Most new investors typically tend to focus on the companies with the highest dividend yields. I am often being asked why I never write about companies such as Hatteras Financial (HTS) or American Agency (AGNC), each of which yields 16% and 19% respectively. While some of my holdings are higher yielding companies, I typically tend to invest in stocks with strong competitive advantages, which have achieved a balance between the need to finance their growth and the need to pay their shareholders.
After looking at my portfolio, I have been able to identify three types of dividend stocks.
The first type is high yield stocks with low to no dividend growth.
Realty Income (O) (analysis)
Enbridge Energy Partners (EEP)
Kinder Morgan Partner (KMP) (analysis)
Consolidated Edison (ED) (analysis)
It is important not to fall in the trap of excessive high yields, caused by the market’s perceptions that the dividend is in peril. Recent examples of this included some of the financial companies such as Bank of America (BAC). While current dividend income is important, these stocks would produce little in capital gains over time.
The second type is low yielding stocks with a high dividend growth rate.
Wal-Mart (WMT) (analysis)
Aflac (AFL) (analysis)
Colgate Palmolive (CL) (analysis)
Archer Daniels Midland (ADM) (analysis)
Family Dollar (FDO) (analysis)
One of the issues with this type of strategy is that it might take a longer time to achieve a decent yield on cost on your investment. It is difficult to achieve a double digit dividend growth rate forever. Once you achieve an adequate yield on cost on your investment, it might slow down dividend increases. The positive side of this strategy is that many of the best dividend growth stocks such as Wal-Mart (WMT) or McDonald’s (MCD) never really yielded more than 2%-3% when they first joined the Dividend Achievers index. The main positive of this strategy is the possibility of achieving strong capital gains.
The third type is represented by companies with an average yield and an average dividend growth. Some investors call this the sweet spot of dividend investing.
Johnson & Johnson (JNJ) (analysis)
Procter & Gamble (PG) (analysis)
Clorox (CLX) (analysis)
Pepsi Co (PEP) (analysis)
Automatic Data Processing (ADP) (analysis)
There is a common misconception that buying the stocks in the middle, would produce average returns. Actually finding stocks with average market yields, which also produce a good dividend growth could produce not only exceptional yield on cost faster, but also capital gains as well.
At the end of the day successful dividend investing is much more than finding the highest yielding stocks. It is more about finding the stocks with sustainable competitive advantages which allow them to enjoy strong earnings growth, which would be the foundation of sustainable dividend growth. A company like Procter & Gamble (PG) which yields almost 3% today butraises dividends at 10% annually would double your yield on cost in 7 years to 6%. A company like Con Edison (ED) would likely yield around 6% on cost in 7 years. The main difference would be capital gains – Procter & Gamble (PG) would likely still yield 3%, while Con Edison (ED) would likely yield 6%. Thus the investor in Procter & Gamble would have most likely doubled their money in less than a decade, while also enjoying a rising stream of dividend income.
Full Disclosure: Long all stocks mentioned in the article except HTS and AGNC
This article was included in the Carnival of Personal Finance #252: Famous People With Tax Troubles Edition
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