Dividend investing: a proven strategy for all seasons – Medical Economics

When he made this observation, the oracle from Omaha was referring to the benefits of passive income.

Earning money while sleeping or sitting on the beach is normally associated with bond yields, rather than stocks, because dividends from many companies aren’t reliable. Yet dividends from an elite category of companies are different. These companies have long, consistent records of not only reliably paying dividends, but of increasing them annually.

Dividends are regular, small cash payments (usually monthly or quarterly) of a set amount per share; they are what companies pay investors to hold their stocks. Corporate directors review dividend amounts regularly, but many companies don’t increase them often, much less annually.

For many individuals, holding a portfolio of dividend-grower stocks can be an effective investing strategy in just about any market. If you expect major indexes to continue to sag or decline further, dividend-grower stocks can serve as an alternative to bonds, which continue to pay paltry yields and never give holders a raise in income.

Or, if you think the indexes have hit bottom, then dividend stocks may be an even better option, as share-price growth would probably be closer at hand. And you get dividends to boot.

Dividend investing has served as the foundation for investment empires. Since 1960, reinvested dividends have accounted for 84% of the total return of the S&P 500 index, according to a recent study by Hartford Funds. The investment capital involved would never have existed had it not been for dividends.

Cream of the Crop

Many companies don’t pay dividends at all. Those that do tend to be mature, disciplined firms that, unlike capital-intensive newer ones, don’t need this money for expansion, new ventures or R&D, as younger companies (especially young tech firms) typically do.

Companies that have raised their dividends year after year, through down markets, wars and recessions, have demonstrated their perennial financial strength and dedication to shareholders. This practice attracts new investment, driving up share prices, so dividend investors can get the best of both worlds—reliable income and likely growth.

A company’s dividend yield, the ratio of the share price to the current dividend, shows how much investors must pay to get the dividend paid at the time. These yields range from 1 to 2% for many companies to more than 4 or 5% in some cases. The lower the share price, the higher the yield for a given dividend, and vice-versa.

This inverse correlation has resulted in dividend yields that are quite high now that shares of many companies are depressed, including those of many dividend growers. Though up somewhat from their lows this year, shares of ProShares S&P 500 Dividend Aristocrats ETF (NOBL) and Invesco Dividend Achievers ETF (PFM) through July were both down about 8% from January levels. This has pushed up dividend yields, which decline as share prices rise. Thus, periods of higher dividends can compensate investors for dwindling share prices.

Real Cash over Flash

Investors should consider a caveat regarding high dividend payers that lack a record of increases: There’s a good chance their dividends won’t rise down the road. Nor likely will their share prices in many cases, as their transitory high dividends may be nothing more than a shiny object to lure investors—not a reflection of sustainable financial strength. These companies are often of lower quality, with lower prospects for long-term total return.

Professional investors view dividends as a way to get paid for their patience in waiting for a stock to rise. And for individual investors nearing retirement, including physicians, long-term dividend investing can be an excellent strategy. These payments can provide an additional retirement income stream, an attractive feature for practitioners who lack corporate pensions but have large portfolios with plenty of room for a diversified selection of dividend stocks.

The Nifty Nine

Even if a stock has a dividend yield of only 1%, if you hold it long enough, regular increases and the magic of compounding can eventually bring this number to double digits.

Dividends sometimes grow astonishingly fast. An example lies in the records of some stocks in the NASDAQ Dividend Achievers Index—a group of growers that has increased dividends annually for at least the last 10 consecutive years. Because of their exceptionally high cumulative dividend increases over the last three years—an average annual increase of 12%—nine of these achievers I call the “nifty nine.”

Their average annual dividend increases over the trailing three years range from 5.78% (Johnson & Johnson) to a whopping 23.55% (Broadcom, a long-established tech company that’s optimistic after acquiring VMware). Between these two is Kroger at 13.75%, Allstate at 20.76%, Snap-On at 14.43%, Target at 7.84%, Cummins (engines and power-generation products) at 8.04%, Hubbell (electrical products for construction) at 8.20% and 1st Source (regional banking and finance) at 8.2%.

This degree of dividend growth is historically unusual, and investors shouldn’t normally expect it. Yet the Nifty Nine illustrate the potential benefits of owning dividend growers: Assuming that the 12-percent annual dividend increase were to continue indefinitely, an investor’s dividend income would double every six years.

Growers over Show-ers

A big reason for such companies’ commitment to sustained dividend growth is their perennial interest in distinguishing themselves from Johnny-come-lately high-dividend payers, which we’ll call “show-ers.” These are companies that inconsistently or sporadically declare an attractive dividend though they may lack the financial strength to sustain it.

Investors researching dividend histories should take a long look back, over at least several years but preferably a decade, to determine consistency. Of course, with dividend-grower funds, managers have already done this vetting.

Historically, dividend growers have been associated with downside risk protection in difficult markets. During down periods between January 1999 and March 2022, stocks in the S&P High Yield Dividend Aristocrats (an index of dividend growers) on average outperformed the S&P Composite 1500 and S&P 500 High Dividend Index (show-ers).

Growers have also outperformed show-ers during periods of high volatility. During such periods, show-ers are far more likely to cut dividends, often because their defenses against turbulence tend to be weaker. Greater leverage, lower profitability and lower earnings growth render show-ers less able to withstand rough markets.

Moreover, dividend investing can be tax efficient, especially since most dividends paid by common stocks are qualified, taxed at capital gains rates, which tend to be much lower. Whether investors are still working or retired into a lower tax bracket, this difference can help them keep more of their investment income.

Thus, well-chosen dividend stocks can provide reliable, rising income with high potential for growth and relatively low long-term risk, even in challenging markets.

And all while you sleep.

Dave Sheaff Gilreath, CFP®, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors, LLC, a portfolio management firm for individual investors, and Innovative Portfolios, LLC, an institutional money management firm. Based in Indianapolis, the firms manage about $1.4 billion in assets nationwide.