Inexperienced investors often chase “hot” or “trending” stocks hoping that they’ll buy at the right time and the right price. Those investors also hope that the share price will rise.
That’s a lot of hoping — and maybe praying too. But, living on a prayer just isn’t realistic, no matter how great the song is.
Instead, to build an investment portfolio that can provide passive income for comfortable living in retirement, consider learning more about dividend growth investing.
To confidently build real wealth for retirement, you need a strategy like dividend growth investing that doesn’t depend on luck or timing. An investment strategy that combines attractive dividend yields with steady distribution growth is one of the surest paths to significant financial stability and income.
That’s why this article will dive into how dividend investing works, some indicators of dividend sustainability, and why timing and diversification are important considerations as well.
Slow and Steady Wins the Race
Let’s just get it out there. Dividend investing is not sexy. It’s not a get-rich-quick scheme.
Most investment advisers don’t lead with it because they want to entice you by promising that they can drive unrealistic earnings in just a few months.
But educated dividend growth investors know better.
Dividend investors know that slow and steady wins the race when it comes to a financially secure retirement. Receiving a dividend payment every year, every quarter, or in some cases every month can build serious wealth over time.
How Dividend Growth Investing Works
When you invest in dividend growth stocks, the growth rate of those dividends is the driver of stable and profitable returns. Dividend payouts are where you reap what you’ve sown through your diligent planning, but it’s important to make sure that those payouts are sustainable.
Dividend Growth Investing Is Like Building an Orchard
Whether the stock pays a monthly, quarterly, or annual dividend, you can liken dividend growth investing to owning an apple orchard. The trees are the stocks, and the apples are the dividends. The trees bear fruit, and the farmer generates income.
If the farmer has chosen strong trees and tends to them properly, over time the trees will hopefully bear even more fruit, thereby generating even more income. If the farmer uses that income to reinvest in good soil and tree maintenance, the farmer’s income will continue to climb — just like the concept of compounding dividends.
The Rule of 72
To leverage the power of dividends to produce growth for your investment portfolio, a bit of simple math illustrates how you can double your money in 10 years.
It’s called the Rule of 72, and it’s been around for centuries. The rule shows how long it takes for money to double at a certain compound interest rate. Essentially, the rule states that if you dividend the number 72 by the expected rate of return, you can find out how many years it will take you to double your money.
For example, if your investment earns 4% per year, use the Rule of 72 this way: Divide 72 by 4, and you get 18, which is the number of years it will take to double your money if — here comes the important part — if you reinvest your dividend income.
In other words, your rate of return of 4% is now compounded because you’re reinvesting the dividend income to purchase more stock, which means that you now earn even more dividends — and so on and so on.
The Rule of 72 tells us that with a compounded return of 7%, your money will double in just 10 years, because 72 divided by 7 equals 10.29.
The true wealth-generating power of dividend growth stocks requires a system of diligent stock picking. Investors just need a handful of investments with stable income-generating power.
But how do you pick them?
Indicators of Sustainable Dividend Growth
If dividend growth investing were as easy as simply choosing dividend stocks with the highest yield, everyone would be rich. But unfortunately, it’s not that simple. Just because a yield is high now doesn’t mean it will be next year. For that reason, it’s important to consider the indicators of sustainable dividend growth.
Historic and Predictive Analytics
You’re looking for companies, like Dividend Aristocrats, that have grown their dividend at an impressive rate while also growing their business.
But here’s the catch — you’re not just looking at the company’s balance sheet. That’s like only using your rearview mirror. Keep your eyes on the road ahead and ask yourself this question: What is the likelihood that these dividend payers can keep up this excellent growth rate?
Nothing is more frustrating than buying a stock because historically it performed well and met your criteria, but then the company decreases or altogether eliminates the dividend growth rate, or worse — announces dividend cuts.
So, learn how any company you’re considering makes money. Evaluate the business model, the potential for earnings growth, the industry, the competitive landscape, etc.
For example, Warren Buffett is a fan of bank stocks because banks take your money, pay you very little, and then turn around and lend your money at much higher rates to generate income for themselves. And ever since the financial crisis in 2008, banks are highly regulated and must abide by conservative lending practices, which in turn make them a safer investment.
You want a company that has grown earnings and increased the dividend — but has done it in a way that avoids crippling the company in the long term. In other words, dividends were not too aggressive in light of the company’s liquidity position, and capital has been allocated in a responsible and effective way.
Some experts call competitive advantage an economic moat. Why? Because a moat protects that castle. And this is exactly what competitive advantage does for a company and its ability to grow dividends over time.
You want to feel confident that the company can generate cash flow and provide dividend increases in the long run, even during periods of stock market volatility.
So how can you tell if the company has a moat?
Well, look around at the competitive landscape and ask yourself this question: Does the company have a structural advantage that will enable them to outperform competitors for a decade or more? Because it’s that advantage that will drive the profits that allow for dividend growth over time.
The structural advantage can come in the form of strong management teams with a track record of making responsible and effective decisions.
Consider Apple (NASDAQ:AAPL). Apple has an economic moat.
Because the company’s array of digital service offerings is dynamic. Plus, Apple has said it’s considering venturing into the self-driving car market, which could result in tremendous long-term upside potential.
With the halo effect that Apple enjoys, the company certainly has an established competitive advantage in its industry.
Timing and Diversification Are Important
Develop and keep a watchlist of dividend growth stocks.
Many companies have high dividend growth rates but extremely low yields. These are the stocks you want to buy when the stock market crashes and the yields come up.
Be sure to assemble a diversified portfolio when you’re ready.
Look to a variety of economic sectors — everything from communication, consumer product, energy, and finance to health care, real estate, technology, and utilities.
And now that you know the indicators for companies that can maintain a sustainable dividend payout, you can even keep an eye on stocks that don’t yet pay a dividend but someday might.
Take Amazon (NASDAQ:AMZN) for example. Amazon doesn’t currently pay a dividend, but it is growing its base of repeat customers, which is another indicator of the ability to sustain a growing dividend payout.
When customers value the company’s products and services, the likelihood of future increased revenue and net earnings is greater. Consistency like this helps companies maintain dividend payouts and increase them over time.
Build Your Dividend Growth Portfolio
When seeking dividend stocks to add to your dividend growth portfolio, it can be important to consider companies from a variety of industries with a history of raising dividends and the potential to continue doing so.
Investors who purchase shares of high-quality dividend stocks can help secure a financially stable retirement for themselves. You’ll have income to pay the bills and enjoy retirement with a heightened peace of mind.
So if you’re interested in building a portfolio with a passive income stream from stocks that raise their dividends, subscribe to Investors Alley’s “Dividend Hunter” newsletter.