The case for dividend growth stocks

What’s the better investment, growth stocks or dividend stocks with high dividend yields? It’s the age-old question, but why should investors have to choose? An alternative option, one that combines the best of both worlds, is to look for the market’s best dividend growth stocks.

This approach merges the benefits of seeking out growth stocks with robust cash flows, which will underpin further growth and shareholder returns. 

What’s more, dividend growth stocks come with an added psychological benefit. It’s hard watching the stocks you own fall 50%, but if you’re still picking up a couple of percentage points in income on the purchase price every year, that cushions the blow. 

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You could also reinvest this income, buying more at lower prices to benefit from higher returns in the long term. 

A case for dividend growth 

S&P Global made this point in a paper published in June last year titled A Case for Dividend Growth Strategies.

The paper looked at the performance of equities in the S&P High Yield Dividend Aristocrats® index, which tracks a basket of stocks from the S&P Composite 1500® that have consistently increased their dividends every year for at least 20 years (the average in the index is 37 years). It compared the performance of these equities to those in the S&P 500® High Dividend Index—a high-dividend strategy built on the S&P 500. 

Those companies in the Dividend Aristocrats index had lower levels of leverage, high returns on equity and higher earnings per share growth over the previous three years compared to those in the standard S&P 500® High Dividend Index. In fact, over the three years to March 31, 2022, those in the latter index saw earnings per share fall -2% compared to 8.1% growth for the Dividend Aristocrats. 

And when it comes to dividend sustainability during times of stress, there’s a clear trend in the data. 29 constituents of the S&P 500 High Dividend Index, 36.1% of the index cut full-year dividends between 2019 and 2020, while only 7.2% of S&P High Yield Dividend Aristocrats Index constituents did so over the same period. 

Outperformance with income 

Looking back over the period December 31 1999 to March 31 2022, S&P’s researchers found the S&P High Yield Dividend Aristocrats outperformed the S&P Composite 1500 and S&P 500 High Dividend Index by an average of 140 bps per month and 49 bps per month, respectively. 

The index also outperformed in down markets, losing just 2.5% on average in down months for the S&P Composite 1500, outperforming the market by 1.4% in each down month on average.

These numbers confirm the fact dividend growth outperforms on average in the long term. 

They also show us yield only has a very small part to play. What matters is dividend sustainability. Companies with dividend track records stretching back four decades have shown they know how to balance cash returns to investors, capital spending and acquisitions to produce positive returns for all stakeholders. 

The Warren Buffett approach 

Focusing on dividend growth will give a similar return, it’ll just take time. The best example of this in action is Warren Buffett’s investment in Coca-Cola. When he bought the stock (he never buys for income) it had a yield of around 3%. Today, after nearly four decades of consistent dividend growth, his yield on cost stands at over 50%. 

Even today Coke remains a good model of what investors should look for in a dividend growth stock. The company does not require much capital spending each year as most of its production is outsourced to bottling companies (the likes of Coca-Cola HBC (LSE: CCH). Meanwhile, it can raise prices every year due to its strong brand loyalty and has a highly diverse product portfolio. 

Over the past decade, capital spending has ranged from $1.5bn to $2.5bn annually as operating cash flow has increased from $10.5bn to $11bn. This has left plenty of room to return cash to investors via both dividends with any left being returned as share buybacks. 

The dividend growth portfolio 

Buying a portfolio of dividend champions like Coke is a good way to build a dividend growth portfolio, but, as I noted at the beginning of this article, investing is hard and picking stocks is even harder. 

That’s why I’d choose to go with a fund specialising in quality income stocks. On the passive front, there’s the SPDR® S&P US Dividend Aristocrats ETF listed in both pounds and US dollars. There’s also the SPDR® S&P UK Dividend Aristocrats ETF (UKDV). 

Then on the active side, there’s a range of investment trusts that fit the bill. Finsbury Growth & Income (FGT) has a focused portfolio of businesses that dominate their respective sectors, with pricing power and robust cash flows to support their dividends. STS Global Income & Growth (STS) has a wider, more international portfolio of income plays. A little over a third of the portfolio is invested in the UK, with 56% invested in US equities.

Scottish American Investment Company (SAINTS) has less exposure to the US (35%) and its largest holding is Novo Nordisk. It also has a small allocation to corporate bonds and infrastructure trusts. 

JPMorgan Global Growth & Income (JGGI) has by far the best track record when it comes to creating value for investors. It targets a dividend of 4% of capital each year, funded with both capital gains and income, so it doesn’t focus purely on income stocks. It can buy growth stocks as well and trims these holdings to fund its dividends. A truly growth-focused fund with income as a second thought.