The high dividend growth rate strategy is one of two "proven" strategies offered in the book "Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks."
In the view of author Mark Lowe, the second proven strategy is the high dividend yield strategy; note the distinction: The first focuses on the dividend plus growth, while the second focuses on just the dividend yield.
In this discussion of chapter four, we give our attention to Lowe's explanation of the high dividend growth rate strategy, which begins with growth stocks. The author pointed out this is different than the conventional strategy of choosing domestic, large-cap stocks.
Why a growth strategy?
For a start, Lowe wrote, "Because of the focus on healthy balance sheets, growth-oriented stocks are recommended to investors who are averse to volatility and increasing interest rates but are still looking to hold shares that will provide them passive income. If you like this arrangement, HGDRS seems a good fit for you."
In other words, this is a classic dividends plus capital gains strategy. You start with a stock that may pay a lower dividend, assuming greater growth will lead to substantial increases in the dividend yield in the future (while also enjoying gains from stock price increases). As an example, the author contrasted two hypothetical companies:
- First, Company P, which has a 3.7% dividend yield and a history of growing the dividend by at least 4% per year. Its current dividend payout ratio is 58%.
- Company Q pays a dividend of just 0.90%, but is experiencing growth of 19% and its current payout ratio is 11%.
As Lowe put it, "As dividends increase alongside profits, the yield-on-cost starts to overtake the company with minimal growth."
Why dividend growth matters
If we had a choice, most of us would prefer a company paying a small dividend now but consistently brings in higher revenue each year, than a company that pays a large dividend now but has posted revenue declines.
Given the inherent cautiousness of boards of directors, they're not likely to promise increased dividends if they don't think they can keep doing it for the next 10 years. Growing dividends signal confidence by management and the owners' representatives.
Be warned, wrote Lowe, that while HDGRS may be an attractive approach to dividend investing, that attractiveness can be reversed by interest rates. He cited Warren Buffett (Trades, Portfolio)'s analogy that interest rates are financial gravity because they are "the universal force in the financial world."
Central banks and governments determine interest rates, which leaves investors with no control over one of the most important external variables.
Currently, interest rates are very low, making equities more attractive than bonds. That pushes up share prices, but what if interest rates reverse and go up? Then share prices will need to come down to normalize relative stock valuations, dashing hopes for a win-win on dividends and capital gains.
Risks using the HDGRS
Investing, even cautiously, in growth stocks has its risks. Companies can lose their upward momentum for many reasons, whether self-inflicted or externally imposed. Lowe used the example of Best Buy (NYSE:BBY), which once was a high-growth company with an outstanding record for profit and growth. However, the tide turned as more and more buyers went shopping online and in 2006, the company's fortunes turned. The stock price fell from $60 to $12 in 2012.
Such reversals are not uncommon. In fact, one study out of Yale University in 2016 found the average lifespan of a company on the S&P 500 was just 15 years, compared to 67 years in the 1920s.
Look for companies with robust competitive advantages
Competitive advantages, also known as economic moats or simply moats, protect a company's margins from being attacked by competitors. Companies without moats may flourish for a time, but eventually, they will be hurt by reversion to the mean.
Examples of companies with strong moats are Coca-Cola (NYSE:KO), Harley Davidson (NYSE:HOG) and Google parent company Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL).
What if you started your search for dividend stocks by focusing on growth stocks? Most of them would likely pay a smaller dividend to start than you might receive from other dividend stocks, but you could come out ahead when you consider both dividends and the potential price appreciation of growth stocks.
That's known as the high dividend growth rate strategy. Theoretically, it could deliver higher total returns than a typical dividend stock, where the dividend is good, but growth is slow. As Lowe noted, there are risks to this strategy as there are with any approach involving growth stocks.
One of the best ways to deal with this risk is to choose growth companies with strong competitive advantages or moats. These are companies that have an advantage that competitors cannot easily overcome, ensuring the company is able to produce above-average returns for a number of years.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Dividend Investing: 6 Considerations
- Dividend Investing: Key Metrics, Part 2
- Dividend Investing: Key Metrics, Part 1
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This article first appeared on GuruFocus.