Here’s a novel concept… Your investments should pay you money every year. Even better, your investments should pay you more money every year.
There was a time when most investors thought this way – and so did publicly traded companies. The S&P 500’s historical average dividend yield is 4.4%.
But things have changed. Lazy Man at "Let’s Generate Cash" sums the zeitgeist up nicely:
"Sometimes I forget that people once bought stocks to generate cash. Companies would pay out profits to shareholders and shareholders could use that money, to well, buy stuff they need. It was a good little system. I speak of it in the past tense because many companies stopped paying dividends and instead kept the money to grow profits."
Today, the S&P 500 offers investors a dividend yield of 2.1% - less than half of its historical average. You may be wondering “what happened”?
Why Yields Have Fallen
There are various contributing factors. The primary factor is a change in corporate policy. Share repurchases have dramatically increased. Instead of paying money out to shareholders in the form of dividends, businesses are buying back their own stock.
Don’t get me wrong, share repurchases are beneficial. When you reduce the number of shares outstanding, each share remaining entitles you to a bit more ownership of the business.
Share repurchases are great for managements. That’s because management compensation is often tied to share price increases. Share repurchases help to boost share prices – and trigger incentive packages for management... But they do not put cash into the hands of shareholders.
So that’s what happened.
The good news is, there are still many companies that pay high dividends and increase their dividends every year. This article explains how to invest in these dividend growth stocks to build growing income streams.
Where to Find Dividend Growth Stocks
Dividend growth stocks are companies that:
- Are still growing
- And paying dividends
Pretty straightforward, right? They pay growing dividends over time. The best dividend growth stocks increase there dividend payments every year.
The amazing benefits of compounding this creates will be discussed a bit later... For now, here are some places you can quickly find dividend growth stocks:
- The Dividend Achievers List: 200+ businesses with 10+ years of consecutive dividend increases
- The Dividend Aristocrats List: 50 businesses with 25+ years of consecutive dividend increases
- The Dividend Kings List: 15+ businesses with 50+ years of consecutive dividend increases
These are all great places to find high quality businesses with long histories of paying rising dividends.
Dividend Aristocrats in particular have done well for investors. They have outperformed the market by over 3 percentage points year over the last decade.
Source: S&P Dividend Aristocrats Factsheet
The real benefit to owning these businesses is how they increase your dividend income over time.
Investing Monthly & Compounding
You don’t have to be rich to start your dividend growth portfolio, you just have to be consistent. It pays to invest monthly.
Imagine you invest $600 a month into different dividend growth stocks. Now imagine that (on average) you are investing in businesses with 3% yields that increase their dividends by 6% a year. You are also reinvesting your dividends back into the market.
These are very reasonable targets when selecting from the lists discussed earlier.
After 1 year, you will have invested $7,200. Your investment will (on average – remember, the market fluctuates) be worth $7,492. That extra $292 is from both growth in the businesses you invested in, and the dividends they pay.
Now if you stopped saving after year 1 and spent the dividends on random expenses you’d get $225 in extra income every year… But you’d get a 6% raise (on average) every year without having to invest any extra money. The next year, you’d get $238, then $253, and so on. Your investment would keep paying you more every year.
That’s because the underlying businesses in which you invested in keep growing and raising their dividends.
That’s what would happen if you only saved one year and then stopped reinvesting your dividends. If you keep saving and reinvesting your dividends, you’d be a millionaire in 30 years – and would be generating over $30,000 a year in passive income that would still be growing every year.
Ideas To Start Your Portfolio
Here’s how you can start your portfolio.
- Step 1: Get your budget in order. Start saving, today.
- Step 2: Open a discount brokerage
- Step 3: Being investing!
You probably have some questions on step 3. There’s 2 ways to do this. The ‘easy way’, and the ‘cost effective way’.
[Editor's Note: I'll give you what I believe is the perfect combination of "easy" and "cost effective" at the end of the article. You don't want to miss it.]
The easy way is investing in an excellent dividend growth ETF. The Dividend Aristocrats ETF (NOBL), the Vanguard Dividend Appreciation ETF (VIG), and the First Trust Value Line Dividend ETF (FVD) are all very good choices.
The downside to all these ETFs is that they have expense ratios – you have to pay every year to invest in them. You also don’t get to select what businesses you want to invest in. The upside is you save a lot of time.
The cost effective way is to select businesses from the 3 lists outlined earlier in this article. I recommend looking for the following:
- Businesses you understand well (the Coca-Colas and Procter & Gambles of the world)
- Stocks trading below a price-to-earnings ratio of 20 (at most), and preferably under 15
- Stocks with long histories of dividend increases every year (I prefer 25+ years)
- Stocks with dividend yields above 3%
If you invest in businesses like this every month, over time you will build a well-diversified portfolio of high quality dividend growth stocks trading at fair or better prices.
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