Dividend growth investing

Dividend growth investing is an active management style that focuses on stocks with a long history of dividend increases (e.g., ). One objective is to produce a steadily increasing income stream that is mostly immune to market fluctuations. Compared to the broader stock market, dividend growth stocks, as a group, have had higher total returns and lower volatility according to some studies (see below). This article first provides an overview of the strategy, and then explains what place it can have in portfolios for Canadian investors. The article subsequently discusses implementation, mostly focusing on stock selection. It concludes with some pros and cons of the strategy.

Income investing vs. dividend growth investing
An investor requiring high current income will select stocks with relatively high current yields to maximize tax-advantaged dividend income from the portfolio, probably with the intent to spend this income. This probably means accepting low dividend growth rates, or even no growth in dividends. Most of the return will come from the yield.

On the other hand, dividend growth investors do not necessarily need high current incomes. They attempt to pick stocks that have a reasonable, but not necessarily high, current yield, and instead focus on the anticipated long term growth in dividends. These investors are interested by long term total return. They may intend to spend the dividends during retirement.

Why focus on dividend growth?
Some investors believe that rising dividends indicate that a company's management is confident about the future. Management interviewed by Lintner in the 1950s indicated that they would only rise the company dividend if that was supported by growth in earnings per share. A company that has raised its dividend for 5, 10 or 15 consecutive years must therefore be profitable, and not strongly cyclical.

A counter argument to the "confident about the future" reasoning is that dividend growth may persist even after earnings per share stall, perhaps because managers are overconfident: "managers of more than two thirds of 145 NYSE firms responded to stalled earnings growth by increasing dividends, with most increases at least as large as the dividend increase of the peak earnings year". More generally, Benartzi et al. (1997) conclude that dividend increases are related to changes in past earnings, but do not predict future earnings increases.

Nevertheless, the stock prices of dividend growth companies, in aggregate, are less volatile that the broader market, and much less volatile than non-payers, as shown by a US study.

A UK study concluded that equally weighted dividend growth portfolios "outperformed the wider market on an equally weighted basis for 1986-2006, particularly when the minimum requirement [was] set at 10 years of continuous growth. In addition, these stocks [had] a lower variance of returns and [...] suffered smaller drawdowns over shorter durations.

Are dividends relevant?
Since 1956, dividends have contributed 30% of the total equity return of the S&P/TSX Composite index, while capital gains have contributed 70%. Yet some authors state that based on financial theory, dividends are irrelevant. A dollar paid in dividend decreases the stock price by a dollar, so the investor is no better off. And depending on tax rates, a dollar in capital gains may be preferable to a dollar in dividends.

The dividend growth strategy may instead be seen as a way to tilt a portfolio toward certain factors, by selecting companies with blue chip characteristics. According to Vanguard, the success of the dividend growth strategy in the US has been due to exposure to two factors: lower volatility and quality. Therefore, "an emphasis on these strategies therefore represents, in effect, a conviction that these factors will continue to outperform".

Place in portfolio
A concern for Canadian investors is the S&P/TSX Composite index is lack of diversification. The S&P/TSX Composite index is far less diversified than the US S&P 500 index or other foreign developed markets. The Canadian stock market is highly dependent on just three sectors: financials; energy (oil and gas); and materials (gold and mining). Therefore, an investor who purchases only Canadian equities may have insufficient sector diversification. Even though they are possibly satisfied with indexing for their US and international stocks, they may wish to replace the Canadian index, or at least complement it, with a collection of Canadian dividend growth stocks.

Other investors will want to extend their selection to US dividend growth stocks, or perhaps international dividend growth stocks as well, the easiest to purchase being those trading as American depositary receipts (ADRs). However, only Canadian stocks have a tax advantage in non-registered accounts.

Implementation
There are two ways to pursue a dividend growth strategy: (1) purchase a mutual fund or ETF; (2) stock picking. In choosing a fund or ETF, one must be comfortable with the selection criteria or investment objectives and guidelines. Some Canadian ETFs to consider are: - The Ishares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ) - The Vanguard (Canada) U.S. Dividend Appreciation Index ETF (VGG)

Numerous dividend growth ETF are listed in the US from providers such as Vanguard, Ishares, Wisdom Tree, etc. The rest of this page focuses on the stock picking approach.

Lists of “dividend achievers” and “dividends aristocrats”
A great place to start researching candidate stocks are the “dividend achievers” and “dividends aristocrats” indices. The “Aristocrats” indices are maintained by S&P whereas the “aristocrats” indices, formerly run by Mergent’s, have been purchased by Nasdaq. The index components are not always easy to find on the index providers websites, but the holdings are listed in ETF pages when an ETF is available.

For example, holdings for the CDZ are here. This list of 70 companies that "have increased ordinary cash dividends for at least 5 consecutive years" includes familiar names such as Emera (EMA), an electrical utility; BCE inc (BCE), a telco; TransCanada Corp (TRP), a pipeline; Toronto Dominion (TD), a big-5 bank; Canadian National Railway (CNR), an industrial company; and Metro (MRU), a consumer staples. It also includes some less familiar names.

Narrowing down a watch list
For most DIY investors, maintaining a portfolio of ten Canadian stocks and ten US stocks is probably enough work. (This portfolio will not be diversified enough to fully reduce risk, so it may need to be added to other holdings such as broad ETFs or index funds.) Because some individual stocks will be cheap and other will be expensive at a certain time, it is a good idea to build a watch list of say 20 Canadian companies and 20 US companies, to eventually build a portfolio of ten of each. To narrow down the watch list one can start from the “dividend achievers” and “dividends aristocrats” compilations and further screen the stocks using certain criteria. Ideally 5 to 10 years of historical data on revenues, earnings, dividends, debt, payout ratios, etc. should be compiled. Data can be found at Sedar, Morningstar, etc.

Preferences will vary between investors but here are some ideas:
 * 1) Select stocks mostly from defensive/non-cyclical sectors such as consumer staples, electrical utilities, pipelines, telcos, and to a lesser extent financials, industrials, ... This lessens the chance of future dividend cuts.
 * 2) Dividends are growing at rates as high as possible, but look sustainable based on similar growth in earnings per share (EPS) and revenue.
 * 3) No dividend cuts in the last 10 years.
 * 4) Current yield is more than 1% (or some other lower threshold) but not extremely high either (signals danger of a dividend cut).
 * 5) Payout ratio (dividend per share dividend by EPS) is no more than 50% for most sectors, maybe 70% for utilities, consistently over the last 5-10 yrs.
 * 6) For US stocks, S&P “quality ranking” of A and above.
 * 7) High levels of long term debt may be a sign of danger. Ideally LT debt normalized to (LT debt + shareholder equity) should be 50% or less.
 * 8) Return on equity (earnings divided by shareholder equity) of 15% or more.
 * 9) The business is understandable and management seems competent and prudent.

Some bloggers' selection criteria: - Our Top Criteria for Selecting Dividend Paying Stocks” - “How to select dividend stocks”

When to buy
After a watch list has been compiled, which stock(s), if any, should be purchased? Even if the intended holding period is long, buying at a low or at least reasonable price will make a difference to the total return. Simple valuation metrics such as P/E and dividend yield can help, keeping in mind that these ratios should be compared to the stock’s own history, for example the averages over five or 10 years.

When to sell
Some investors will sell dividend stocks automatically after a dividend cut. Such cuts are reported on the FWF under threads such as Dividend and Distribution Cuts – 2020.

Other reasons to sell or trim:
 * Risk control: a certain stock has gone up in price and now makes up too large a percentage of one’s total portfolio (e.g., 5%)
 * No future: after reading the latest annual report, the long term prospects of the company now look bleak, and the funds can better invested elsewhere
 * Fiscal reasons: tax loss harvesting in non-registered accounts
 * Mergers and acquisitions, where the investor does not like the results

Arguments for the strategy

 * There is an intellectual challenge (and for some people, pleasure) involved in stock picking.
 * With stock picking, the investor gets full control over his/her portfolio. Only companies that have been screened are purchased. This may be reassuring. The timing of purchases is controlled; this may increase returns.
 * More opportunities for tax loss harvesting.
 * Many stocks that are deemed suitable for dividend growth portfolios are low volatility, non-cyclical (defensive) stocks that may perform better than others in down markets (although see )– this is a sleep well factor.

Arguments against the strategy

 * The number of stocks in a typical dividend growth portfolio is too small for full diversification. There is a risk that the broad indices will perform much better in the long term and that the investor will not meet his/her objectives. According to W. Bernstein, “nonsystematic risk is only a small part of the puzzle. Fifteen stocks is not enough. Thirty is not enough. Even 200 is not enough. The only way to truly minimize the risks of stock ownership is by owning the whole market”
 * Tracking error relative to board (cap-weighted) indices. Some years the strategy will beat the index, leading to joy, but other times the strategy will lag, leading to doubt.
 * The Canadian Couch Potato blog discusses a number of “dividend myths” in a series of six posts from Part 1 to Part 6. One interesting quote from Part 2: “There is no shortage of data showing that dividend-paying stocks outperformed the overall market during many periods in the past. The problem isn't that these data are wrong, it’s simply that they are backward-looking and have no predictive value. Stocks that pay consistently high dividends over the next 20 years probably will outperform the market between now and 2031. The problem is no one has figured out how to identify those companies today.”