Saturday, July 19, 2014

Why Dividend Growth Investing Is Such A Robust Investment Strategy For Those Seeking Early Financial Independence

I first started investing back in January 2010. I had NO IDEA what I was doing. I deposited $5,000 into my brand-new Scottrade account and got busy right away. I honestly don’t know what came over me, because I’m typically the type of person that researches a subject for countless hours before initiating activity; I’m not particularly spontaneous.
But I guess I was just so excited to get my journey to financial independence started. I was reading books like Your Money or Your Life and I was raring to go.
After stumbling out of the gate and feeling a bit lost, I sold everything I had bought and started over again. I figured if I wanted to be a successful investor, I should read about other successful investors. This of course led me to Warren Buffett and the idea of buying great businesses, focusing on value rather than price, and thinking like an owner. This was revolutionary to me and I’ve been investing with this knowledge in mind ever since.
It was during this time of early research, however, that I formed what would ultimately be the same strategy I use today. And that strategy is investing in high-quality dividend growth stocks. That basically means I take any excess capital I have left over after paying for expenses and purchase equity in great businesses that consistently post rising profits, and even better consistently share a piece of those rising profits with shareholders in the form of regular and increasing dividends.
So if you’re after financial independence at a relatively young age, I implore you to discover why dividend growth investing is such a fantastic investment strategy toward that end as I describe below.

Dividend Income Is Passive

One fundamental benefit of dividend growth investing is that dividend income is about as passive as it gets. Sure, there’s the initial “work” involved in analyzing and valuing stocks, although I don’t really find this work at all. But once you own a chunk of a company, that chunk of ownership (the shares you own) could potentially pay out more and more income for the rest of your ownership experience, assuming the company remains increasingly profitable. And this income will come your way no matter what you do.
All you have to do is wake up and you’ll automatically get paid. In fact, you could just stay in bed and not wake up if that’s your thing. It doesn’t really matter. What matters is that once you own a piece of a business that pays rising dividends, you’re a partial owner and you’ll receive your rightful portion of those rising profits. And this process is passive.
This is one huge reason I love dividend growth investing. When I’m financially independent I want to be able to focus on whatever it is I’m enjoying at the time: reading, writing, traveling, spending time with family, relaxing, or volunteering. Passive income gives me the opportunity to focus on the things I enjoy rather than constantly generating income. It’s exactly because income usually requires work on one’s part that many of us are seeking financial independence in the first place. We can cut the work out of the equation and still earn income. And this is why passive income makes so much sense.
I could have easily pursued a strategy of investing in rental properties or I could have tried to buy some local franchise or something else. But I don’t want to have to continue actively working for my income when I’m too busy enjoying life. If I want to work, then so be it and I will. But having to and wanting toare very, very different.

Acts As A Filter

I’ve found that most of the companies with particularly lengthy dividend growth streaks – at least 20 years – are able to grow dividends for decades on end because they’re wildly profitable. By honing in on dividend growth stocks you’re automatically filtering out most of the garbage out there. I’m not saying that stocks that do not pay a dividend are garbage, but rather you’re limiting your chances of picking up a dud of a stock by focusing on stocks that are able to increase both profits and dividends for long periods of time.
There’s thousands of publicly traded stocks out there. But, according to David Fish’s Dividend Champions, Contenders, and Challengers document, there’s only 543 businesses out there that have been able to raise their dividends for at least five consecutive years. Of that, only 106 have raised their dividend for 25 or more consecutive years. So you’re taking thousands of stocks out there and condensing that down into a few hundred or so. That makes research much more manageable.

Dividend Growth Comes From Profit Growth

And that filtering process brings me to my next point.
You simply cannot grow a dividend for long periods of time without being able to sustain these rising payouts to shareholders with rising profit.
Think about that. Let’s say you own a local business. It could be anything. Let’s say it’s a restaurant. And let’s assume you have some investors that fronted you some capital for equity in your new restaurant. And these partial owners want regular dividends on their investment. Even worse, they want more and more money as time goes on. These investors are greedy!
Well, if you’re not growing this business where does this cash come from? From the magical money tree out back? Nope. Typically, you have two choices: You can either tell these partial owners that you have no money to give them, or you can go out and borrow the capital necessary to pay these investors. But that will only work for so long, as you now have both debt and equity holders after a piece of the cash flow. Eventually, the balance sheet of the business is stressed and nobody will lend you any more money.
Think about what it takes to not only pay shareholders a dividend, but the kind of business that can pay more and more capital to shareholders for decades on end. That means the business is out there just dominating. You simply cannot pay and grow dividends for decades on end if the profit growth isn’t also there. So by focusing on growing dividends, you’ll naturally find yourself focusing on profit growth. Because with no profit growth you’ll eventually stop seeing dividend raises.
Dividends are the “proof in the pudding”, if you will. It proves the cash flow is there. You can’t pay dividends with cash that isn’t really there, at least not for long. And a dividend raise means management is confident about business operations going forward. Decades of dividend raises means management has been correct, and business operations are indeed solid.
Furthermore, the commitment of capital to shareholders in the form of rising dividends not only forces a company to grow, but also forces management to make prudent decisions with the capital left over. When a company is sending out a fairly significant portion of profit to the owners, the money left over has to be used wisely in order to maximize efficiency and return on equity. This creates a culture of good decision making for management, which bodes well for shareholders.

Income Versus Expenses

One of my favorite concepts from Your Money or Your Life is what the book described as a wall chart where you plot your investment income against your expenses. At some point in the future, dependent on your expenses and the passive income you’re able to build, you hit what’s called the “Crossover Point”, which is where investment income exceeds expenses and you’re essentially financially independent.
But what makes dividend growth investing so robust is that you can actually see the real-life passive income your investments are generating rise over time against (hopefully) lower expenses. It’s not a theoretical withdrawal rate where you could potentially sell off assets to provide a certain amount of income, dependent on stock prices. These are actual numbers.
For instance, last month I earned $699.43 in passive dividend income. And I can easily compare that against the ~$1,490 in personal expenses that I recorded for June. These aren’t theoretical numbers; these are real-life numbers based on real-life experiences. I know for sure no matter what happened in the stock market I was going to earn almost $700 in passive income last month. That’s certainly reassuring in a world where the stock market gyrates wildly from day to day.
And since I’ve been consistently recording both my monthly expenses and my monthly dividend incomesince I started this blog back in early 2011, I can clearly see the dividend income rising against expenses – with this last month nearing the 50% coverage mark. That’s real, tangible progress.

Eliminates Mr. Market

Speaking of gyration, the last thing anyone wants to deal with when they’re financially independent is the thought of having to go back to work because the investment income that they’re generating from selling off assets won’t last much longer. And this can happen if you’re abiding by a strategy where you’re selling off pieces of your equity ownership stakes a few shares at a time. If the stock market has a particularly bad year this can create a double whammy where your portfolio is devastated both by the market and your selling activity.
I instead have determined that the best way to make sure that financial independence is maintained once achieved is by living solely off of the passive dividend income my ownership stakes provide me. If my portfolio is a tree and every business investment is a branch, then surely the dividends are the fruit. Well, I plan to live off of the fruit. Selling off chunks of my portfolio, regardless of how the market is performing, is like cutting off the branches, which will eventually leave me fruitless.
Instead, by living off of the rising dividend income you can eliminate the stock market altogether. The dividends flow directly from a company to your pocket. So if Mr. Market is in a bad mood, you get paid. If Mr. Market is in a good mood, you get paid. It’s great to know that your investments will provide you with the livelihood necessary to pay for expenses, instead of relying on a fickle stock market. You’re a business owner, not a stock trader.
And by following this strategy you’ll eventually train yourself to focus less on stock quotes and more on the income hitting your brokerage account. In fact, after I was investing for a while I started to actually look forward to cheaper stocks. Once I realized that I can’t buy goods based on my net worth down at the local net worth store, I opened my eyes to the fact that a cheaper stock means a higher yield. And a higher yield means more income. More income means I can attain financial independence even faster.

Go With What You Know

The wonderful thing about many of the businesses that have been able to grow their dividends for years on end is that they’re familiar to us as consumers before we ever become investors. You don’t have to be some stock market insider to know Johnson & Johnson (JNJ)The Coca-Cola Company (KO)The Clorox Co. (CLX), or Chevron Corporation (CVX). Most people are already aware of these companies, and have some semblance of what they produce and offer society.
You don’t need to find the next social media darling or nanotechnology startup to become financially independent. Focusing on successful businesses that produce products and/or provide services that people all around the world rely on every single day almost ensures you wild success. These businesses essentially make the world go ’round, and they profit as a result. And then they share those massive profits with shareholders in the form of dividends.
I love being able to consume the products and/or services that the companies I invest in produce and/or provide. I’m drinking a Powerade Zero as I type this article, which is a Coca-Cola product. It’s fantastic to be able to intimately understand what the businesses you invest in do on a day-to-day basis. In fact, I would argue that if you don’t really understand what a business does you should probably stay away. Why talk yourself into something when there’s easier ways to make money?

Dividends Are A Major Part Of Total Return

Finally, I wanted to point out the power of dividends themselves, and specifically the growth and reinvestment of dividends. There are basically two components of total returns: dividends and capital gains. But whereas capital gains are the “exciting” part of total returns because you can see stock prices gyrate up and down like a roller coaster, growing dividends and the reinvestment of them is highly underrated and an extremely important part of your overall ability to build wealth over a long period of time.
Investors might assume that dividends are half or less than half of what one might receive in terms of total returns, but that actually isn’t the case.
As I pointed out earlier, when I first started this journey I read about hugely successful investors. And I noticed that many of them held major positions in really great businesses that pay and raise dividends.
Even someone who isn’t a big fan of individual stock investment, John Bogle (the founder of Vanguard), has recognized the power of dividends and dividend reinvestment over long periods of time, and how they build wealth.
Per adapted comments made to the Financial Industry Regulatory Authority in 2007, as can be found onETF.com:
Consider this: An investment of $10,000 in the S&P 500 Index at its 1926 inception (Figure 2) with all dividends reinvested would by the end of September 2007 have grown to approximately $33,100,000 (10.4 percent compounded). [Using the S&P 90 Stock Index before the 1957 debut of the S&P 500.] If dividends had not been reinvested, the value of that investment would have been just over $1,200,000 (6.1 percent compounded)-an amazing gap of $32 million.
Over the past 81 years, then, reinvested dividend income accounted for approximately 95 percent of the compound long-term return earned by the companies in the S&P 500. These stunning figures would seem to demand that mutual funds highlight the importance of dividend income. But in this era of ”total return,” income is virtually ignored.
Furthermore, Ned Davis Research, Inc. has done considerable research on dividend growth stocks against other non-dividend-paying stocks and the broader market as a whole, and J.P. Morgan Asset Managementreleased a report last year citing Ned Davis Research, Inc. and some of their findings. It is interesting to note in the study that dividend growers and initiators posted average annualized total returns of 9.5% from January 31, 1972 – December 31, 2012, while non-dividend-paying stocks posted average annualized total returns of just 1.6% during this same 40-year stretch. That’s a pretty stark difference.

Conclusion

So there you have it. I’m a dividend growth investor seeking early financial independence, and a proud one at that. I truly believe this is a robust and powerful strategy for anyone who has the patience and temperament necessary to invest in stocks and see the journey through to the end.
And I’m doing more than just writing about it. I’m living and breathing it every single day, and putting (all) my money where my mouth is, as I continue to maximize this strategy on my way to financial independence.
I believe in this, but I encourage you to find the best strategy that works for you and your needs. It may not be dividend growth investing, but whatever it is make sure you learn as much as you can about it and use every advantage you can.
Full Disclosure: Long JNJ, KO, CLX, CVX.
How about you? A fan of this strategy on your way to financial independence? 

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]

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