the most part, is all about the long term. Therefore, don’t worry about the low current income, and instead focus on companies that have the highest potential to grow their dividends in the future.
Dividend growth investing has historically offered investors an opportunity to outperform the market with lower volatility. Despite the popularity of dividend yield, dividend growth has been a better indicator of outperformance relative to the broad equity market, and the magnitude of dividend growth should be considered as part of a dividend investment strategy.
After running the dividend analysis numbers, here are the companies we believe are poised to raised their dividends the most (according to in-house research and our proprietary methodology, DIVCON):
- Visa (Ticker: V)
- NVIDIA (Ticker: NVDA)
- Texas Instruments (Ticker: TXN)
Click here to find out how you can identify the leading dividend growth stocks for your portfolio.
Warning Signs an Investment’s Too Good to Be True
Visit www.realityshares.com for important disclosures.
Topics
Building Wealth
