As with any form of investment, you have to learn the do’s and don’ts with Dividend Growth Investing.There are nuances and pitfalls to avoid in order to be successful. Here are my 10 Commandments for Dividend Growth Investors to follow:
- Know Thyself and Your Timeline
Your risk tolerance and your timeline will determine which investments fit your needs. Some of us may be willing to take a higher risk to get a potentially higher yield, or we may be risk averse and should take a more conservative approach. Likewise, the length of time before you plan on using the money will determine your investment choices. I discuss this consideration here.
- Be Patient
Dividend Growth Investing is a long term investment process. To take advantage of the benefits of compounding and dividend growth, prepare to invest for years or decades. The slow and steady rise of portfolio values and dividend payments in the beginning will exponentially increase over time. Prepare to invest for the long term and don’t get distracted by the shiny objects in the stock market.
- Remember that Free Cash Flow pays the dividend
Free Cash Flow – the money left over in the company after all obligations are covered and the needs of the business are met. This is where the money for a dividend payment comes from. If the company can’t produce free cash flow, it can not sustain the dividend
- Understand that dividends are not guaranteed
Dividends should never be taken for granted. The company’s Board of Directors can reduce or cancel the dividend at any time. Finding a company that is committed to the dividend and has the means to pay is paramount. Do not buy a stock solely based on the dividend.
- Diversification and risk management matters
A portfolio of investments should be diverse across economic sectors and types of companies. No more than 5% of the portfolio should be in any one company, and no more than 15% in any sector. Position sizing should be based on your conviction of the company, their stability, risks, and their future prospects.
- Don’t chase yield
The appeal of a high yield is intoxicating. Why would you not want to make a 10% or higher dividend? Higher yields typically are typically warning signs that there are issues with the business or the market doesn’t believe that the company or dividend is stable. Looking for a company with a low to modest dividend will provide better long term capital appreciation and stability.
- Focus on finding good companies
Dividend investors should not focus on the dividend itself, we should be focusing on quality companies that pay dividends. At the end of the day, we are buying a piece of a real company, with real assets and revenue. A good business that continues to grow will provide better value to its shareholders than a company with a high dividend that can’t grow their business.
- Excessive debt is the killer of dividends
Dividends are paid from the Free Cash Flow of a business. As stated above, this is the money left over after all expenses have been paid. A high debt load, especially if it is variable rate debt, wil reduce the amount of free cash flow left over. This debt payment will reduce the cash available for dividends, therefore putting the dividend at risk. Debt has to be paid for the company to stay solvent, and dividends are one of the first levers a company can adjust to come up with funding to pay these debts.
- Understand compounding
Our brains are trained to think linearly. 1+1=2. Investing is exponential. 1+1+Time = 3. The longer you invest, the faster the upward trajectory of your account balance and income will become. Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns. Investing $100 a month for 30 years and getting an 8% return can provide you $228,000 with only investing $36,100.
- Understand valuations
Even a great company can be a bad investment if bought at the wrong price. Before any purchase look at the valuation metrics and calculate a reasonable price to buy at. Use valuation calculations such as Discounted Cash Flow, P/E Mean Reversion, and Dividend Yield Theory. Click here for more info on how to do this.