Today we have a guest post from Bob Ciura from Sure Dividend. Sure Dividend produce a ton of free and paid research and articles for those who wish to build a portfolio of reliable, dividend paying stocks. Take it away Bob!
Momentum trading, which involves purchasing stocks that have exhibited great recent performance, has some enticing advantages that have led many investors to follow this investing strategy. The most important advantage is the high probability of short-term reward, as a strong trend is more likely to persist than reverse in the short run.
However, this strategy is highly risky in the long run. Instead, in order to achieve superior long-term returns, investors should buy quality dividend growth stocks. In this article, we will analyze the advantages of investing in Dividend Aristocrats. This group includes the stocks that have grown their dividend for at least 25 consecutive years.
Dividend Aristocrats have underperformed the broad market lately due to the impressive rally of the technology sector. However, they have outperformed the broad market over the last decade. During this period, they have offered a 14.2% average annual total return, which is slightly higher than the 13.9% average annual total return of the S&P 500. This difference may seem small on the surface but investing in this high-quality group of stocks exhibits many advantages.
As mentioned above, Dividend Aristocrats are the companies that have raised their dividend for at least 25 consecutive years. Only companies with a high-quality, robust business model can achieve such long dividend growth streaks. These companies usually enjoy durable competitive advantages, such as unparalleled brand strength or presence in niche markets, with strong pricing power amid weak competition. In the long run, companies with high-quality business models are likely to outperform companies which lack a meaningful competitive advantage and thus struggle to defend their market share. This is a key factor behind the outperformance of Dividend Aristocrats in the long run.
Many companies are highly profitable but most of them need to spend a significant portion of their profits just to remain in business or defend their market share. For instance, airlines need to spend hefty amounts year after year to maintain and renew their fleet. Auto manufacturers spend most of their earnings on the development of new models in order to remain relevant. Oil producers spend excessive amounts every year only to offset the natural decline of their fields. Therefore, it is not surprising that the group of Dividend Aristocrats includes only two oil companies and no company from the aviation and auto industry.
Dividend Aristocrats largely engage in businesses that have low capital requirements. As a result, they need to reinvest only a tiny portion of their earnings in order to remain in their growth trajectory and hence they enjoy excessive free cash flows. Moreover, thanks to their rich cash flows, Dividend Aristocrats usually have healthy balance sheets, in contrast to most companies, which carry appreciable amounts of debt. Most investors ignore the debt load of companies in their investment process but it is critical to realize that a high amount of debt renders a company highly vulnerable to downturns, such as recessions or heating competition. The healthy balance sheet of most Dividend Aristocrats should be of great importance to investors with low risk tolerance.
As the economy grows, investors usually base their investing decisions on their experience during booming economic periods. However, this is a highly risky investing strategy. Recessions inevitably occur every few years. They are usually short in duration but tend to cause a steep decrease in the earnings of most companies and hence a collapse in stock prices. During bear markets, capital gains of years may evaporate in just a few weeks. Dividend investors have the advantage of having received generous dividends for the whole period they have remain invested, providing a buffer against falling stock prices. Therefore, risk-averse investors should select stocks that are resilient to recessions.
Dividend Aristocrats have definitely proved their resilience to recessions. Not only have they endured many recessions, but also they have continued raising their dividends throughout these rough economic periods. The last 25 years include a mild recession in 2001, the Great Recession and the fierce recession caused by the pandemic last year. As Dividend Aristocrats have kept raising their dividends throughout these downturns, they obviously have superior business models, which perform well even under the most adverse business conditions.
Moreover, thanks to their defensive business models, Dividend Aristocrats exhibit lower stock price volatility than the broad market during bear markets and sell-offs. It is well known that the vast majority of individual investors, including the professional investors, underperform the S&P 500 by a wide margin in the long run. Most of this dramatic underperformance is caused by the inability of investors to retain their holdings during bear markets. Unfortunately, many investors sell during market downturns out of fear.
Dividend Aristocrats exhibit lower volatility than the broad market, meaning it is easier for their shareholders to endure bear markets. As no one can predict the duration of a bear market, it is much easier to endure a bear market while receiving a generous dividend.
The ultimate goal of having a portfolio is to generate a rising stream of income. This may not seem obvious to young investors but it is obvious to those who try to prepare for their retirement phase. Dividend Aristocrats are ideal for this group of investors, as they have a proven record of raising their dividends even under the most adverse economic conditions. Therefore, income-oriented investors should first examine the stocks of this group and select the ones with the most promising prospects.
As long as a Dividend Aristocrat has a healthy payout ratio, a strong balance sheet and it has not incurred permanent business deterioration in recent years, it is safe to assume that the company will keep raising its dividend for many more years. Those who select their stocks based on these criteria have great chances of securing a reliable and growing income stream.
The technology sector has outperformed the broad market by a wide margin lately. As a result, many investors have shifted their focus on this sector. However, they should realize that many technology stocks have become highly risky after their steep rally, as they are now trading at nosebleed valuation levels.
Investors who try to secure a reliable and growing income stream should focus on the group of Dividend Aristocrats. These stocks enjoy a durable competitive advantage and excessive free cash flows. In addition, as their stock prices exhibit low volatility, they make it easier for their shareholders to remain invested in the long run, even during fierce sell-offs. For all these reasons, investors looking for quality dividend growth stocks for the long term should consider the Dividend Aristocrats.
Although investing in individual stocks should be reserved for more experienced investors and for those with a larger portfolio (many people will be just fine with a simple tracker fund), there comes a time in every mutineers journey where they want to begin generating an income stream from their investment portfolio.
As Bob highlights above, this will tend to be close to the 'retirement' phase of an investors life (or at least the point where you want to begin taking a passive income from your investment portfolio so you can enjoy a life of Financial Freedom).
Please beware though, most investors who choose individual stocks end up under-performing the market. As such, it is very important to do your research carefully if you wish to get into this game. That's where research newsletters like Sure Dividend can come in useful.