Dividend aristocrats are an exclusive class of stocks that consist of the companies that have increased their dividends for at least 25 consecutive years. Investing in these companies is one of the most efficient ways for investors of all risk tolerances to build wealth over time. These companies demonstrate a commitment to building shareholder value by prioritizing raising the payout on their dividend. Currently there are 65 companies that are dividend aristocrats. This is up from 53 in 2018.
To achieve the status of dividend aristocrat a company must meet the following criteria:
- Their stock must be listed on the S&P 500
- They must have at least 25 consecutive years of dividend increases
- They must meet certain market cap and liquidity requirements. Currently, a company must have a float-adjusted market cap of at least $3 billion (meaning these are large-cap companies). In terms of liquidity, a dividend aristocrat should have an average trading volume of at least $5 million.
In this article we’ll explain the significance of dividends and why that makes dividend aristocrats an appealing option for investors.
What is a Dividend?
Let’s start by briefly reviewing what a dividend is and its role in a balanced investment strategy. To do this, it helps to start with the basics. When you buy stock in a company, you are taking an ownership stake in the company. The company can reward you in several ways. The one that investors think about the most is share price appreciation (i.e. capital gains). You buy stock in a company at one price hoping that the stock price will be higher at the point in the future when you need the money. In a perfect world, you buy low and sell high.
But the stock market is far from a perfect world. As many shareholders know stock prices don’t move in the same direction all the time. And when they move lower, it can be difficult to watch the value of your portfolio fall sharply, even if it is only on paper.
That’s why it’s important to understand the role of dividends and dividend stocks as a way to build wealth. Another way that some companies reward shareholders is by paying them a portion of their profits in the form of a dividend. Many companies pay a dividend every three months (i.e. a quarterly dividend). That means that investors earn this dividend on a regular schedule no matter what is happening with the company’s stock price.
Why Do Companies Pay a Dividend?
Many of the companies that pay a dividend fit into the category of value stocks. These are companies that for a variety of reasons have some limits on their growth. For example many of these companies are what are known as large-cap companies. These companies have large market capitalizations. What that means to investors is that these are companies that generate consistent revenue and earnings per share (EPS). They generally have very sound balance sheets and generate significant free cash flow (FCF).
The downside of this consistency is that the companies don’t deliver the same growth as companies that are involved in disruptive technology. And for that reason the stock price of these companies tends to underperform the overall market.
To help offset this relative lack of stock price appreciation, these companies will help increase their shareholders total return by issuing a dividend.
Dividends Help Increase Total Return
The total return on an investment includes interest, capital gains, dividends and other distributions that an investment generates over a period of time. If a company doesn’t issue a dividend, the total return of that investment is almost exclusively limited to capital gains. When the market is going up, these stocks can outperform the market. However when the market is in a correction or a bear market, the total return on these stocks can be significantly lower than broader market.
By contrast, dividend stocks offer investors a dividend in addition to the opportunity for capital gains. This has a smoothing effect on many portfolios. While these stocks may not outperform the market in terms of capital gains, the dividends can help move them closer. But these stocks really shine in times of market downturns. In this case, the stocks tend to perform “less badly” than growth stocks. In addition, the “rent” that investors collect from the dividend can help trim losses even more.
That’s because in most cases, investors have the ability to reinvest their dividends. This increases the amount of stock an investor owns which increases their capital gains as well as increasing their dividend payout. This creates a wealth-building cycle.
The Significance of Dividend Aristocrats
Some companies pay consistent dividends. Utility companies, for example, are highly regulated so there is a ceiling on how much revenue and earnings they can generate. But a consequence of that is these companies may not generate enough of a profit margin to increase their dividend.
The best of both worlds for dividend investors is companies that are not only paying a consistent dividend, but also increasing that dividend. This helps boost an investor’s total return and can be a way to offset the effect of inflation on an investment.
Dividend aristocrats prioritize increasing its dividend over time. That makes them attractive to investors who have a low risk tolerance and are looking to build wealth slowly over time. And owning stocks of dividend aristocrats can also help investors generate income in retirement when wealth preservation becomes a primary goal.