Wednesday, July 28, 2010

Dividend yield or dividend growth?

I have always had a requirement for a minimum dividend yield, whenever I have analyzed and purchased dividend stocks. The reason for this requirement was to provide with at least some dividend income in case the stocks stopped increasing distributions for some reason. If a stock stopped raising distributions I would put it on my hold list and would stop contributing new funds to the position, while reinvesting dividends in other more promising candidates. I do require at least a decade of consistent annual dividend increases, before even looking at a stock. This decreases the size of my watch list to less than 300 stocks.

My entry yield requirement has ranged from a low of 2% in 2008 to a high of 3% since 2009. After analyzing some of the most successful dividend stocks such as Wal-Mart (WMT), Johnson & Johnson (JNJ), McDonald’s (MCD) and Becton Dickinson (BDX) I have come to realize that a minimum yield requirement could have been a detriment to acquiring those stocks when they first became dividend achievers.

Stocks such as Johnson & Johnson (JNJ) never really yielded more than 3% until 2008 for example. As a result I would have missed on strong double digit dividend growth for several decades, which would have surely turned the yield on cost on original investments into the triple digits. A company that yields 2% currently but manages to raise distributions by 12% due to strong earnings growth would double the yield on cost in 6 years.

It seems that a more flexible approach would be to analyze the average yields investors could have received over the past decade and then decide whether it makes sense to purchase the stock based on valuation and earnings power. In this sense making sure not to pay over twenty times earnings or accepting an unreasonably high dividend payout is very important.

Another thing to do is to simply ignore current yield altogether and instead focus on the fundamentals, while evaluating whether the company could reasonably expect to boost distributions for the next decade. A company with a yield lower than 3% would definitely have to have an average dividend growth of at least ten percent.

While I would ignore current yield, I could still create a dividend portfolio where I try to obtain an average current dividend yield of 3% or 4%. This could be achieved by grouping high yielding stocks with low yielding dividend growth stocks. The high yielding stocks typically are slow growing and would provide current income. The low yielding stocks would have a growth component, which would ensure purchasing power protection from inflation. If an investor decides to create a diversified dividend portfolio with 40 individual stocks in it, they could purchase 20 dividend growth stocks yielding 2% or 3% on average and 20 stocks which yield 5% - 6% on average in order to obtain a portfolio yield of 4% for example. Examples of high yielding stocks that could used in this strategy include Realty Income (O), master limited partnerships such as Kinder Morgan Energy (KMP) ,utilities companies such as Con Edison (ED) or telecom firms such as AT&T (T).

To summarize, investors do not need to choose between yield and dividend growth. Instead, they could create portfolios where they take advantage of both.

Full Disclosure: Long JNJ, MCD, WMT, O, KMP, ED, T,

This article was included in the Carnival of Personal Finance #269: THE DIVA$ EDITION

Relevant Articles:

- Four High Yield REITs for current income
- Dividend Grouping for Dividend Income
- Highest Yielding Dividend Stocks of S&P 500
- Dividend Growth beats Dividend Yield in the long run

9 comments:

  1. Hi! Thanks for a very good blog.

    One site(don't remember which though) presented an idéa that one would like to achive a YOC for lets say 10 % within a certain amount of time - 10 years could be suiteful.

    To decide if the combination of dividend yield and dividend growth will achieve such a target, this forumla can be used for your excel spreadsheet:

    Years until 10% YOC
    = LOG(10%/Dividend Yield)/LOG(1+Dividend Growth)

    Example1 JnJ:
    = LOG(0,1/0,036)/LOG(1+0,15)=8,1 years

    Example2 CINF:
    = LOG(0,1/5,92)/LOG(1+0,11)=4,8 years

    So for this example CINF is the clear winner in spite of its lower divident growth.

    I personaly aim to use 10% YOC within 10 years as a target before investing

    Best Regards
    Erik in Sweden

    ReplyDelete
  2. DGI,

    According to my Fidelity account, KMP has a payout ratio of 281%. I'm not sure that it's correct, but if it is, wouldn't you consider that too high?

    I think you've mentioned that certain types of companies will have higher payout ratios, but I was thinking that was a bit high... or Fidelity calculates it incorrectly.

    If you could provide a clarification, I'd appreciate it.

    In any case, great posts. I've been a long time follower of your blog and I'd like to thank you for all the great information you've discussed.

    ReplyDelete
  3. Erik,

    Maybe this is waht you are refering to:

    http://www.dividendgrowthinvestor.com/2008/11/10-by-10-new-way-to-look-at-yield-and.html

    Tquill,

    KMP does have a high diviend payout ratio. The issue is that as a master limited partneship it distributes all of its earnings to partners. I think that cash flow is a more important measure for MLPs. Over the past decade the distribution payout ratio has been rather stable between 50% and 60%. For this company I used the ratio of current cash flow/unit to the annual distribution/unit.

    http://www.dividendgrowthinvestor.com/2009/12/kinder-morgan-energy-partners-kmp.html

    ReplyDelete
  4. Good post. I think if you buy great stocks; established, "branded" companies, you can have your cake and eat it too.

    ReplyDelete
  5. Great article, as a novice just learning the game its good to understand the thought process that goes into making a purchasing decision on a dividend producing stock. It definitely create a situation where I need to diligently decide what my criteria will be. I appreciate your perspective.

    ReplyDelete
  6. DGI: Thanks, that might have been the place I read it :) (everything goes around on the Internet...)

    Hopefully the formula was somewhat new atleast.

    Regards / E

    ReplyDelete
  7. An emerging high yield investment vehicle in Canada is the mutual fund trust ("MFT").

    A MFT is RRSP, RESP, LIRA eligible in Canada. In addition to RRSP eligibility, MFTs have certain tax advantages to standard corporations and are typically deemed to be "flow-through" vehicles. Private mutual funds trusts are gaining in popularity in Canada following the changes to tax legislation which forced many publicly traded royalty trusts to convert back into corporations. Investors seeking the high yields typically associated with the public royalty trusts are increasingly investing in private MFTs - particularly in the energy sector.

    The MFT structure is frequently used to create investment holding vehicles for "non-reporting" issuers in Canada due to the tax efficiency and simplicity of creating eligibility for registered plans (RRSP, RESP, LIRA etc) without having to go to the cost of creating a public company. Some examples of Canadian non-reporting issuers utilizing the MFT structure are:

    * Mineral Fields
    * Enervue
    * Mosaic Diversified Income Fund
    * Agcapita Farmland Investment Partnership
    * Petrocapita Income Trust
    * Walton International
    * Prestigious Properties

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  8. I have to admit that at the moment, I do care about a decent yield and growth. Don't be mistaken though as I am not just after the yield but if I have the choice between 2 companies I like, I will go towards a higher yield for a faster compound growth. Examples are CPG, JE.UN, REI.UN, CUF.UN. It's a bit of a balancing act as I still want the aristocrat with 50 years of dividends and growth. I start them on a DRIP with Transfer Agents.

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  9. I look at dividend yield as an indicator of valuation. For example if a stock's price falls it's dividend yield goes up since dividends don't change as often as price. Screening for a reasonable dividend yield (like between 4-8%) usually results in stocks trading near their long terms lows. An unusually high dividend yield can signal a dividend cut since the "smart money" dumps the stock before the dividend cut announcement.

    I look at dividend growth as a litmus test for dividend stock investing. The stock must have dividend growth to continue analysis.

    ReplyDelete

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