Portfolios of high quality dividend growth stocks have fulfilled the need for a steady, sustainable and rising stream of income capable of keeping pace with inflation for decades. This is especially appealing of course for those who are building a portfolio of investments to sustain them for decades in retirement.
The income from dividend growth stocks has the potential to continually rise from original dividend amounts over time as dividends are increased. In addition, dividend growth stocks may provide added portfolio stability and the potential to gain in value over time.
Dividend Growth Stocks Tend to Have Sustainable Competitive Advantages
To understand dividend growth stocks, let’s look at the companies behind them. These businesses tend to sell things that people will continue to buy throughout the economic cycle.
No matter how bad things might get, you probably won’t stop brushing your teeth, using dish soap or feeding your pets. The business result is remarkable for a firm like Colgate Palmolive, which sells soaps, toothpaste and pet food, and has paid uninterrupted dividends on its common stock since 1895 and increased payments to common shareholders every year for the past 59 years.
Dividend growers tend to have competitive advantages such as product leadership, dominant brands, operational excellence or customer intimacy. All of that translates into pricing power, which helps the companies to maintain profit margins, boost revenues and pay growing dividends.
By the way, the quality and stability of their earnings make dividend growers especially desirable in the eyes of investors, which tend to help make their share prices less volatile than those of other companies. As a result, the prices of these stocks tend to move more steadily and gradually rather than swinging dramatically. And that can help smooth out portfolio performance.
Dividend growth companies also tend to be well managed, demonstrating a capacity to generate more consistent free cash flow. This cash allows management to invest in growing their businesses, even as they pay rising dividends.
Share Price Appreciation Tends to Follow Consistent Dividend Growth Stocks
Historically, consistent dividend growth has also been associated with solid stock price appreciation. As a company’s dividends rise, the market bids up the price of its stock to reflect the additional income. This relationship was evident as PepsiCo’s (PEP) dividend increased every year from 2000 through 2021.
In 2000, PEP paid a $0.135 per share dividend. By 2021, PEP was paying $1.075 per share in dividends (a 10.4% compound annual dividend growth rate). Meanwhile, PEP’s stock price rose from $35.25 to $172.67 over the same period (a 7.9% compound annual share-price growth rate). The total annual compound rate of return for a share of PepsiCo stock for the 21-year period totaled 10.2%.
One common characteristic of dividend growth companies’ consistent moderate growth and steady earnings is that they’re rarely cheap. After all, investors know these companies well and are almost always interested in owning them. If a company’s prospects remain in tact and shares are priced at fair value, however, we believe a continuation of a company’s historical record of generating rising free cash flow over the long term will make them a sound investment.
While dividend growth stocks are a good fit for many kinds of investors, they are particularly attractive for retirees, who need to generate a long-term rising income to combat a long-term rising cost of living. Dividends for the S&P 500 as a whole have historically risen an average of 5.7% per year, about 1.7 % more than 4% average inflation over the past 50 years.
Dividend growth investing may be an important strategy to pursue for retirees seeking rising retirement income and stable returns. Bonds also remain an important portfolio component for income and stability for many investors. But until recently, bonds have paid paying extraordinarily low yields as a result of the rock-bottom interest rates for the past 15 years. And bonds are not without meaningful price risk when interest rates rise, as we have witnessed this year. As rates rise, the values of outstanding bonds will fall, dealing a potentially serious blow to investors’ capital.
Meanwhile, alternative strategies like hedge funds and absolute-return funds produce little if any income that can be distributed to investors. This is due in part to their high fees. It’s not unusual for hedge funds to charge a 2% management fee, plus a 20% performance fee. Even when alternative strategies are available in a mutual fund form, their expenses are typically well above those of the average mutual fund. The complexity of these funds also exposes investors to significant new risks.
If you would like help building a portfolio of high quality dividend growth stocks with an income yield that’s higher than the S&P 500 currently offers, and with better dividend growth prospects, as part of your retirement income strategy, we may be able to help. Contact us.
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Information on this website is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. References to specific securities are made for the sole purpose of explaining investment strategies and investment concepts. They should not be construed as past or current recommendations of our firm.