Wednesday, April 7, 2010

Three Dividend Strategies to pick from

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

Relevant Articles:

- 2010’s Top Dividend Plays
- Six Dividend Stocks for current income
- Best Dividends Stocks for the Long Run
- Capital gains for dividend investors
- Dividend Growth beats Dividend Yield in the long run

5 comments:

  1. Since the economy is finite, high yielders could also be considered to be companies that have reached a point of stability whereas with low yielders and growth prospects you are speculating that the company can keep growing. I remember WAG having a low yield and a history of nice dividend increases. However, when they failed to increase sales, or was it earnings, for the first time, the company was suddenly no longer accorded the P/E of a growth company and there was a substantial capital loss of about 20%. All in all, I don't think there's a sweet spot per se. It's more of a "what do you want from the company?"-spot.

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  2. Financial FreedomApril 7, 2010 at 11:20 AM

    Deciding which kind of dividend growth stock to buy really starts with one's personal needs.

    Someone who needs dividend income for living expenses (e.g., retired) would want enough dividend growth to stay ahead of inflation. After that requirement is met, the higher the sustainable dividend yield, the better.

    But someone who doesn't need dividend income for a long time into the future might want to buy stocks with a high sustainable dividend growth rate, with the current yield being a secondary consideration. Yield on original cost will likely be quite high by the time those dividends are needed for living expenses.

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  3. Dividend Growth assumes growth (duh) -- but assumption is the mother of all crises. If you get your greater dividends now, you can choose to reinvest in the same stock, elsewhere, or stuff it under your mattress. Let's say you "hold" for three years with 6%/yr, that's a pretty safe hedge against market fluctuations! So I think there is room for all three strategies, as Dividend Growth Investor points out in his own holdings.

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  4. I understand what you're saying about high yield dividend stocks. However, I don't know about sticking MLP's in the category of little to no dividend growth. Most all the MLP's I've tracked have increased their payouts quite a bit over the past decade, and they can afford to pay more than other companies since they pay no taxes. These are companies that have near monopolies since they are the only pipeline connecting A to B. They aren't affected by commodity prices either as they are just a glorified toll road.

    The only thing I'd be worried about with them is losing their tax-free status, or we find a replacement for oil and gas lol.

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  5. I would like to read discussion on those high-yield companies whose tax status of tax-free distributions is the largest single factor in their ability to offer consistent large annual pay-outs of six-to-12-percent.
    I am speaking of the classes: REITs, BDC's and MLPs.
    Personally, I largely fill upon these clsses for most of my income. Then, I apportion some into more voltile dividend and non-dividend classes such as alternative asset managers (OZM, FIG). Any cap gains I can take from these risky 'recovery plays' go into perhaps something a little more conservative such as NGG, which currently pays approx 6-to-percent.
    And, my only mutual funds are one high-yield and one New Market, with yield to cost of approx 8-9 percent. I bought in Feb-March, 2009
    SO, to sum it up, I'm done chasing cap gains. I am done 'playing it safe. I most lose.
    I pursue my risk/return and income in conservative to risky dividend stocks. I am 'paid to wait,' as they say.
    Furthermore, that lovely top line figure 'portfolio total' is secondary. Plus, I am even willing to suffer an occasional dividend cut and cap loss, depenmding on the reasons.
    Discussion?

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