Why a dividend-growth strategy could help you retire early

Many investors understand that dividends are important when it comes to generating wealth from the stock market. However, there's one particular style of dividend investing that has the potential to really supercharge your investment returns over the long term: dividend growth investing. Here's a look at how the strategy works and why it could help you retire early.

Powerful strategy

Dividend growth investing is an extremely powerful investment strategy than can generate fantastic returns over time. The premise behind the strategy is that instead of just picking out stocks for their high yields, you choose stocks that have grown their dividends in the past and will continue to grow their payouts in the future. There are several reasons why this strategy is so effective.

Increasing income stream

The most obvious benefit of the strategy is that the income stream you receive increases each year. This is important for several reasons. First, if you own a portfolio of companies that are consistently increasing their dividends by a healthy figure of say 5%-10% per year, the growth of your income stream is likely to outpace inflation. By contrast, if you're investing in high-yield stocks that aren't raising their dividends, inflation is likely to erode the purchasing power of your income stream over time.

Second, an increasing income stream gives you more reinvestment compounding power. It's no secret that compounding can generate exponential returns over the long term. However, in this strategy your compounding power is essentially magnified, because your income stream is growing each year.

Cash cows

It's also worth noting that companies that consistently raise their payouts have the potential to become cash cows. Consider Imperial Brands. The tobacco manufacturer has increased its dividend by 10% for nine consecutive years now. That means that an investor who bought the shares for say 2,000p nine years ago with a yield of just over 3%, is now enjoying a yield of around 8% on their purchase price.

Capital gains

But it gets better. As a company raises its payout over time, upwards pressure is placed on its share price. Turning back to Imperial Brands, you may have noticed that today, the share price is considerably higher than 2,000p. Indeed, the stock now trades at 3,200p. Over time, a rising dividend generally leads to a rising share price.

Strong total returns

Furthermore, research suggests that over the long term, dividend growth stocks tend to outperform both non-dividend paying stocks and companies that don't raise their dividends.

Analysts at Ned Davis Research looked at the performance of US dividend stocks vs non-dividend stocks between 1972 and 2014. They found that companies that increased their dividends or commenced paying dividends generated annualised returns of 10.1% per year. In contrast, S&P500 companies paying flat dividends returned 9.3%, and S&P500 companies paying no dividends returned an annualised return of just 2.6% during that period.

Capital protection

Lastly, companies that have strong long-term dividend growth track records are generally well-established, stable companies. When market volatility increases, investors often move their capital out of riskier assets such as speculative shares, and gravitate towards these kinds of companies. This can offer an element of protection during bear markets and help you preserve your capital, which is the key in any investment strategy, especially if you're planning to retire early.

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Edward Sheldon owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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