(Published by Nicholas McCullum on March 15)
Dividend investing is one of the most actionable, repeatable methods of building wealth over time.
Fortunately, there are many resources available to learn about dividend investing. Many of them are published by some of the most successful dividend investors in the business. These include books, websites and even shareholder letters.
One particular example is the portfolios of large, institutional investors, made visible through the 13F filings required of institutional investment managers with more than $100 million in qualifying assets.
Warren Buffett (Trades, Portfolio) oversees a $100 billion-plus common stock portfolio that holds many dividend-paying companies through his company Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). These holdings are detailed in a quarterly 13F.
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13F filings are only a single source of investment knowledge. There are many others.
The following are seven tips to grow your wealth like the best dividend investors.
Invest in companies with long dividend histories
One of the best ways to grow dividend income is to invest in companies with proven histories of raising their dividend payments over time.
When companies successively raise their dividend payments, investors can benefit from a growing income stream even without contributing more capital.
A great place to search for these companies is the Dividend Aristocrats Index.
The requirements to be a Dividend Aristocrat are:
- Be in the Standard & Poor's 500.
- Have 25-plus consecutive years of dividend increases.
- Meet certain minimum size and liquidity requirements.
If 25 years is not enough, then the Dividend Kings Index is even better.
To be a Dividend King, a company must have 50-plus years of consecutive dividend increases – twice the requirement to be a Dividend Aristocrat.
Besides the obvious rising dividend payments, there are many advantages to investing in companies with long histories of steady dividend increases.
First of all, these companies tend to outperform the market in general on a total return basis.
The performance of the Dividend Aristocrats is compared to the S&P 500 Index below.
The Dividend Aristocrats have demonstrated meaningful outperformance over the broader stock market as measured by the S&P 500 over a long period of time (10 years).
Numerically, the Dividend Aristocrats have returned 10.14% per year compared to the S&P 500’s 7.62% per year over the past decade. This represents an outperformance of 2.52% per year (on average).
This outperformance over varying time periods can be seen below.
There are also many qualitative reasons why companies with sustained dividend histories make good investments.
Companies with 25-plus years of steadily rising dividends must have a durable and sustainable competitive advantage.
Otherwise, when economic environments or consumer tastes undergo periods of change, the company’s profitability will be reduced. Without a competitive advantage, companies cannot withstand "shocks" to their operations.
Lower profitability leads to dividend cuts, which triggers an automatic sell according to The 8 Rules of Dividend Investing.
Regular dividend increases are also a sign of shareholder-friendly management teams.
Companies that are committed to increasing dividend payments are also likely to exhibit other shareholder-oriented behavior such as:
- High levels of insider ownership.
- Candid communication with shareholders.
- Reasonable executive compensation.
- Stock buybacks.
Stock buybacks in particular are discussed in the next section.
Believe in stock buybacks
Stock buybacks (alternatively called share repurchases) occur when a company purchases its own stock on the open market with the intention of reducing the number of shares outstanding.
On a per-share basis, stock buybacks improve a company’s financial performance even if overall business performance remains unchanged.
The reason for this is the denominator of per-share metrics is reduced. If the same amount of earnings is distributed among fewer business owners, then each owner’s share of the profits becomes proportionally larger.
The effects of stock buybacks on shareholder returns can be tremendous. The following table shows the financial performance of a company that:
- Grows earnings at 8% per year.
- Trades at a constant price-earnings (P/E) ratio of 15.
- Uses 75% of earnings on share repurchases.
Notice that even though the company’s earnings only grew by a factor of 4.6, the company’s stock price grew by more than a factor of 10.
Despite the obvious advantages of share repurchases, many pundits have been critical of stock buybacks, saying that they divert capital from the "real economy."
They argue that money spent on share repurchases could be better spent on creating jobs, building infrastructure and investing for organic business growth.
Buffett, arguably the most successful investor of all time, has dispelled these claims.
In Berkshire Hathaway’s 2016 Annual Report, Buffett wrote extensively on his belief in the value-creating capabilities of share repurchases.
“As the subject of repurchases has come to a boil, some people have come close to calling them un-American – characterizing them as corporate misdeeds that divert funds needed for productive endeavors. That simply isn’t the case: Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital. (Call us if you have a candidate.)”
Source: Berkshire Hathaway 2016 Annual Report, page 8
In his shareholders’ letter, Buffett placed a notable caveat on share repurchases. The Oracle of Omaha justifies share repurchases only if company stock is repurchased below intrinsic value.
“For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value enhancing or value destroying for continuing shareholders is entirely purchase-price dependent.”
Source: Berkshire Hathaway 2016 Annual Report, page 7
Companies reduce intrinsic value when they repurchase overvalued stock. It has the same value-destroying capabilities as buying overvalued companies for an individual’s investment portfolio.
Buffett also stated two scenarios in which repurchases should not occur, even when a company’s stock is undervalued:
“One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.”
Source: Berkshire Hathaway 2016 Annual Report, page 7
All in all investors do well to invest in companies that repurchase their own shares at an attractive valuation, assuming that the business has the capital to do so and there are no opportunities that offer greater value.
Take advantage of DRIPs
DRIP stands for Dividend Reinvestment Plan.
When an investor enrolls in a DRIP, it means that a company’s dividend payments are used to purchase more shares of that same company – automatically.
The Dividend Aristocrats are the perfect compliment to DRIPs. DRIPing Dividend Aristocrats allows investors to "triple down" on their dividend payments since:
- The Dividend Aristocrat is steadily increasing dividend payments to shareholders.
- Dividends are being reinvested automatically.
- New investment contributions are being used to purchase more dividend-paying stocks.
Many businesses offer DRIPs that require investors to pay fees to enroll.
As a general rule, investors are better off by avoiding fee-based DRIPs.
The fees paid are often substantial relative to the size of the purchases being made, at least until the investment portfolio becomes substantial in size.
Many businesses (including Dividend Aristocrats) offer no-fee drips as an alternative.
Enrolling in no-fee DRIP plans is a great way to passively build wealth over the long run.
Some more active investors (myself included) may prefer to selectively reinvest dividends into companies that appear appealingly valued at the time of purchase. Both strategies will work to increase dividend income over time.
Invest with a long time horizon
A lot of the money in the markets today is institutional in nature, being controlled by mutual funds, pension plans and other big-money investors.
These institutional investment funds are judged on a quarter-by-quarter basis as this is the schedule by which they must report their performances to their investors.
While these investment funds have larger research budgets and better technology at their disposal, time horizon is an advantage of the individual investor.
The importance of this advantage cannot be overstated.
“The single greatest edge an investor can have is a long-term orientation.” – Seth Klarman
There are many advantages to having a long time horizon.
Buying a stock with a multidecade time horizon requires less of an investor's time. Time is money, after all, and the purpose of life is not to spend hours each week monitoring existing investments.
Long-term investing also allows for the deferral of capital gains tax.
When investors own stocks that appreciate in value, they can sell the security for more than it was purchased. The difference between the purchase price and the sale price is the capital gain, and tax must be paid on this income.
However, the tax is only paid when the security is sold, which means that holding stocks for the long run allows for the compounding of this deferred capital gains tax.
Buffett has used this technique to such success that it has been called a "Buffett Loan."
For instance, if Buffett were to sell his stake in Coca-Cola (NYSE:KO), it would trigger a ~$15 billion capital gain which is not taxed until the stock is sold.
Until then, Buffett can happily collect dividends for the long run, knowing his yield on cost for Coca-Cola is so high that he will receive more than half his original investment in dividends this year alone.
Some investors find having a long time horizon to be difficult. Holding stocks through prolonged market downturns can be stomach-wrenching and test the resolve of even the most experienced investors.
One of the easiest ways to encourage a long-time horizon is to invest in companies with durable sustainable advantages, which are almost certain to be in operation 10, 20 or 50 years from now.
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” – Warren Buffett
Applying the Lindy Effect can help to identify companies that have such long-term investment prospects.
The Lindy Effect states that for nonperishable items (businesses, ideas, etc.) the observed lifespan of the item is most likely to be at its half-life. This applies to companies as well. On average, a company with a 50-year operating history can be expected to last another half century.
While this might not apply to any one particular stock, it can be effectively applied to groups of stocks (the Dividend Aristocrats or the Dividend Kings, for example).
Regardless of your exact screening method, choosing companies with solid long-term prospects and holding them for decades can provide an investing advantage over larger investment funds that are judged on quarterly performance.
Minimize investment fees
Investment fees can be a huge detriment to investor returns, particularly over the long run.
Consider the mutual fund industry for an example. Many mutual funds charge around 1% of assets under management (AUM) as a fee for their professional management services.
While this might not seem substantial on the surface, consider that the long-term total return of the S&P 500 Index is around 9%. A mutual fund with a 1% AUM fee structure reduces this performance to 8% if they match the index’s performance, which reduces investor returns by 11% (1% dividend by 9%).
This performance loss is even more pronounced over longer periods of time.
The following chart illustrates the difference of $100 invested at a constant rate of return of 8% and 9% per year over a 10-year period.
Over a 30-year time period, a 9% annual return results in a portfolio that is ~30% larger than an 8% annual return.
Unfortunately, many mutual funds charge fees that are higher than 1% of AUM. Funds that require extensive research (international funds and small-cap funds are examples) charge more for their services. Hedge funds are even worse with many charging 2% of assets and 20% of profits.
Investors are increasingly becoming fee-conscious, and financial products have been undergoing significant "fee compression" in recent years.
It is now possible to buy an index ETF of the S&P 500 with a management fee of 0.08%. This means that on investment of $10,000, investors would only pay $8 of fees per year (excluding transaction costs).
Investors who purchase stocks directly have a great deal of control over how much they pay in fees. In fact, many of the previously mentioned strategies in this article provide other ways to help minimize investment fees.
Enrolling in a DRIP from one of the no-fee Dividend Aristocrats mentioned above allows investors to increase their dividend income at a faster rate without paying more in transaction fees.
Further, there exist stock brokers that do not charge a transaction fee for a "synthetic" DRIP. A synthetic DRIP is when the broker purchases more company stock with incoming dividend payments (rather than the paying company issuing more stock from treasury).
Investing with a long time horizon also helps minimize investment fees. Long-term systematic investing minimizes the number of transactions an investor performs, which reduces trading fees (the majority of fees that self-directed investors pay).
Altogether reducing investment fees is can have a profound effect on one’s ability to build wealth over the long run. Savvy investors will identify and minimize the fees that they are paying.
Avoid chasing yield
There are few better ways to consistently lose money with dividend stocks than by chasing yield. Focusing on stocks with excessive dividend yields (i.e., 10% plus) will almost always lead to below-average returns in the long run.
This is because it is almost impossible to achieve such a high dividend yield without having one of the following:
- An unsustainable payout ratio.
- An incredibly cheap valuation.
To illustrate the two points above, I will provide an example for each.
Consider a company trading at $100 per share with a P/E ratio of 20. Based on this valuation multiple, the company has reported earnings per share of $5.
The company’s dividend yield at various payout ratios can be seen below.
This company could not exceed a dividend yield of 5% without paying out more than its total per-share earnings as dividends. Anything higher than a 5% dividend yield would lead to a payout ratio above 100%, which is unsustainable.
In general, it is impossible for normally valued companies to achieve dividend yields higher than ~5% without high payout ratios. For MLPs, the threshold is a bit higher.
For severely undervalued companies, the mechanics are a bit different.
A great example of this is General Motors (NYSE:GM). Because of the company’s bankruptcy during the financial crisis, many investors are wary of this stock, and it trades at a dramatically low P/E ratio of ~6.
In other words, General Motors’ stock is dirt cheap, which is why the company has a low payout ratio (~24%) and a high dividend yield (4%), a combination that generally does not occur. For comparison, a company with a P/E ratio of 20 would require an 80% dividend payout ratio to achieve a dividend yield of 4%.
Undervalued stocks can be a source of high dividend yields, but make sure to understand why the market is discounting the company’s stock. It could be that there is a serious issue with the underlying business that you have not yet identified.
To conclude, chasing high dividend yields is usually detrimental to total shareholders returns. There are many high-quality companies suitable for investment with low dividend yields. A few examples are:
There are many high-quality companies suitable for investment with low dividend yields. A few examples are:
- Walt Disney Co. (NYSE:DIS): 1.4% dividend yield.
- Hormel Foods (NYSE:HRL): 1.9% dividend yield.
- Walgreens Boots Alliance (NASDAQ:WBA): 1.8% dividend yield.
- General Dynamics (NYSE:GD): 1.8% dividend yield.
- Sherwin-Williams Co. (NYSE:SHW): 1.1% dividend yield.
With so many high-quality companies with low dividend yields, there is no reason to move higher on the yield spectrum to drive shareholder returns.
Be mindful of valuation
Buffett has famously invested with a value focus for most of his career. His perspective is summarized succinctly with the following quote.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
Value investing is focused on buying stocks that are trading below their perceived intrinsic values. In other words, value investors are looking to buy a dollar's worth of assets for 50 cents.
Eventually, the hope of the value investor is that the market will recognize the true value of the asset and the price will increase. The value investor then can sell his stock at a profit and begin searching for the next mispriced security.
When performed properly, dividend investing incorporates aspects of value investing. There is no company that remains an attractive valuation regardless of price, regardless of the safety or quality of its dividend.
Incorporating valuation analysis into dividend investing is done on a quantitative basis. We often measure valuation with the P/E ratio. However, there exist a number of other financial metrics that can be used to assess valuation including:
- Price-to-book (P/B) ratio.
- P/E ratio.
Regardless of how exactly it is measured, it is important to incorporate valuation measures into your investment strategy. Buying high-quality companies at a discount will lead to above-average returns over the long run.
Investors can learn a great deal about investing by reading the thoughts of industry-vetted professionals like Buffett and Klarman.
This article provided seven tips to grow your wealth like the best dividend investors:
- Invest in companies with long dividend histories.
- Believe in stock buybacks.
- Take advantage of DRIPs.
- Invest with a long time horizon.
- Minimize investment fees.
- Avoid chasing yield.
- Be mindful of valuation.
Implementing these tips into your investment strategy can help improve returns, reduce fees and result in satisfactory performance over the long run.
Disclosure: I am not long any of the stocks mentioned in this article.
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