I’ve read a lot of comments about the potential dividend bubble for the past 12 months. Some investors are afraid to see so much money leaving bonds and money market funds to be piled into dividend paying stocks. Most investors are craving for revenue and dividend stocks are pretty much the answer to this desire… unless they continue to starve with their bonds and CDs paying less interest than I pay my kids!

 

But the fact remains: dividend investing is far more solid than a simple bubble created by a few retirees looking to receive a big fat check every month. While this investing strategy might look like flavor of the year since 2009, I can tell you it will continue to work out for decades to come.

 

Dividend Investing has Outperformed the S&P 500 Since The Very Beginning

 

You can do some research on the internet, the conclusion will always include the same fact: dividend growth stocks generate a better return than pure capital appreciation. In fact roughly 50% of the total stock market return comes from dividend payout. Trying to select pure growth stocks without dividends is like claiming you can ignore 50% of the stock market return in your portfolio.

Total Return Vs Dividend

 

But following a few case studies and buying dividend stocks for that sole reason would be a bit simplistic… even borderline stupid. It’s your money after all, are you here to make money or to gamble it on some geek studies?

 

Let’s dig deeper to see if there is a reason why dividend stocks are better than any others…

 

Dividend Payouts Require Cash Flow

 

By definition, a dividend is paid from a company’s after tax money. Therefore, the company must first generate sales, then earn sustainable profits, pay its taxes, save/invest for the future… and then pay dividends to its investors. There is no point of bleeding the company’s cash flow into dividends simply to please investors. Most companies paying a dividend because they make money and believe they will continue to do so in the upcoming years. Isn’t this the first reason why you would buy shares of a business in the first place: because your investment will generate positive future cash flow? A company paying dividends strongly believes in its ability to do so.

 

Dividend Growth Requires Profit Growth

 

Thinking that any stock paying a distribution is a good fit for your portfolio would be, here again, kind of ridiculous. There are multiple reasons to pay dividends besides having a sound balance sheet:

It may want to attract more investors, pushing the stock value higher.

It may be done to please a major investor who wants its money back.

The management might have overestimated their capacity to growth their business in the future.

The management might have underestimated competition.

Since picking just any stock with a dividend yield is not sound investing practice, the second step would be to pick a stock with a positive dividend growth for at least five years. You can become quite picky and require stocks with up to 25 consecutive years of dividend growth. They are called the Dividend Aristocrats.

 

A constant dividend growth requires, by definition, a constantly growing profit. Therefore, if you pick a company that increases its dividend payouts by 5% for the past 10, 15 or 25 years, chances are its profits are following the same trend. I’m asking you once again: wouldn’t you like to buy a company that believes whole-heartedly in its ability to generate future positive cash flows PLUS showing a strong history of profit growth? We are getting closer to what any investor would call a “perfect investment”, right?

Profit Growth Requires Sales Growth

 

It is true that a company could cut its costs for a few years and generate profit growth this way. This is a good solution to cut fat but management must make sure it doesn’t cut too much and jeopardize future growth.

 

This is why I like to combine both sales and earnings per share on the same graph. I want to make sure that both are on an uptrend. A company making more profit but showing a slowdown in sales or, worse, a decline will lift a red flag. On the other hand, a company with both sales and profits going up will definitely lead to more dividend growth in the future. This is how you can beat the market.

 

Here’s McDonald’s (MCD) example where sales, profits and dividends are growing while the payout ratio is decreasing (due to a bad year in 2008 where the payout ratio was much higher than previous years).

 

MCD Dividend

Sales Growth Requires Competitive Advantage

 

What’s the best reason why a company’s sales grow? The company has a competitive advantage. It can be a total leadership in its market, new innovative products, better locations, better process, strong branding, etc, etc, etc.

 

A company without a competitive advantage can’t really push its sales higher over several years. It will rapidly hit the ceiling and will have to cut on their costs to increase its profit. It will eventually hit them as you can’t continue to grow simply by cutting costs.

 

By selecting a dividend growth stock, you select a company with strong cash flows coming from increasing profits generated from more sales. Sales growth is often linked to a competitive advantage. Aren’t we drawing the picture of a perfect company for any investor by now?

 

Investing in Companies with Competitive Advantage is the Key in Becoming a Successful Investor

 

Regardless of your investment strategy, you will be investing for several years. Most investors have money allocated to investments for more than ten years. If you don’t want your face pressed up against your trading screen for the next ten years, you might want to select a more passive investing approach than day trading.

 

The best way to become a successful investor for the next decade is to find companies with competitive advantage. It is sometimes hard to define what kind of advantage is sustainable or not. This is why I focus on dividend growth stocks to make sure I pick businesses with all the qualities mentioned in this article.

 

With simple filters like dividend growth, dividend payouts, earnings per share and sales growth, you can easily find strong companies with a competitive advantage.

 

No need to do extensive research to know if a company is coming with “the next big thing”.

No need to hope for a homerun with your next pick; most of your stocks will be singles or doubles with dividends.

 

No need to track your portfolio on a daily basis, dividend investing is meant for the long term.

 

When you think about it, dividend stocks beat the overall market in general simply because they are rewarded by investors for their sustainable business model. A model allowing them to pay dividends for years.

 

A Word of Caution – Not All Dividend Stocks Were Created Equal

 

It’s not because a company shows strong dividend metrics that it is automatically a buy. For example, Radio Shack (RSH) was showing strong dividend metrics not so long ago and everything collapsed rapidly since their business model wasn’t a great match for today’s economy.

 

It is important to design a strong dividend growth model approach before picking anything from your filtered list. Don’t forget there are Dividend Traps to avoid!

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10 Comments   |  

10 Comments

June 17, 2013, 2:01 pm

Hi Dividend Guy,

Always great to get a historic perspective on dividend investing. It has indeed always been a gentleman’s way of investing money, and it is still as valid today as it was in the ’20s!

Could you tell me where you got those data of your first graph? Thanks!

Matt
The Dividend Theory

Mike
June 17, 2013, 2:32 pm

Hey Matt,

I think I’ve taken it from JP Morgan… I’ll check it out. I’ve completely forgot to link to the credit source!

June 17, 2013, 7:00 pm

All excellent points. You have to do a lot of things right to pay and grow dividend payouts.

June 18, 2013, 5:28 am

One of my favorite aspects of dividend growth investing is that dividends are always positive. Once they are paid out to you, they can’t be taken back by corporate mismanagement or by market volatility.

Mike
June 18, 2013, 1:16 pm

@My Financial Journey,

you are so right! seeing cash in my broker account is recomforting :-)

June 18, 2013, 3:44 pm

“One of my favorite aspects of dividend growth investing is that dividends are always positive. Once they are paid out to you, they can’t be taken back by corporate mismanagement or by market volatility.”

Unless you (like I and most others) reinvest the dividends without even thinking about it

June 18, 2013, 7:17 pm

Great post!

It takes a high quality company to pay out cash dividends for decades on end, and then regularly raise those cash payouts to investors. You can’t make up cash and it’s not an accounting trick. Cash is cash, and that’s why I love dividend growth investing.

Also, dividends are completely independent from Mr. Market’s volatility. You don’t need to rely on, or necessarily worry about, the underlying asset prices when you’re getting monthly checks to reinvest or live off of. The capital gains will come eventually, but there’s a lot less worry and fear involved when you’re regularly getting cash payouts. This eliminates a lot of the emotional reactions that turns paper losses into realized losses.

Best wishes!

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