Over the past few months, we have received numerous requests from some of our newer investors on how to start a dividend growth portfolio. In this piece, I will take you through the ins and outs of starting a dividend growth portfolio and why it is a highly rewarding approach. Starting a dividend growth portfolio could be your ticket to financial freedom.
I started investing in my early 30s with little to no experience or guidance. Like some of you, I took the long road by learning on my own through reading online articles and publications to familiarize myself with the industry. I also started reading different investing books in order to gain the basic knowledge of how the market works and how to perform basic research of an individual company. Everyone has their own journey, and we are here to ensure yours is a successful one.
Developing A Strategy For Your Portfolio
Making the decision to begin putting your money to work in stocks could be one of the single most important financial decisions you make over the course of your life. The amount you begin with is not important; it’s the decision to begin investing in your future that is important. I began my investing journey with $2K I had saved up after graduating college.
The first step is to open a brokerage account and to fund that account with the money you are planning to invest. Some investors fund a portion of the account every month to slowly build the base, but however you choose to move forward is up to you.
Once we have an account open we must begin developing a strategy for the portfolio. I have had numerous readers and friends over the years express their interest in investing, and they all have the same questions, “Should I invest in Stocks or ETFs, and which ones?” Personally, I invest in both individual stocks and ETFs, but more so individual stocks. Now, this does not go to say this is the route you should take.
Individual stocks require much more work, as investors must stay up on important news events and their quarterly earnings to ensure the company still aligns with what you would expect. In addition, investment in individual stocks brings a much higher level of risk, but also offer large rewards.
Investing in ETFs, on the other hand, better suits the average investor, as they offer greater diversification and safety. This also allows investors to take a more hands-off approach, so it really comes down to how much risk you are willing to take and how much work you want to put in.
Once you determine an investment strategy for your portfolio it is time to figure out the stocks to invest in. My general answer when readers ask which stock to invest in is generally always the same, “Invest in quality companies with a strong historical track record.” This is my answer whether it is your first stock or 100th stock. You tend to know what to expect with these types of companies, thus offering fewer surprises along the way. Another piece of advice I tend to give to investors is for them to invest in companies they are familiar with.
We tend to lean toward sound companies with strong dividend track records. These types of companies are able to withstand any economic backdrop. The great Warren Buffet describes a key to investing as follows:
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”– Warren Buffett
How To Start A Dividend Growth Portfolio
Once we have developed a strategy it is time to start looking into possibilities for a position in your portfolio. I tend to lean towards dividend stocks, so a great place to start is to look at stocks that are included on the Dividend Aristocrats list. In order to be included in this prestigious club, a company should:
- Be included in the S&P 500
- Increase dividends 25+ consecutive years
- Maintain a minimum market cap rate of $3 Billion
As of today, the Dividend Aristocrat list includes 57 different companies meeting the criteria mentioned above. To be on this list a company has a strong track record of dividend growth, as such, they tend to make for quality positions to consider for your portfolio.
A company does not have the ability to consistently raise dividends year after year without growing earnings. Dividends at times may grow more quickly, but that is not sustainable over the long term. The key to dividend investing is to feel confident in a company’s ability to pay a dividend in the years to come and to beware of unstable yields that appear to be sucker yields, which are high yields that a company will not be able to pay going forward.
In order to further reduce the number of choices, one must learn the art of value investing. This means investing in a company at a quality price and not overpaying for a stock. This is not something learned overnight. I continue to pick up on new valuation metrics to this day and I have been performing stock research for a number of years now. The best researcher is a continuous learner.
There are several ways to find value in high-quality dividend growth stocks. The most popular valuation metric investors look at is the price-to-earnings ratio, or P/E ratio. Stocks with low price-to-earnings (P/E) ratios are a good place to look for value, but just as a starting point. Compare the PE ratio to that of the S&P 500, the company’s 5yr or 10yr historical PE average, and its competitor’s current PE ratio.
Other valuation metrics include: Price to Free Cash Flow (P/FCF), Enterprise Value (EV) to EBITDA or EBIT, PEG ratio, Price-To-FFO and AFFO (when comparing REITS), etc., you could include these as well in your comparable metrics to find stocks at quality prices.
Recent research has shown that the P/FCF and EV/FCF ratios are among the best at identifying value stocks, followed by EV/EBITDA.
Building Block Stocks To Begin Your Portfolio
Now, let’s get into a few examples of some stocks to begin your portfolio with. I like to refer to these stocks as building blocks or foundation stocks. All stock investments are important, but if you are just getting started, you want that first investment to be of the highest quality, as you do not want to fail right out of the gate, which could happen with anyone. Here are a couple of stocks with which I would start my dividend growth portfolio along with a short explanation of why. The stocks are not listed in any particular order.
|(JNJ)||Johnson & Johnson||Healthcare||2.61%|
Apple: A Delicious Dividend
The first company we will discuss happens to be one of the most popular companies in the world, Apple (AAPL). The stock has been on a tear to start 2020, riding the coattails of their service department. Sales of iPhones have slumped over the years; however, the company’s service segment has seen strong double-digit growth for a number of years now.
Service revenue includes the likes of Apple Music, Apple TV+, the App Store, Apple Pay, and iCloud. Apple subscriptions continue to grow, especially with the addition of Apple TV+, as Apple joined the streaming wars with the likes of Netflix (NFLX) and Disney+ (DIS).
In terms of hardware, Apple’s Earbuds business may have generated $8B in revenue in 2019, while Apple Watch has been the best-selling wearable on the market with tons of potential when it comes to use within healthcare.
The healthcare opportunity is related to the Apple Watch’s ability to determine irregular heartbeats, among other fitness and wellbeing tracking. Apple Watch and other wearable revenues continue to break records and raise the bar in the wearable industry.
The company continues to transition to more of a software company and investors are finally beginning to value the company like one. For the past decade, the stock has traded more in-line with hardware companies having a low double-digit P/E, but now the stock trades with a P/E ratio in the mid-20s, which is at the higher-end of where the stock has traded since going public.
The stock currently yields a dividend of 1%, which is nothing to go crazy about, but the potential for growth is what excites us as the stock has a payout ratio of only 25%.
Johnson & Johnson: A “Healthy” Dividend
The next company we are going to discuss is JNJ, which has one of the longest historic dividend stories known to investors. The company has paid and grown its dividend now for 57 years making them a dividend staple that should have a position in every portfolio. JNJ is a mature company but still offers areas for growth within its diverse portfolio in the healthcare industry. New products from their loaded pharmaceutical pipeline always provide an opportunity for growth.
One could find a JNJ product in almost every household (go ahead, look around and see if you find one, it shouldn’t take long). The company is stable with a dependable dividend with the trailing 12 months (TTM) payout ratio only being 52%. The payout ratio measures the amount of earnings the company uses to pay the dividend. A low payout ratio combined with strong cash flows usually gives investors a sense of satisfaction that the dividend should continue to rise going forward.
Though the company continues to reach millions of consumers with their in-demand products, risks are present, such as the asbestos lawsuits they are currently going through.
Source: JNJ Investor Relations
The last stock we will discuss comes from the Real Estate Investment Trust (REIT) industry. REITs operate differently than regular common stocks, but see that article to learn more.
Realty Income (O) is one of the most popular publicly-traded REITs on the market. The Company is also known as “The Monthly Dividend Company” for their monthly dividend payment to investors, which many retirees enjoy, but this stock is not just for retirees as it is one of the most well-run REITs around.
The Company is a member of the S&P 500 as well as the S&P High Yield Dividend Aristocrats index for having increased dividends every year for over 20 years. In fact, the company has increased its dividend every year for the last 27 years.
The company maintains a high-quality portfolio of real estate assets that are filled with quality tenants that are well-vetted by the Realty Income leasing team, which keeps occupancy levels high year in and year out.
The Company currently pays a dividend yield of 3.64% with a payout ratio of 86%, which is normal for a REIT, who must payout 90% of their taxable income in order to maintain their REIT status. The stock currently trades at a premium and appears slightly overvalued, but on any pullback, an investor could be smart to accumulate shares of O in order to have a footprint in the Real Estate sector with one of the most well managed real estate companies in the world.
Source: Realty Income Investor Relations
In conclusion, we hope you found this article helpful to get started with dividend growth investing and beginning your journey to financial freedom. When getting started, it is important to have an investing strategy before deciding which stocks to invest in.
We discussed some potential stocks to build your portfolio around and get started. As we mentioned, dividend growth investing may not be the most exciting form of investing, but with compounding growth in dividends, time is your friend. If you are able to let the money sit, the dividends will continue to grow your position over time, so invest in your future today.