How to find reliable, profitable dividend growth

If you want to build a high yield, low risk portfolio, looking for companies with a record of reliable dividends and profits is a good start, but it’s not enough.  

A truly low risk portfolio must defend again inflation, which means it must pay a dividend which can grow fast enough to match – and preferably beat – inflation.  In short, an investor looking for high yields and low risk should look for reliable, profitable dividend growth.

But first, a note of caution.

Although I use the phrase ‘reliable’ growth, it’s a relative term.  Growth can never truly be relied upon, but for some companies it’s a more likely outcome than it is for others.  It’s the companies that are most likely to grow at or above the rate of inflation that I’m after, and I want them to do it year after year after year.

Finding progressive dividends

The most obvious way to find reliable growth is to search for it in a company’s financial history.  I know some people say “don’t invest by looking in the rear view mirror”, but I don’t believe that.  I think the best place to look for companies that can grow in the future is to look for companies that have already proven that they can grow in the past.

For me, this means looking back at a company’s dividend growth record over at least the last 10 years.

And my approach to measuring dividend growth quality is simplicity itself: I just count how many times the annual dividend per share went up over those ten years.  I then express this as a percentage of the maximum possible number of increases (in ten years there are nine opportunities to increase the annual dividend). So:

10Yr dividend per share growth quality = Number of annual dividend per share increases / 9 * 100%

What to do about dividend cuts

A lot of investors panic when a company cuts its dividend.  I’m not talking about a complete suspension and no dividend payment at all; I just mean that the dividend went down from one year to the next.

Is that reason enough to sell?

I don’t think it is.  Although I don’t like dividend cuts, I am not entirely put off by them.  There may be some circumstances in which a dividend cut is beneficial to shareholders; perhaps the cash could be diverted to some new internal project which promises excellent rates of return.

Even if the dividend cut isn’t beneficial to investors, it’s often a mistake to sell after the cut.  The share price will often drop by 10-20% on the day of the cut, and if you sell you’re locking in that loss.

What will happen if you hold on to the shares?  Of course the future is always uncertain, but I’ve seen shares rebound often enough to know that I won’t sell on a cut.  That’s especially true given that, as a defensive value investor, I’m focused on owning very high quality companies, and with high quality companies a dividend cut is more likely to be temporary; there’s a good chance it will climb back up again in the years ahead.

As a defensive value investor I’m also a contrarian; I want to buy on bad news and sell on good news.  In other words I want to buy low and sell high, and selling low on bad news from a dividend cut just doesn’t fit with a contrarian value approach.

As a long-term investor the idea of buying and selling shares because of dividend movements sounds too much like trading rather than investing.  I think it’s better to make a decision and stick with it, taking a somewhat stoic attitude to short-term ups and downs in both the company’s fortunes and the share price.

It all starts with revenue

So far I’ve concentrated on finding reliable growth by looking for progressive dividends, but dividends do not exist in a vacuum.  In some ways they’re the final output from a company.

Exactly what comes before dividends depends on how you frame the concept of cash flows through a company, but from my perspective shareholder returns begin with revenue.

Revenue is the first step where customers actually pay for a company’s products or services.  Without revenue a company has nothing but dreams and plans, and without revenue growth there can be no sustainable dividend growth.

My approach here is exactly the same as for dividends: I just count how many times revenues per share went up over the last ten years.

10Yr revenue per share growth quality = Number of revenue per share increases / 9 * 100% 

Earnings are an important intermediate step

From revenues the accountants will strip out expenses of various sorts, eventually leaving us with a figure for earnings, which is easy to find on a per share basis.

Earnings can be a tricky subject, with various different definitions of exactly what ‘earnings’ are, from basic, to reported, adjusted and normalised.  Where possible I prefer reported earnings, as these include “exceptional” one-off expense items which are excluded from adjusted earnings.

The story here is exactly the same as it was for revenues and dividends.  I’m looking for reported earnings that grow and the more frequently and consistently they grow the better.  The same trick of counting how many times they went up in the last decade can be applied as before:

10Yr earnings per share growth quality = Number of earnings per share increases / 9 * 100%

I think it’s also a good idea to count how often earnings covered the dividend, as a dividend that is not consistently covered by earnings is much more likely to be cut.

10Yr dividend cover quality = Number of times the dividend was covered / 10 * 100%

Creating an overall Growth Quality score

So now we have a variety of ways to measure the consistency of a company’s growth, taking into account its revenues, its earnings and dividends.

Bringing all these steps together, the idea is to look back at the company’s finances over the last 10 years and:

• Count how many times revenues per share went up
• Count how many times earnings per share went up
• Count how many times dividends per share went up
• Count how many times the dividend was covered

Companies that score full marks – or even just close to full marks – will have the best track record of producing consistent, broad-based growth, and consistently covered dividends.

If you’re looking to find companies that can produce consistent dividend growth in the future, companies with an above average Growth Quality score should be an excellent place to start your search.