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Scott Newman | September 7, 2016

The power of dividend growth

The case for dividend income has become even more compelling as record-low interest rates and macroeconomic conditions have driven bond yields down. In uncertain and choppy markets, yield-starved investors are looking for ways to satisfy their income needs.

But what about those seeking capital growth? Investing in companies that have a history of not only paying, but increasing, their dividends can provide both capital growth and income – as these companies have historically outperformed the broad market over time (see chart below). A high-conviction focus on dividend growth as an investment factor can result in higher yield than the broader market and overall growth potential from stock price increases.

Steady growth vs. current yield

A dividend grower is a company that not only pays a dividend, but has consistently increased its dividend over time. Why does this matter to an investor? While it may seem enough to simply focus on the current dividend yield relative to income needs, this only tells part of the story.

Companies that consistently grow their dividends tend to be those that are mature enough in the business lifecycle to be able to pay dividends and yet still have room for continued business growth through reinvestment projects. Dividends are certainly an important part of overall returns, but dividend growth over time demonstrates a level of stability and growth potential that a high dividend alone doesn’t.

A high, above-market dividend payment may signal that a company is undervalued. The high yield simply may not be sustainable during down markets, which could lead to a dividend cut and subsequent drop in share price during tough times. It can also indicate a lack of long-term thinking if excess cash flow isn’t required for plans to grow the business. High-conviction investing based on dividend growth as a factor can help mitigate these issues by focusing on steady growth over current yield.

A steadily growing dividend can be an indicator of a company’s overall corporate health. Businesses that have consistently grown their dividend over time tend to illustrate key merits of financial strength. Put another way, the consistent increase may be a by-product of corporate health, intelligent capital allocation decisions and consistent earnings growth. The fact that they consistently have free cash flow available to increase the dividend after they’ve taken care of future growth by investing in the business is a key determinant of both stability and quality. These businesses are generally more likely to exhibit resiliency in tough economic environments.

Historically, dividend growers have traded at a higher price-to-earnings ratio (P/E) than companies that pay higher dividends because they tend to grow faster. However, there has been a shift in this norm, as many investors seeking yield are making buying decisions based solely on current yield, pushing valuations for high-dividend paying companies beyond those of the dividend growers. Investors can take advantage of this price gap by focusing on dividend growers over simply current yield.

Dividend growers over time

The chart below shows how dividend growers have fared over the long term, both in terms of volatility and performance. Dividend growers have not only outperformed, but have also provided a much smoother ride for investors along the way – demonstrating that investors don’t need to choose between income and growth. Why not strive for both?

chart_dividend_en
Source: RBC Capital Markets Quantitative Research. Data is calculated on an equal-weight basis using the S&P/TSX Composite Total Return Index between October 1986 and July 2015. Dividend cutters represent stocks that have lowered or eliminated their dividend; non-dividend payers represent non-dividend-paying stocks; dividend payers with no changes represent all dividend-paying stocks that have maintained their existing dividend rate; and dividend growers represent all dividend-paying stocks that raised their existing dividend.

Finding dividend growers

High-conviction, active portfolio managers use a disciplined approach to researching companies, looking past markets trends to find high-quality dividend growers at the right price.

Factor-based smart beta strategies can provide exposure to dividend growers by following an index focused on companies that exhibit a history of increasing dividend payments, such as the Nasdaq Select Canadian Dividend Index.

The following actively managed and factor-based, smart beta strategies recognize the importance of dividend growers:

If you have any questions about dividend growers or how access to these companies can impact your portfolio, please leave a comment below.

More from Scott Newman

The power of dividend growth
September 7, 2016

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Price-to-earnings (P/E) ratio measures a stock’s valuation by dividing its share price by its earnings per share.

2 responses to “The power of dividend growth

  1. HI Scott
    I understand the value of the dividend grower concept but given the anticipated rise in rates in the US does buying solely dividend growers make sense at this point in the cycle?
    Does it make sense to have a dividend paying fund in a Corporate class (in an open account) is you want the dividend payout anyway ( paid to wait)

    1. Thanks for your question – it’s a good one.

      Potential further increases in interest rates in the U.S. tend to be one of the primary reasons to own an investment in a company with a history of dividend growth. It’s the more high-yielding dividend stocks – those that look and behave a lot like bonds – have seen their share price suffer since the U.S. election and interest-rate increase in mid-December. Companies that have consistently shown an ability to efficiently and effectively allocate capital, such that earnings, free cash flow, and dividends may continue to grow consistently can be a very good defense against rising rates, as these characteristics demonstrate strong fundamentals. In my opinion, this is one key consideration.

      As for corporate class, if you are buying an investment that issues foreign dividends within a corporate class umbrella, there is some potential to have that income deferred via the corporate class mechanism, but we recommend investors seek a financial advisor’s guidance on this issue.

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