I view the construction of a portfolio of high-quality dividend growth stocks as a lot of fun, and something of an adventure all in itself. Now, I’ve made my fair share of mistakes over the years, and I’ll likely make many more before I’m all done. But I suppose that’s some of the fun, and every mistake makes me a more experienced investor.
It’s possible to think of your portfolio as a rocket ship with multiple stages, each of which propel your portfolio in different ways. Each stage has its own unique engine, and each of these engines is comprised of different types of dividend growth stocks with different yield and growth characteristics to serve different purposes within the portfolio.
I’ve found that there are three general classifications of dividend growth stocks. Now, these aren’t hard and fast rules, and some stocks can move from one classification to another as companies mature and/or change, while other stocks may be a blend of more than one category at a time. But you’ll find that most stocks will fall under one of these three categories.
Stage 1 – High Yield, Low Growth
So if one were an engineer building a multistage rocket, the first thing you need to do is make sure the thing can actually get off the ground. And that’s where stocks that have a higher starting yield fit in. These stocks get your dividend income off the ground and into the lower atmosphere.
You see, stocks that have a higher entry yield provide plenty of propellant to really get your passive income rocketing from the get-go. While many stocks with a higher initial yield have lower growth profiles, the current income these types of stocks can provide allow a dividend growth investor plenty of regular, fresh cash with which to reinvest into other areas of the portfolio. Keep in mind you wouldn’t want your entire portfolio to be allocated to Stage 1 stocks only because the lower growth means your income will have a hard time keeping up with inflation over the long term.
Typically, you’ll find stocks that fit well in this stage come from telecommunication companies, real estate investment trusts, utilities, and master limited partnerships, among other areas.
A couple of stocks that might provide the propellant to get things off the ground include:
AT&T (T) & Realty Income (O)
Stage 2 – Moderate Yield, Moderate Growth
Stage 2 stocks offer a more moderate yield and growth profile, and if you’re busy reinvesting your heavy dividend income from the big payers in Stage 1 into these companies you’ll find yourself rewarded well. These stocks can take you from the lower atmosphere into the stratosphere and beyond with their more attractive growth profiles.
This is the “bread and butter” of many dividend growth portfolios, with mine being no different. Stocks that offer yields of between 2.5% and 3.5% or so offer moderate current yield, but also offer pretty attractive growth rates. You’ll often find many of the stocks in Stage 2 have dividend growth rates of 7-12%, which means your purchasing power increases well over the rate of inflation over time, allowing you to compound your wealth over and over again as you reinvest this income.
The reason these stocks typically don’t have sky-high yields is because investors tend to bid up the stocks to the point where the yields aren’t as attractive as some of the stocks you’ll find in Stage 1. And this is because they offer a lot of attractive qualities. Many of the companies that are able to grow dividends by 7-12% per year for decades on end have wonderful business models and sell products and/or services that people across the entire world want and/or need every single day. Think beverages, food, toothpaste, gas, cleaning supplies, toilet tissue, and literally bread and butter.
While many of the companies you can invest in that offer moderate yield and growth have great business models that are easy to understand and also sport lengthy dividend growth streaks, the trade-off is that neither the current yield nor the growth rates are particularly earth shattering. There are benefits and drawbacks to anything in life, but because many of these businesses are very defensive and traditionally deliver stable and secular profit growth, my portfolio is allocated heavily to stocks in Stage 2.
Two stocks that are great picks to get you into the stratosphere when Stage 1 growth doesn’t offer enough may include:
Coca-Cola (KO) & Procter & Gamble (PG)
Stage 3 – Low Yield, High Growth
Stage 3 is perfect for down the road when your portfolio is comfortably off the ground and well into the stratosphere. While you’re cruising around thousands of feet off the ground, you’ll eventually want to get into outer space. And the growth these stocks can offer can do just that.
I personally don’t have a lot of allocation to these stocks myself, and that’s because I’ve been busy getting my dividend income off the ground and into the stratosphere. While many of the stocks in Stage 3 do not offer a lot of current income, their potential for huge dividends down the road means you’re trading off dollars today for even greater dollars years from now.
The big question, however, is whether these stocks can grow as fast as they may indicate. Potential is one thing, but living up to it is quite another. As such, I’ve tended to gravitate towards a little more bird in the hand, while also leaving a little in the bush as well. But I also know that many of the stocks that are currently Stage 2 stocks were once Stage 3 stocks that eventually slowed down. The key is to latch on to these stocks early enough to not only capture that eventual maturity and stability, but also that early growth as well.
Two stocks that offer lower current yield, but plenty of potential growth include:
Visa (V) & Starbucks (SBUX)
I’ve personally experienced the benefits and drawbacks of stocks in all three stages.
Keep in mind that you can build a rocket to your specifications. You are your own engineer! If you’re an older investor much closer to retirement then you might want to focus more on Stage 1 stocks. You need more current yield which will generate more dividend income to pay your expenses now. The future growth of that income doesn’t matter quite as much, but it’ll be helpful if you can at least keep up with inflation to keep your purchasing power intact. Conversely, if you’re a really young investor then you might want to sway your interest a bit more toward Stage 2 and especially Stage 3 stocks as you have plenty of time for the growth stories to play out and eventually attain huge annual dividend income totals because you’re runway for takeoff is so long.
I’m personally aiming to become financially independent by 45 years old via the dividend income my portfolio generates. Therefore, it’s imperative that my portfolio not only generate sufficient current income which I can live off of in 15 years, but also must be able to grow that income enough so that inflation doesn’t eat into my purchasing power. Thus, I’m interested in selective opportunities in Stage 3 stocks as valuations make sense. Currently, I think Visa (V) is an interesting opportunity.
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