The pros and cons of high-quality dividend growth stocks as a means of passive income.
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” John Rockefeller.
Why did Mr Rockefeller say this, because passive income has many advantages? It frees up time and allows you to focus on the things you really want in life. Creating passive income is easy when you know how to start the journey.
What are high dividend paying stocks?
Shareholders are the owners of publicly traded companies. These companies are managed by a board of directors and a chairman who is elected by the shareholders. The directors provide a strategy, and the C level executives (CEO, CFO, CTO) execute it. Profitable companies can share their profits with their shareholders as dividends. Not all companies do this. Some keep all the profits to reinvest them others are not profitable enough to distribute a dividend. Good companies tend to grow their revenue and profits, in turn, they have the potential to increase the size of their dividend. Hence the name of “Dividend Growth stocks.”
Dividend Growth stocks are companies which have grown in size and periodically increase their dividends returns.
Learn more: How to find dividend growth stocks
The pros of Passive income from dividend growth stocks
The Golden Goose is safe. Investing in dividend growth stocks generates passive income. There are very few passive income assets which require no management. Owning growth stocks for passive income requires the investor to make decisions over which stock to sell. Dividend growth stocks save the investor the decision on which stock to sell. Getting rid of equity feels like killing the Golden goose. This is especially important for those who expect to be retired for the next 60 years plus.
Absolutely no maintenance needed, many passive income assets listed here such as crypto [LINK], Real estate [LINK] or side hustles [LINK] require some level of maintenance. This is not the case with dividend stocks. The more these companies grow, the more passive income is received, and the recipient can go even deeper in retirement!
Inflation proof. Growing companies will adjust their dividends with inflation. They can do this because the prices of their products will also increase with inflation and so should their profits. This gives the dividend investor some Inflation protection.
Easy to diversify. It is impossible to predict the future. Some sectors of the economy will flourish others will flutter. There are many opportunities for diversification with Dividend growth stocks as they exist in every sector of the economy.
Stable income. Property, Crypto, Side Hustles have the potential for better returns than dividend growth stocks. However, dividend growth stocks rate of returns is more predictable. In early retirements stability of income is important.
Difficult to manipulate accounts. Companies that have been distributing dividends for many years have transparent accounts. Companies which do not distribute dividends can in some cases make some accounting acrobatics, which makes it difficult to evaluate. Since dividends are cold hard cash, it makes impossible for companies just to look nice rather than also being nice.
Long-term in mind. A portfolio of dividend growth stocks designed to support a life of financial freedom needs to have good prospects for the long term. If such a portfolio were to fail, the life of FIRE would not be viable. This focuses the investor to choose sustainable dividend growth stocks. Stocks suitable for such a portfolio should have been around for a long time and their management has learnt how to turn change into an opportunity.
This automatically excludes hot trends or fads, which tend to leave a streak of failed companies in their wake. Typically such long-term plays come in the shape of strong business models, in industries which have a high entrance cost and the leaders of which have a strong competitive advantage which cannot be easily replicated.
Increasing Income. Choosing the right dividend growth stocks increases the likelihood of growing your dividends over time without having to invest more funds. This is powerful. It would take a lot of capital to increase the dividend income by investing new funds rather than by the organic dividend increase. Let’s take an example. A dividend income portfolio worth $500,000 with a 3% dividend yield would provide $15,000 of dividends a year. If that portfolio went up by 6% to $530,000 while assuming it would still give 6% then it would give $15,900 of dividends. To increase an annual ROI by $900 would mean investing a further $30,000 in the portfolio! In dividend growth investing the compounding happens both with the dividends and the capital growth.
Dividend Reinvestment and Stock Purchase Plans, Some public companies allow you to reinvest the dividends automatically in their stocks. That is investors will receive more stock instead of a cash dividend. The advantages here are that the purchasing fees of the stock are saved and the compounding effect. One such company that does this is Honeywell
The Cons of Passive income from dividend growth stocks
Dividend growth stocks are not exciting. Actually, they are boring businesses. Companies in a dividend growth portfolio tend to have simple business models. Reading through their reports will not enlighten you about the cutting edge tech on AI or Nanomaterials. Select masternodes a crypto passive income system, on the other hand, can be an exciting “investment”
Becoming a good investor is a long process. Books and Blogs need to be read, and some mistakes will inevitably be made!
Taxes. Dividend income has different tax implication than capital gains. It might be more costly to earn yearly dividends than to pay taxes on capital gains. This varies from person to person.
Dividends can be misleading. A high yield does not make a good dividend stock. High dividends are not sustainable in the long term. The dividend history, the payout ratio, the yield and the P/E ratio of the stock can help the investor understand the sustainability of a dividend.
Profits vs Capital expenditures. Companies using all their profits to pay for dividends run the risk of not being prepared for the future. Profits come from capital expenditures, research, new products etc.. these cost money and high payout ratios do not allow the companies to prepare for the inevitable changes in the future.
Good Bargains are not easy to find. High dividend stocks are followed closely. Everyone likes dividend stocks! Finding a bargain in this sector is more difficult than in the general market. First, because the dividend gives the stock a floor and secondly many investors are waiting on the sidelines to buy the stock at the right price.
Missing out on good companies. Some companies might have cut their dividends just because they are going through a restricting or a rough patch. These companies would not pop up on your dividend filter.
No Guarantee. Dividends are issued at the discretion of the board of directors. Any company even those with a long history of dividends can cut their dividend. This is why diversification is important.
Is constant growth possible? The global economic model requires constant growth otherwise it falters. The whole system runs on energy, lots of it. The fact is that oil discoveries are becoming less frequent and renewables at their current stage of development cannot replace oil. If It were the case that our sources of energy become too expensive than business would have to radically change their way of working to cope with such drastic changes.
Dividend ETF Portfolio more efficient? Investing in dividend growth stocks for Passive income requires monitoring of the stocks in your portfolio and new opportunities. This takes time and commitment, an ETF portfolio could be a better solution for those who do not want to invest as much time.
Dividend growth stocks are the most sustainable form of passive income out there. They require low maintenance, and it is very easy to diversify amongst different geographies and industries. They can be one of the pillars of a financial freedom plan.