Receiving a dividend check in the mail (or a deposit to your account these days) every quarter is excellent. This income can supplement salary or retirement, fund some entertainment, or be reinvested to bolster your retirement account.
However, with tons of options when it comes to investing in dividend stocks, it's tough to know which are the best. Many investors think a buying high yield stocks is the best strategy, and many promote this theory because it's an easy sell. For example, a stock offering a 7% dividend yield is better for income investors than one offering just 2%, or so goes the wisdom. But this isn't necessarily the case. Investors call this "chasing yield" -- if you indulge me, I'd like to explain why dividend growth is vital, rather than yield.
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What are the best dividend stocks?
Companies pay dividends from free cash flow, the money left over after expenses and fixed asset purchases. If a company offering a high yield pays out more than its free cash flow (often by taking on debt), it depletes its value. This means the stock will probably lose value in the long run; a 7% yield doesn't look as good if the stock loses 10% of its value.
Some funds offer incredible yields, sometimes 10% or more. Have you wondered how they do this? It is because they are leveraged -- they buy securities and then borrow against them to purchase more. This is incredibly risky if the market goes south, but don't take it from me. Warren Buffett says leverage is one of the few ways smart investors go broke.
What's an investor to do? I recommend focusing on dividend growth and business strength. Here's how it works over time.
Dividend growth is king
Texas Instruments (TXN 1.27%) is an incredible example of dividend growth in action. The company leads the analog semiconductor industry, selling mainly to the industrial and automotive sectors. It has 100,000 global customers and 80,000 products. Revenue grew from $14.5 billion in 2020 to $20 billion in 2022, and the market is forecast to grow by 8% CAGR over the next five years. Texas Instruments currently yields 2.8% with an annual payout of $4.96 per share. Don't let the yield scare you off.
Texas Instruments has increased the dividend by 25% CAGR since 2004 while growing free cash flow per share by 11% yearly on average and cutting the share count nearly in half. The company is an awesome example of dividend growth in action.
If an investor bought a $1,000 5% 10-year bond 10 years ago, the yield was double Texas Instruments' 2.44% yield at the time. But buying the lower yield was a far better move. Texas Instruments raised the dividend prolifically on the strength of the business over this time, and the share price grew along with it, as shown below.
The annual yield on the original investment in Texas Instruments today is 14%, and the stock has risen from $35.69 to $173.70. The value of the $1,000 investment in Texas Instruments stock 10 years ago, including dividends, is $6,350, crushing the aforementioned bond's 5% return. This is the essence of dividend growth investing.
Given its excellent management and the tailwinds noted above, Texas Instruments is poised to continue rewarding shareholders.
Lowe's, 25 increases and counting
Home improvement is a resilient industry. People spend to fix up their homes for sale and to make their new place their own when housing is hot. When housing is tight, folks buy goods to improve their current space. Either way, Lowe's (LOW -0.04%) can thrive. This is one reason the company has paid a quarterly dividend since 1961 and increased the payout each of the last 25 years.
Lowe's enjoyed quite a boom due to the pandemic stimulus spending and low interest rates, raising revenue by 35% from $72 billion in fiscal 2019 to $97 billion in fiscal 2022. Operating income nearly doubled from $6.4 billion to $12.2 billion over that period. The company is forecasting a small drop in sales this year because of the economy, but this is to be expected. The dividend yields 1.4% and is well covered with a payout ratio of just 39%.
Lowe's has another ace in the hole. The U.S. is woefully short on single-family homes, up to 6.5 million according to some sources.Drastic under-building since the 2008 Great Recession is the culprit, as depicted below. The purple line represents new home construction.
US Housing Starts data by YCharts.
This means continued secular demand for Lowe's as millions of homes will be built, sold, and improved over many years.
Bet on Vici
If you still aren't ready to sacrifice yield, Vici Properties (VICI -0.28%) offers both a juicy 5% yield and an increase in each year of its short five-year history. Vici is an experiential REIT holding some of the most recognizable properties on Earth, like Caesar's Palace, The Venetian, and MGM Grand in Las Vegas. The trust holds 50 properties in total in 15 states.
Vici has a few advantages that should enable it to continue paying and raising its dividend. Its "trophy properties" are much more difficult to replace than an office building or warehouse, a majority of its leases escalate along with inflation over the long term, and Vici has a history of 100% rent collection -- even during the worst of COVID-19. Vici's growth strategy includes expanding internationally, providing financing for tenants to improve and expand, and purchasing nongaming properties like golf resorts.
All three companies above make compelling cases for income-oriented investors. Growing dividends are a terrific way for investors to earn cash and sleep well at night when the market gets topsy-turvy, but remember, bigger (yield) isn't always better.