Three Essential Rules when Investing in Dividend Growth Stocks

Good, High Income, Growth

Our entire premise for investing in Dividend Growth stocks is to get to 10% yield on cost or greater within 10 years. Unfortunately, you can’t do that if you don’t have some guidelines on how to deploy capital. We have three simple rules in place that we’ve borrowed from The Single Best Investment that are guiding how we identify suitable dividend growers to add to our portfolio.

The stocks must have all three of the following criteria:

  1. High Quality
  2. High Current Yield
  3. High Dividend Growth

You can often find 2 of the criteria in the large universe of stocks, but getting all three can juice returns for the long term.

High Quality

High quality is most subjective, but essentially boils down to predictability of earnings or cash flow. Well managed companies have highly predictable revenue and earnings growth because they have excellent capital allocation and risk management programs. This results in revenue and earning charts that look like a hockey stick. Ultimately, good management looks for opportunities to deploy capital above their cost of capital. If they don’t have great opportunities, then they should either buy back stock or pay more dividends.

Which leads to the payout ratio. Strong management will want to pay enough dividends where it makes financial sense, but not exceed their capacity to pay in the future. This balances both internal rates of return for capital projects and ability to make cash payouts.

Good proxies for quality can be found in credit ratings. S&P and ValueLine usually rate credit offerings for companies that are looking to issue debt. You’ll want AAA credit ratings to help you indicate high quality. The resulting rule would look like the following:

Only invest in companies with Investment Grade (BBB or higher) Credit Ratings

High Current Yield

There are a number of high quality companies. Unfortunately, most of them pay out tiny yields. The average at the time of writing for the S&P 500 is just over 2%. If we want to get to 10% yield on cost with a starting yield of 2%, we will need incredibly high growth of that dividend rate, 38% compounded annually to be exact. Those rates do not exist consistently.

A good minimum to start out with comes from retirement planning: The 4% Rule.

The 4% Rule states that you should only draw 4% of your principal balance during retirement to reduce your risk of running out of money in your remaining lifetime. That mindset seems slightly flawed to me, but we’ll assume it works. At a $1 million capital balance, you should be able to withdraw $40,000 per year safely.

If we approach the 4% rule slightly differently, we come up with a different set of rules

Only invest in companies paying a 4% dividend rate or higher, with high quality, and sufficient growth to cover inflation.

High Growth

After filtering out high quality, and high yield, you’ll need to find companies that are consistently growing their dividend yield. This weeds out a number of companies. Some companies have payouts that become too aggressive, or invest in projects that don’t return enough earnings, or simply don’t raise their dividends on a consistent periodic basis. Others may raise their dividends, but only a tiny amount because they don’t grow earnings very quickly. Usually these are large companies in saturated markets or are heavily regulated in how much they can increase revenues (utility companies).

So what might a good rule here be? At a minimum you don’t want to lose earning power from your dividends not increasing at the rate of inflation. Ideally, you’ll want to continue increasing your inflation adjusted income without additional work. Inflation is highly variable, but a general rule of thumb is to stay above 3% per year, but since we are over achievers we are going to set a threshold of 4%.

Only invest in companies consistently raising their dividends at a compounded growth rate of 4% or higher.

Conclusion

By applying the above rules, you will eliminate about 99% of all public stocks. This is a good thing! There is too much to possibly know about every stock. By narrowing down the pool of investable stocks, you simplify your decision making process. So to summarize the rules:

  1. Invest in companies with BBB or higher Credit Ratings
  2. Invest in companies with a 4% yield or greater
  3. Invest in companies consistently growing dividends by 4% or more per year

Do these rules match up with your dividend growth investing philosophy? Continue the discussion on Twitter.

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