Month: May 2024

Finding companies with a historical alignment between dividend growth and price growth and purchasing them when their current yields exceed historical averages is a straightforward strategy for successful dividend growth investing.

Metro Inc. serves as a prime example within our ‘Core’ category stocks. Let’s examine two crucial charts: dividend growth (DG) versus price growth (PG) alignment and the 10-year yield chart for this quality dividend grower.

Dividend Growth vs. Price Growth Alignment

Over the past decade, Metro Inc.’s stock price has closely mirrored its dividend growth. The price rarely stays out of alignment for long. Dividend growth stocks that behave this way are some of the highest-quality companies in your portfolio. In addition, recognizing and acting on this short-lived misalignment can lead to outperformance in your portfolio returns.

Last week, we identified the ‘Timely Ten’ companies on ‘The List’ that were reasonably priced based on dividend yield theory. This week, we will delve deeper into this group of stocks and explore what determines a quality company to see if there are any investable candidates. The stocks above the black line make up the ‘Timely Ten.’

With Q1 2024 earnings behind us now, it’s time to take another look at our ‘Timely Ten’ DGI stocks. These are the ten most undervalued stocks on ‘The List’ according to one of our valuation metrics, dividend yield theory.

Step three in our process involves monitoring our quality dividend growers regularily, which can become quite challenging depending on the number of companies we track. Fortunately, we rely on ‘The List’ instead of the vast array of stocks in the index, which streamlines our task. Nevertheless, we continually seek methods to enhance our efficiency. Through dividend yield theory, we’ve discovered an approach that has proven remarkably effective over the years in aiding us with our efforts.

Dividend yield theory is a simple and intuitive approach to valuing dividend growth stocks. It suggests that the dividend yield of quality dividend growth stocks tends to revert to the mean over time, assuming that the underlying business model remains stable. In practical terms, if a stock pays a dividend yield above its ten-year average annual yield, its price will likely increase to return the yield to its historical average. Knowing that price and yield go in opposite directions, this theory helps us find stocks that are poised for a positive price correction.

We have already pre-screened our candidates using the criteria we laid out in building ‘The List’ initially. This helps us considerably narrow the universe of investable stocks.

1. Dividend growth streak: 10 years or more.
2. Market cap: Minimum one billion dollars.
3. Diversification: Limit of five companies per sector, preferably two per industry.
4. Cyclicality: Exclude REITs and pure-play energy companies due to high cyclicality.

Next, we rank ‘The List’ by how significantly each stock is priced below its fair value (Low Price), as calculated using dividend yield theory. The stocks that are currently trading below this threshold form our ‘Timely Ten’.

If you were given a choice between receiving an immediate cash payment of one million dollars or a magical penny that doubles in value every day for 30 days, which option would you choose? At first glance, the million dollars might seem like the clear winner. However, a closer examination reveals a startling outcome. If you take a moment to do the math—doubling a single penny each day for 30 days—you’ll discover that on the 30th day, that humble penny would have grown to over $5 million.

This scenario serves as a powerful illustration of the power of compounding, an essential concept for anyone new to investing. It shows how small, seemingly insignificant amounts can exponentially grow over time, yielding astonishing returns.

However, one crucial question remains: How can you achieve consistent, reliable returns on your investments year after year to truly harness the magic of compounding? By leveraging the right investment strategy, you can transform the theoretical promise of compounding into real, tangible wealth.

Dividend growth investing is a strategy that focuses on buying stocks of companies that not only pay dividends but also consistently increase them over time. This approach combines the immediate benefit of receiving regular income from dividends with the potential for capital appreciation and the powerful effect of compounding. Here, we’ll explore how dividend growth investing works and why it might be a beneficial strategy for long-term wealth creation.

Understanding Dividend Growth Investing

Dividend growth investing targets companies with a track record of increasing their dividend payouts. These companies are typically well-established, with stable earnings and strong business models, which enable them to progressively increase dividends. Investors who adopt this strategy look for companies with a “dividend growth streak,” meaning they have increased their dividends for a number of consecutive years.

The appeal of dividend growth investing lies in its dual return mechanism. Firstly, investors receive regular dividend payments that can be used as income or reinvested. Secondly, if the dividends are consistently growing, the yield on the original investment cost can rise over time, potentially outpacing inflation and increasing the investor’s purchasing power.

The Power of Compounding

Compounding occurs when the earnings from an investment are reinvested to generate their own earnings. In the context of dividend growth investing, compounding amplifies returns over time as dividends are reinvested to purchase additional shares of stock. This increases the total dividend income because more shares accumulate more dividends, which can then be reinvested again.

For example, if you invest in a company that pays a $1 dividend per share annually and increases this dividend by 10% each year, your dividend payment in the first year on 100 shares would be $100. By reinvesting these dividends, you could buy more shares. Assuming the stock price remains constant, in the second year, you would not only receive the increased dividend on your original shares but also dividends on the additional shares purchased with your first year’s dividends.

The Impact of Long-Term Investing

The effectiveness of dividend growth investing becomes most apparent when practiced over long periods. This strategy is less about speculating on stock prices and more about being patient, allowing the power of dividend growth and compounding to play out over time. Over the decades, reinvested dividends that grow can contribute to exponential growth in the value of the investment portfolio.

Starting with Dividend Growth Investing

To begin with dividend growth investing, it’s essential to identify companies with potential for long-term growth in dividends. Look for companies with low payout ratios, strong balance sheets, and a history of earnings growth. Tools like dividend yield, payout ratio, and the dividend growth rate are fundamental metrics to assess the suitability of a stock for dividend growth investing.

Conclusion

Dividend growth investing offers an attractive combination of regular income, potential for increasing returns through rising dividends, and the powerful effect of compounding. This strategy requires patience, a focus on long-term rewards, and a disciplined approach to reinvesting dividends. By carefully selecting stocks and committing to a long-term strategy, dividend growth investing can be a cornerstone of building sustainable wealth.

If you have time this week, please review the SAMPLE-DGI Business Plan on our site to see the effects of dividend growth and compounding in action. Pay close attention to the article’s ‘Income Target’ section and see how quickly your income and capital compound using our process. It’s never too late to get started.