Dividend challengers are a group of stocks that consist of companies that have increased their dividends for a time period between five and nine years. Many dividend investors would argue that this is a low bar for a company to clear particularly since it’s the only requirement that these companies have to meet.
However, many of the best dividend stocks on the market today had to start the same way. One year at a time of prioritizing delivering shareholder equity via a dividend. That means that investing in these companies may be a way for income-oriented investors to build wealth over time.
In this article we’ll explain the significance of dividends and why dividend challengers can be an attractive option for investors.
What is a Dividend?
When you buy stock in a company, you take an ownership stake in the company. A dividend takes that one step further by distributing a percentage of its profits (known as the payout ratio) to investors as a dividend for owning the stock.
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?
Companies that pay a dividend usually do so because they are at a point in their business cycle that puts some upside limit on their growth. This doesn’t mean that the companies are in financial trouble. Many of these companies are large-cap companies that generate billions in revenue and have consistent earnings. They have 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 sectors that deliver 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.
Dividend Challengers May be Future Dividend Stars
Many companies pay dividends. Some companies, such as real estate investment trusts (REITs) and master limited partnerships are required by law to distribute the vast majority of their profits as a dividend. Other companies, such as utilities, are highly regulated. Limited growth opportunities make a dividend a necessity.
That’s why it stands out when a company makes a priority of increasing its dividend year after year. Granted a company that increases its dividend for five consecutive years does not provide the same certainty as a dividend king that has increased its dividend for at least 50 consecutive years.
But every dividend king was a dividend challenger at one point. If your due diligence tells you that the company is a good buy, then it may deserve a small position in your portfolio.
Some Final Thoughts on Dividend Challengers
Dividend challengers are companies that have increased their dividend for five to nine years. Long-time dividend investors look for companies that have increased their dividend over a longer period of time.
But the shorter track record doesn’t mean these companies don’t make sense as sources of reliable income. That’s because once companies begin to increase their dividend over several years, investors begin to expect it. And if they stop increasing the dividend, it may be a sign that the company’s growth is slowing. This could lead to the stock price falling as investors look for more appealing options.