The Dividend Method
- Mike Brown
- Nov 6, 2024
- 3 min read
Dividends are the centerpiece of our equity investment philosophy for four reasons:
They provide a source of income for our retired clients, and a source of compounding for clients whose goal is building wealth.
Today’s cost of living (CPI) is nearly 17 times higher today than it was at the end of World War II (1946-2023). S&P 500 dividends are more than 106 times higher over the same time period. Dividends have been an excellent way to hedge against inflation and protect purchasing power over time.
Shares of companies that pay dividends and increase them consistently over time have delivered higher total returns than those that either don’t pay dividends or don’t increase them regularly.
Share prices of rising-dividend stocks have historically also been less volatile than the overall market.
Most investors understand the concept of growth when it comes to their investments. And they are also familiar with investing for income. The Dividend Method focuses on growth of income. Rising dividends help our younger clients compound wealth over their working years, and that rising stream of income makes it possible for retired clients to maintain their standard of living and overcome the corrosive effects of inflation.
How do we select investments for the portfolios we manage? By focusing on six key criteria:
Quality. We look for companies with competitive advantages. They make the things or provide the services that their customers want or need to buy, preferably over and over again.
Financial strength. We want the companies we invest in to exhibit staying power, as evidenced by strong balance sheets, steady cash flow, and little or no debt.
Growth. We like to see consistent growth in earnings (profits) over time, with no annual losses over at least the last decade. And it goes without saying that dividends must also be growing steadily – at least as fast as inflation over time – with no dividend reductions in the past 10 years.
Sustainability of dividends. We want to be confident that the company can continue to increase its dividend in the years ahead. That’s hard to accomplish if the business is paying out most or all of its annual profits in dividends, leaving little to reinvest in the company’s growth.
Current yield. If the dividend per share is too small compared with the price we are paying for that share, it might take too long to reap the benefits of dividend growth. We prefer a current dividend yield (dividend divided by price) that is higher than the market average as a starting point.
Value. Typically, the biggest challenge we face as portfolio managers is finding companies that meet the foregoing criteria that are also selling at reasonable prices. Prolonged bear markets create buying opportunities, as do negative headlines about a particular company, assuming the bad news is temporary and investors are overreacting to it. Otherwise, it takes patience and discipline to find companies we want our clients to own without overpaying for them.
Ultimately, we want a diversified portfolio of about 25 companies that meet all six of the above criteria when we purchase them for client portfolios, with no industry sector representing more than 30% of the portfolio. Stock prices will do what they do, but as long as the fundamentals remain intact, our focus will be on that rising stream of dividends – and the compounding benefits they offer the clients we serve.
Dividends are not guaranteed and must be authorized by the company’s board of directors. Diversification does not ensure a profit or guarantee against a loss.
