One of the things I like about owning shares is the possibility of growing dividends helping to boost my passive income streams. If I wanted to invest in my Stocks and Shares ISA with this objective, this is how I would go about it.
The attraction of growth businesses
There are different ways for a business to fund dividend growth. For example, even in a declining market, a company may be able to keep growing dividends by increasing its own market share or boosting profit margins. That is essentially the strategy Imperial Brands is currently taking in the face of long-term declines in cigarette sales.
I like Imperial for its current yield and hold it in my portfolio. But if I was focussed purely on dividend growth I would not buy it for that reason, with its paltry 1% increase last year. Instead, for dividend growth, I would mostly look at industries where I expect overall demand to increase in coming years. That can make it easier for a company to increase its dividend. Even if its market share and profit margins are flat, the same share of a bigger market could still lead to higher earnings.
So for dividend growth, I would typically prefer to invest in an area where total market size looks set to grow.
Cash flow is king
Dividends are ultimately funded by cash. That is why I think earnings can be a useful financial measure in many ways, but from a long-term dividend growth perspective, what really matters to me is free cash flow. A company can report flat or declining earnings but still see its free cash flow increase – and the reverse is true. Free cash flow is cold, hard cash and that is what is needed to keep dividends flowing, yet alone growing.
To keep funding dividend growth, I think two factors are especially important. One is how much free cash flow a firm generates. The second is how many shares it has in circulation. The larger the ‘share float’, the smaller the proportion of free cash flow can be attributed to each share when it comes to paying dividends. So a company buying back its shares can sometimes be a way to grow future dividends, even if its earnings are flat.
Spread the choices in my Stocks and Shares ISA
No matter how successful a company has been in the past when it comes to growing dividends, that is no guarantee of what will happen next. Shell had not cut its dividend in over 70 years before it did so a couple of years ago.
So I would be sure always to keep my Stocks and Shares ISA invested across a range of shares and business areas. That way, if a company I hoped would grow its dividend failed to do so, the impact on my overall portfolio performance would be limited.