Building wealth through dividend investing

February 18, 2014

  • We believe a disciplined dividend strategy that focuses on rising dividends produced by high-quality companies can help investors build wealth over time.
  • Historically,  dividends have been an important component of total return, with the best opportunity for total return in the stocks of high-quality companies that can sustain and grow their dividend over time.
  • Higher quality stocks act to mitigate risk and offer downside protection during times of market stress.

By Scott L. Davis, Senior Portfolio Manager, and Michael S. Barclay, CFA, Senior Portfolio Manager

How can investors build wealth over time and consistently grow income in a relatively low risk equity strategy? We believe a disciplined dividend strategy that focuses on rising dividends produced by high-quality companies with growing free cash flow should be a core part of any investor’s asset allocation. For patient, long-term investors, such a strategy can offer:

  • Consistent, rising income with a lower tax rate than other income-producing asset classes
  • A hedge against inflation and higher rates to maintain future purchasing power
  • A lower risk profile that protects on the downside yet captures enough upside over time to produce solid, risk-adjusted returns

Dividends in the total return equation

For long-term investors, dividends provide a source of repayment on their initial investment. The more you get up front, the less you have to rely on less-predictable capital appreciation for the cash return on an investment. And, historically, dividends have been an important component of total return, accounting for 42% of total return on average since the 1920s.*

Keys to dividend investing

  • Dividend growth. Rather than focusing on yield, the best opportunity for total return resides with the stocks of high-quality companies that can sustain and grow their dividend over time (Exhibit 1).
  • Free cash flow. A corporation must be able to generate cash returns that exceed what it needs to grow the business. This provides the firepower for dividend growth and other shareholder-friendly actions. Dividends that are not supported by free cash flow may not be sustainable.

Chart: Companies that sustainably initiate or grow a dividend have historically outperformed

  • Active management. The ability to assess a company’s potential to raise its dividend is a critical component of successful dividend investing. This is important because a history of paying a dividend doesn’t necessarily mean a company can increase or even maintain the dividend in the future.
  • High quality. Though there are certainly periods when low-quality stocks outperform, quality acts to mitigate risk and offers downside protection during times of market stress (Exhibit 2). By limiting losses in down markets, there is less ground to be made up when markets rebound.
  • Percentage of cash flow consumed by the dividend. Very often investors look to the payout ratio based on a company’s earnings that are based on accrual accounting, which can more easily be manipulated. We believe this can be misleading and instead prefer to focus on the percentage of annual operating free cash flow consumed by the dividend.

Chart: High quality stocks hold up well during market downturns

Click here to read an extended analysis: Building wealth through dividend investing

*Source: Ned Davis Research, August 2013

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time and issuers may reduce or eliminate dividends paid on securities in the event of a recession or adverse event affecting a specific industry or issuer.

The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.