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To buy quality stocks that increase dividends regularly is a time-honored investing practice, and for good reason. This simple strategy takes a long-term view of investing and focuses on the dividend, not the stock price, which can help some investors maintain perspective. The passive income generated from dividend growth also has two side benefits. First, it focuses your investment strategy on cash-generating, growing companies. Second, it tends to lead to quality businesses that are neither too young nor too old.

Why is this so? Almost by definition, a dividend-growing company tends to cover expenses with rising cash flow. And which companies do these tend to be? They tend to be profitable, established companies in the middle of their corporate life-cycle. By contrast, young companies tend to be burning cash, constantly in need of capital, and face a higher risk of failure. Such young firms tend to not pay dividends at all as they are consumed with growth. On the other hand, older companies often funnel most or all cash to investors as dividends because viable investments can no longer be found. These firms are often in decline and offer little growth, often reflected in a high current yield.

Firms Need Profitable Investments to Grow

When a firm’s management makes profitable investments, new streams of cash result. Those new cash streams, in turn, can create further investments which may solidify and deepen an already well-entrenched competitive position. When this happens, a cycle of profitable growth can often be sustained far longer than many might expect. When this happens, stocks can be purchased at an attractive present value, held for a long time, and produce a rising passive income stream.

If growth is maintained for a sufficiently long time, then dividend growth will far outweigh a high yield at the time of purchase. The idea is that dividends increase alongside profits, making your yield-on-cost (dividend to the price paid) the most crucial measure of success. This “yield-on-cost” is a valuable measurement for you to measure your own investment’s long-term success.

Our Five Keys

The ultimate goal is not just to see dividends grow but see dividends grow dependably. And it is hard for many businesses to remain profitable under the yoke of competition. Many firms can and do fail. How can we increase the odds that we avoid bad outcomes as much as possible?

Five Keys

  1. Flexibility

    We look for companies that have a degree of flexibility. Companies with lots of debt, huge fixed costs, or pay too high a dividend relative to cash flow are risky in our view. Instead, focus on firms with low debt, limited fixed costs, and pay dividends well covered by cash flow.

  2. Profitable Assets

    We seek to invest in firms with profitable assets that reinvest back into the business. Often, the companies with high current yields have stopped investing. This can mean that few growth opportunities exist, or management is missing out on opportunities. In either case, the firm’s present value can be called into question.

  3. Consistent Business

    We try to identify consistent businesses without a heavy debt burden. In our view, debt should not represent more than half of a dividend growth company’s capital structure. Another way to view it is to look for companies with debt less than about three years’ cash flow. Because higher debt firms can tend to exhibit greater risk, we look for lower debt firms that can offer greater stability. We have also found that owning a portfolio of steady businesses with low debt can also allow for a better night’s sleep than owning a portfolio of unpredictable, highly indebted companies.

  4. Profit Supported Dividends

    We try to make sure dividend growth is financed by growing profit, not debt. Dividend increases can be temporarily funded by debt, but this increases risk. Even worse, whatever growth exists can be illusory, leading to misplaced expectations. It is simply not possible to grow dividends continually just by increasing leverage, sustainable growth arises from profitable corporate investments.

  5. Sufficient Diversification

    It is essential to diversify. We think a portfolio of thirty or more companies, spread across several sectors and industries, is sufficient. It is also not necessary to over-diversify, which can lead to an unfocused approach and closet indexing.

For Sanity, Focus on Income, Not Stock Prices

The stock market can be volatile, especially from year to year. Who would have imagined a little over a year ago that a pandemic would lead to the most rapid stock market decline in over thirty years? Even more, who would have imagined that last spring’s plunge would be followed by a record-setting rally to new highs within months? These gyrations have been nothing short of mind-boggling and leave many feeling disoriented and rudderless. Might we suggest that focusing more on a portfolio’s cash stream and less on the swirling of stock movements might help bring a sense of perspective and sanity, which can help foster better decisions.

Coming off a year of extreme volatility and confronted with high market valuations, we think a focus on dividends and dividend growth makes sense. Not only are dividends more predictable, but they offer a sane measure of long-term success, and dividend growth can be a marker of fundamental quality. Therefore, such an approach should be considered a better alternative versus yield chasing, performance chasing, momentum-driven, or reactive strategies.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Client Portfolio Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
External Wholesaler
973-549-4031

Disclosures

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.