With many fixed-income investors looking at dividend investing to bridge their income gap, many are focusing on the dividend yield rather than dividend growth. It can be a mistake that will cost them dearly.
Don’t overlook the importance of investing in solid dividend growth stocks. My annual rate of return (ROR) since 2009 is over 12% and beating the meager 6% return of the Canadian Index.
It means I can double by money in 5 years whereas you need 12 years with the Canadian Index.
There are 2 distinct investing phases (Accumulation & Retirement Income). The accumulation phase is where you build and grow your wealth; the retirement Income phase is where you live from your income and portfolio.
I have a tool that can help organize your portfolio below to see the relationship of your holdings between the dividend yield and the dividend growth.
Each phase requires a different strategy. While dividend investing can be done in many different ways, dividend growth investing is a powerful approach worth using in during the accumulation phase.
While focusing on the dividend yield may satisfy the need for receiving regular income, it may come with the sacrifice of long-term stock growth and prevent your retirement portfolio to reach the size you need.
Dividend Yield is looking at returns today while Dividend Growth is looking at future growth.
Dividend Growth Investing Concept
The concept is pretty simple but to start with, as an investor, you will need to realize that you may be eliminating high yield stocks. If you look at my portfolio, I have a limited amount of high yield stocks.
|wdt_ID||Dividend||None||Low Growth (< 6%)||Medium Growth (> 6%)||High Growth (> 10%)||Total|
|3||Low Yield (< 2%)||0.00||5.52||0.00||34.66||40.18|
|4||Medium Yield (> 2%)||0.00||0.00||25.07||11.54||36.61|
|5||High Yield (> 4%)||0.00||0.00||13.42||0.00||13.42|
Putting that limitation aside, the primary data point to look at is dividend growth. You want to ensure the dividend stock you are interested in grows its dividend regularly and at a good dividend growth rate.
Utility stocks do not usually exhibit a high dividend growth rate since their business growth tends to be regulated and slower. Just having increased dividends for over 25 years does not mean you have good growth either. It means you can rely on it for income.
Assuming the company maintains their dividend payout ratio within their guidelines, what we see is both a dividend growth and a stock appreciation when the corporation is able to grow its bottom line.
One way to visualize it is by comparing the EPS and the dividend paid. When both increase together, the stock shows significant strength in growing their bottom line and the stock will also appreciate. As an investor, you win on 2 fronts:
Have a look at Canadian National Railway TSE:CNR as an example.
The payout ratio is staying within range implying the dividend is not growing at a faster rate than the earnings. The yield is also relatively stable which implies the stock price is growing along with the dividend growth.
With increasing earnings, the price grows as well and somewhat exhibits the same pattern as the EPS which leads to a relatively consistent dividend yield.
In the case of CNR, the dividend yield is usually below 2% but CNR happens to have a really good dividend growth rate.
- 3-year dividend growth: 12.75%
- 5-year dividend growth: 16.54%
- 10-year dividend growth: 15.59%
Steps to Select Dividend Growth Stocks
Step 1 – Annual Dividend Growth
I like 10 years as a minimum as it usually means it has gone through at least one economic recession. You can see the Canadian Dividend Achievers for that list.
As a first step, you can start with one of those lists or just filter from any lists you have access to.
Step 2 – Average Annual Dividend Growth Rate
Even if you have increased your dividend every year, the growth rate of the dividend increases might not match what you want. A 1 cent increase will allow the company to be included in the dividend aristocrats list but it doesn’t offer a significant growth rate.
Choose the dividend growth rate you want to target. I am targeting 10% but I am ok with over 7%.
This data point might be harder to get from free services. You should also decide on how far back you want to look for establishing the growth rate.
Again, I like 10 years and then I look at 3 and 5 years to see if there is consistency. The Canadian Dividend Performance List provides 3, 5 and 10 year CAGR dividend growth rates.
When both steps are combined, you are left with a strong list of dividend investing options. There are currently 20+ Canadian dividend stocks matching the criteria of 10 years of consecutive dividend increased with a 10 year average of 10% or more.