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Dividend Growth Investing: The Path to Financial Freedom

By Edited Oct 9, 2014 2 4

A Candid Talk about Stocks and Investing

I'm going to come right out and say that when it comes to stock investing, there is no better strategy than dividend growth investing. Most people are scared of the stock market because of the daily ups and downs of the various stocks and indexes. Those who are brave enough (or greedy) to enter the market do so as day traders, hoping to buy a stock at $2/share and sell it at $10/share, not even knowing or caring about what it is they are buying. These gamblers are always in for a rude awakening when their tech stocks and bio-pharmaceuticals promising “the next big thing” don't explode in value as they planned. Trying to make a quick buck will never make you the same amount of money as a solid, long term strategy backed by a conservative investment philosophy. And when it comes to stock market investment strategy, dividend growth investing is the best one out there.

But why is dividend growth investing better than the other investing strategies out there? Why can't you just buy a penny stock or something and sell it once it explodes? Well, you can do that, and you can make $10,000 in a day doing that. And lose $20,000 the next day. A day trader has to be quick, always checking his or her stock, waiting for the right moment to buy or sell. For the day trader, especially those who trade penny stocks, every penny counts. You really have to quit your job and become a day trader full time if you want to succeed in doing that. And even that's no guarantee since it is impossible to predict the short term movement of stock prices. Any stock can go anywhere at any time on a given day.

Watch this video of a professional day trader in action. You don't have to watch the whole ten minute video. Any part of it will show you the exotic computer software and split-second decision making one needs to make profits doing that sort of thing. You can see he has multiple monitors, and his computer screens have enough flashing colors and random numbers that this guy is one digital skull away from being a Hollywood computer hacker.

In the comments section, he talks about how he has $600,000 to work with at a given time, and how he is up $30,000, etc. But do you have that sort of money and skill to work with? Can you calculate in a split second how much to short Netflix, or how much to buy Facebook for, or what to do with Alibaba's stock (do you even know what Alibaba is)?

Dividend Growth Investing: The Path to Financial Freedom

No.

The Safer Alternative

Dividend Growth Investing

So why do I promote dividend growth investing as an alternative strategy for stock investing? After all, isn't the stock market still the stock market no matter what “strategy” you use? The answer: Absolutely not!

What is dividend growth investing, you're asking your computer monitor right now? It's a conservative investment strategy where you buy stocks that not only have a long history of paying a quarterly or monthly dividend, but also have a long history of increasing those dividends annually.

What are dividends? Dividends are profits paid to shareholders. Remember that when you own a stock, you are part owner of that business (something that we all know logically but is easily forgotten when watching the high stakes casino that is the Wall Street trading floor). And the owner of a business gets to reap the profits of his business, right? Well, it's the same thing here. Many companies pay their shareholders a quarterly or even a monthly dividend. Unlike the stock price, which can erode your on-paper wealth if it goes down, dividends are cash payments directly into your account.

At first, it won't seem like that much. The average yield is between 2-3%, and you'll have dividend payouts that are less than the change you put in the tip jar at a Dunkin' Donuts. But you're not here for a quick profit. You're investing in dividend stocks to become a lifetime owner of quality businesses. And as the companies increase their dividends, as you reinvest those dividends into more shares, and as you add more capital to the mix, the dividend payouts will start to grow. They will grow and they will snowball over a period of a couple decades. Nothing is stronger in the financial world than decades of compounding growth.

Taking a Page Out of Buffett's Book

Mixing Dividend Growth Investing with Value Investing

When writing my article on stock investing success stories, the first person I mentioned was Warren Buffett. The “Oracle of Omaha” made his stock market fortune purchasing quality companies that were trading at much less their actual value. This is called value investing, and it's important to combine this strategy with dividend growth investing.

You see, just because the stock price is low or high doesn't mean it's cheap or expensive, respectively. A stock that trades at $40/share isn't necessarily cheaper than one that trades at $80/share. That mentality is what leads people to penny stocks, a surefire way to get burned. A stock is cheap if it's trading for less than what the share price should be.

In order to place a value on the company, one must look at their fundamentals. Things like their dividend yield, EPS (Earnings Per Share), Debt-to-Income ratio, etc., will help you place a value on the company, or at least get a gut feeling that screams “cheap” or “expensive”. Analyzing a company's fundamentals can be not only very difficult for beginners, but also very subjective. You may be the mathematical type that likes to assign a share price that you feel the company should be trading at, or perhaps you're like me and you go a bit more for a general feel of the company's worth rather than a single hard number. Regardless, true value investors like Warren Buffett and Stephen Jarislowsky made their fortunes waiting years if necessary for a company to be undervalued by the market, essentially being sold at a discount, before buying. They would hold the company for years or decades as it grew in value, eventually selling the company as it became overvalued and put that capital to work by buying a new, undervalued company.

Dividend growth investing is not the same as value investing, but they have many similarities and quite a lot of room for overlap. While value investors will buy a company that's undervalued and sell it many years later when it's overvalued, the dividend investor is there for the dividends. A value investor doesn't care whether or not a company pays a dividend (or at least dividends aren't the central tenet of value investing), whereas a dividend is imperative for the dividend growth investor (it's even in the name!). The most important think to take away from value investing while employing a dividend growth strategy is how to pick out quality companies that are trading at a discount. To not do this is to simply chase high yields and/or low prices. You will add unnecessary risk to your portfolio without any sort of payoff.

The Endgame of Dividend Growth Investing

Income for Life

Alright, you are investing in businesses (don't say “stocks”, say “businesses”. It will put you in the right mindset). You have a stable of high quality businesses that pay dividends, and they are raising them consistently. So then comes the question of how much your portfolio should grow before you retire and begin cashing out? What dollar amount should you get it up to, how long should you spend building it before retiring, and how much can you reasonably withdraw from it each year in order to outlive it? Most people follow the Trinity Study's Safe Withdrawal Rate of 4%, but when you invest in dividend-paying businesses, you will do something completely different. Your cash-out date is “never”.

You see, I didn't suggest that you buy ownership stakes in these great companies so you can get rid of them the moment you no longer have any other source of income. And that's what happens when you withdraw that 4% or 3% or whatever the new magic number is from your retirement brokerage account. You are selling off assets. If you need to sell them, then they probably weren't that great to begin with, right?

No, your aim is to invest in high quality businesses that grow larger and larger every year, and share more and more of their profits with you. As I mentioned before, the dividends will start small both in amount and in yield, but getting discouraged and deciding it's not worth it is the absolute last thing you should do. Instead, you reinvest and let the dividends compound until your passive income from dividends exceeds your expenses.

If you've invested wisely over the years, not only will your monthly passive income be stable during the years after you retire from your day job, but it will actually grow from year to year. Rather than worrying about how much you have left, how much you can withdraw, and whether you will outlive your money, your strategy of dividend growth investing will create for you a perpetual income machine that will outpace both inflation and your expenses (assuming neither of those pick up in any major way). And once you have comfortably built that perpetual income machine that is paying you more in dividends than you have in expenses, then you are ready to retire.

But who said you have to retire at 65?

What's great about dividend growth investing is that you don't have to wait until you are a couple decades from death to stop working to ensure that you don't outlive your money. You aren't drawing from a finite pool of funds. Instead, that money will build and build and build over time, and even if you somehow live to be 500 years old, that money will still be coming in. As long as these businesses continue to increase their profits, their stock will increase the dividends they pay you. If you find that your monthly dividend income exceeds your monthly expenses at the age of, say, 35, well then you can retire at 35. Dividend growth investing is truly a wonderful strategy because of its flexibility. Perhaps capital gains may make you more money over time, but it's not about making X amount of dollars by a specific date or age. It's all about how much you will be making per month rather than the final total, and dividends are the safest and most stable option of them all.

So forget about making X amount of dollars by age 65 and calculating the safest amount of cash to withdraw each year; dividend growth investing will put you in the position that your money will grow on its own. As the saying goes, why work for your money when your money should work for you?

Investing the Safe Way

Minimzing Risk With Dividends

Some people might still be a little weary of investing. People are afraid of the stock market. They are afraid of its ups and downs, they are afraid of volatility, they are afraid of losing. Risk is not something many people are willing to tolerate in this economy. Millennials especially are adverse to the market. Did you know that they hold more than half their assets in cash[1]? It's a reaction to the Great Recession; they see risk as the permanent loss of capital and are afraid to lose it all.

In my eyes, avoiding the stock market and keeping your savings in cash is great if you feel that you don't want to risk not losing your money. Dividend growth investing is not just the safer, less risky alternative to day trading; it is the safer, less risky alternative to bonds, gold, and yes, even the cash in your FDIC insured bank account!

How is that possible? Because of inflation! Inflation is the rate in which your money loses value over time. As the Federal Reserve prints more money (you might have heard of “quantitative easing”), the money loses its value due to the increasing supply leading to a much lower demand for each dollar. Prices then increase to reflect this. That's why your grandfather used to see movies for a nickel while you have to pay $13 to see something that isn't 3D. The current inflation rate for 2014 is about 1.7%, but in 2011, it was 3%! And in 2007, it went over 4%[2]! What's the average interest rate on a savings account? Half a percent! Your grandmother might tell you that the safest place to put your money is in a CD, but if you do that, you are guaranteed to lose money over the long term.

With a solid strategy of dividend growth investing, backed by a conservative investment philosophy that shuns the “hot stock” that will supposedly make you money fast, not only will your investments outpace inflation, but you will never lose. I'm not recommending any specific stocks, but do you think Coca-Cola, McDonald's, Johnson & Johnson, or Colgate-Palmolive are going anywhere soon? Look up the Dividend Aristocrats—companies that have paid and increased their dividends consistently for the last 25 years—and you will see companies that you buy things from everyday. Which is riskier: The high quality company that's been increasing its profits and dividends since the 1800's, even during the Great Depression, or the bank savings account that won't even match the inflation rate? I can't guarantee the performance of any stock or company—perhaps the four companies I just mentioned will be completely out of business next week—but I can gauge what is risky and what is not, and I can safely say that the stock market is the least risky place to put your money. As long, that is, as you engage in conservative investing rather than speculative day trading.

Remember that while you can't predict the market's short term movements, you can gauge where a company will be ten years from now if you study their fundamentals. So if the stock price for any specific company goes down, don't worry. Just take the time to reassess it. If the fundamentals haven't changed and it still looks like a great company, then a dip in the share price is an opportunity rather than a loss. Remember the principles of value investing; buy a great company when it's at a discount and don't take the ups and downs of the share price to mean anything significant on its own. Apply the principles of value investing to your greater strategy of dividend growth investing, and you will will see opportunity when everyone else sees risk and loss.

While I can't say that there's no risk involved, I can tell you that the risk of not investing in the stock market is significantly greater than the risk of investing and losing, as are the consequences. If you don't believe me, play around with the savings account calculator on bankrate.com, and then play around a bit with the dividend returns calculator right here. See how much a $100, $1,000, or $10,000 investment will grow after ten, twenty, or thirty years. The difference will truly astound you!

Dividend Growth Investing: The Path to Financial Freedom

Astound, I say!

Get Rich with Dividends: A Proven System for Earning Double-Digit Returns
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So you're ready to get started, aren't you? But you still have one problem. How do you know if a company's fundamentals are good, if the stock is undervalued, if they are paying a dividend, or even where to go and research? Theory is great and all, but what good is a great strategy if you don't even know how to execute it?

Dividend Growth Investing: The Path to Financial Freedom

My dog is not amused by your neediness.

Even Warren Buffett's stock advice tends to drift into this, telling people to buy a great company at a discount without telling people in detail how to tell if the company is truly good and if it's actually trading for less than it's worth. Of course, that will take a whole other article to do, but don't worry, I won't leave you hanging. Instead, I will share with you how I analyze a stock and decide if it's something I want in my investment portfolio.

But even then, you might make a mistake. It happens. Everyone makes mistakes. But with a strategy of long term dividend growth investing and a well diversified portfolio of high quality businesses, the chances of you losing money over a period of thirty years are practically non-existent. But the consequences of not starting early, or at all, can be catastrophic!

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Comments

Nov 7, 2014 2:47am
WinterWolf
Great article! You pointed out several obvious things people readily ignore when investing in a business (and yes, "stock" does sound riskier than business) :)

I have always been interested in finance and business field, although I was only able to take Economics on my fourth year engineering. We did a project on financial ratio analysis of an A class commercial bank and I loved every step in it. It feels good to know that we learned about the debt ratio, earnings per share and (may be 8) other ratios. Dividend growth surely is a less risky, but just as long as the businesses remain. And by investing on right businesses, they are almost safe!

Thumbs!
Nov 7, 2014 4:50am
Joey_Batz
Thanks for the comment, WinterWolf!

A lot of the things here may seem obvious, but you wouldn't believe how many people don't know this stuff, or at least need a friendly reminder. People are so afraid of the market and don't realize how much they are shooting themselves in the foot by avoiding it, especially when it's so easy to do it yourself.
Nov 16, 2014 8:15am
egdcltd
I have a stock (Kingston Communications) - which admittedly I bought because I thought it was dirt cheap - that has promised to grow its dividend by, I think, 10% every year. It's got an effective local monopoly so, even though it is not the nest example in its class, it is paying regularly and increasing in the amount. Last time I checked, my dividends covered the cost of the stock. It didn't originally pay dividends, though, and in the UK we only have two dividends a year.
Nov 22, 2014 6:40am
Joey_Batz
Glad Kingston is working out for you! I personally wouldn't have went for it, but that's because it doesn't have a strong dividend history as you said. In Part 2 of this series, I cite that as one of my biggest criteria of analysis. Personally, I'm not a huge fan of semi-annual dividends as well (I like my quarterly/monthly payers), but that's just me and the most important thing is that the company pays consistently and raises the dividend every year.

Is Kingston the only company in your portfolio, or is it the only one you mentioned? You should definitely be working to diversify. If 100% of your investments are in that company and something happens to it, well............

What's the ticker for it? I can't find it on Yahoo Finance.
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Bibliography

  1. Jesse Solomon "Millennials invest like their grandparents." CNN Money. 6/02/2014. 26/09/2014 <Web >
  2. "Current US Inflation Rates." US Inflation Calculator. 26/09/2014 <Web >

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