Wednesday, October 20, 2010

High Income Stocks for a Dividend Growth Portfolio

Most of my articles on dividend investing contain a fair bit of warning about the dangers of high dividend stocks. This has caused several readers to question whether I should include high yielding stocks in their portfolios or not. In this article I would try to explain the advantages and disadvantages of these securities, and let readers decide for themselves whether they suit their investment objectives.

First, I find stocks with above average yields helpful for retirees or future retirees who expect to start living off dividends up to the next 10 years. While dividend growth stocks are a great investment vehicle for the long run, it might take some time for them to start generating a sufficient yield on cost. For example it might take over a decade for a stock like Wal-Mart (WMT) with a current yield of 2% that raises dividends by 12% annually to reach a yield on cost of 8%. For the investor who needs to put food on the table for the next decade, Wal-Mart will likely be ignored due to its low yield in favor of a higher yielding stock such as Kinder Morgan Energy (KMP) or Royal Dutch Shell (RDS.B). A stock with a higher current yield which raises dividends minimally or not at all would provide the best yields for the next few years, provided that the company generates strong cash flows to support the distribution. If the investor simply chases high dividends without checking for their sustainability, they will be better off in cash and short –term maturities, rather than risk their principal on untested investments. If the distributions are sustainable, then the high dividend stock could be bought and held for current income.

Second, it is imperative to understand that a high dividend stock that doesn’t raise its distributions for a long period of time would result in lower inflation adjusted income over time. This is particularly concerning in the event that the investor spends their whole income, and doesn’t reinvest a portion of distributions. That’s why investors should hold only a portion of their income portfolio in high yielding stocks. They should invest the other portion in dividend growth stocks which offer consistent dividend increases. This dividend growth should be supported by a solid business model that generates sufficient cash flows to grow and maintain the business and also return excess cash to owners. The dividend growth component of the portfolio should be quietly working in the first decade or so in order to reach higher yields on cost. This is the component that will ensure that the income stream maintains its purchasing power for the whole retirement, no matter whether it last for one decade or half a century.

As a result, if you look at dividend yield from the viewpoint of your dividend portfolio, one could realize that individual company yields do not matter as much, as long as overall portfolio yield is enough to generate sufficient initial income stream. After that knowing that the addition of a 2% yielder that grows distributions at 15% annually won’t affect overall yield too much, the decision to add a stock like Becton Dickinson (BDX) or Family Dollar (FDO) is much easier that before.

The high dividend stocks which I currently own to supplement my current dividend income, until my future growers increase dividends enough include:

National Retail Properties, Inc. (NNN) is a publicly owned equity real estate investment trust. The company is a member of the dividend achievers index, and has raised distributions for 20 years in a row. The stock yields 5.70% ( analysis)

Realty Income Corporation (O) engages in the acquisition and ownership of commercial retail real estate properties in the United States. The company is a member of the dividend achievers index, and has raised distributions for 16 years in a row. The stock yields 5.00% ( analysis)

Royal Dutch Shell PLC (RDS.B)operates as an oil and gas company worldwide. The company explores for, and extracts crude oil and natural gas. The stock yields 5.40% ( analysis)

Kinder Morgan Energy Partners, L.P. (KMP)owns and manages energy transportation and storage assets in North America. The company is a member of the dividend achievers index, and has raised distributions for 14 years in a row. The stock yields 6.20% ( analysis)

Universal Health Realty Income Trust (UHT)operates as a real estate investment trust (REIT) in the United States. The company is a member of the dividend achievers index, and has raised distributions for 22 years in a row. The stock yields 6.80% ( analysis)

Philip Morris International Inc. (PM), through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States. The company has consistently boosted distributions to stock holders since it was spun out of Altria Group (MO) in 2008. The stock yields 4.50% ( analysis)

Altria Group, Inc. (MO), through its subsidiaries, engages in the manufacture and sale of cigarettes, wine, and other tobacco products in the United States and internationally. This dividend champion has raised dividends for 43 consecutive years. The stock yields 6.20% (analysis)

Consolidated Edison, Inc. (ED), through its subsidiaries, provides electric, gas, and steam utility services in the United States. This dividend aristocrat has raised distributions for 36 consecutive years. The stock yields 4.90% ( analysis)

Dominion Resources, Inc. (D), together with its subsidiaries, engages in producing and transporting energy in the United States. The stock yields 4.10%

At the end of the day, investors should determine what they are trying to accomplish with their dividend portfolios. The stocks mentioned above are just a piece of the puzzle and not the solution to building a dividend portfolio for the long run.

Full Disclosure: Long WMT, FDO, D, ED, MO, PM, NNN, O, KMP, UHT, RDS.B

Relevant Articles:

- A dividend portfolio for the long-term
- Living off dividends in retirement
- Three Dividend Strategies to pick from
- Dividend Investing Works in All Markets

4 comments:

  1. Love the post! I would agree with you for the most part--but for someone who is retiring I would probably put the funds in more stable dividends rather then higher yielding ones.

    I would then allocate a % of a younger person portfolio in the higher yielding dividends. I believe growth is important when young and stability is important when old.

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  2. Thanks for this post. I like your portfolio management strategy posts especially ones like this with examples illustrating your point.

    I think the general gist of the post is on point, namely that investors just starting to invest near retirement should put more weight on current yield, while long term younger investors should focus on yield-on-cost potential. Balanced investors somewhere in between probably want a good mix.

    I think this guideline is solid in the context of the overall strategy presented on this site. When reading this post I'm thinking back to the post a week or so back on "holding windows", so I wonder if this guideline is only as instructive when assuming a longer holding window. For example, it seems that a long-term but highly "active" investor, with a shorter holding window, might be able to use high current yield positions towards long term capital growth if he's constantly reallocating his capital out of positions when those high current yields seem in danger or aren't most attractive. Or would you make the case that he'd still be better off focusing on yield-on-cost?

    j-

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  3. I love hearing your strategy tips.

    I would love to see a post your strategy for how to approach adding more capital to your portfolio. I know you recommend dollar cost averaging. You also have posted about diversifying with respect to industries and sectors. This post address tailoring portfolio to your income goals by balancing current yield versus yield on cost. You've also frequently described your criterion for initial investment, reinvesting dividends, and exit criteria. These topics are priceless for people first starting to build and monitor their portfolio.

    The post I would love to see would be targeted towards dividend growth investors would have already initiated starting positions in a diverse group of 20-30 companies and they are wondering, "What next?" It seems the same criterion for entry could be used for reinvestment. That said, it seems that must be balanced by maintaining diverse portfolio not too heavily invested in one sector/stock. Is there any harm in adding a position with a new stock instead of beefing up your existing positions? I've been focusing my additions in positions whose dividends have continued good dividend growth without corresponding increases in stock price. This seems counter intuitive at first glance since this generally means that I'm investing more capital in positions that I've seen the most capital depreciation (ignoring capital growth related to dividend reinvestment), but I suspect this is rather intuitive when keeping your eye on yield-on-cost.

    Thanks!

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  4. FYI, this post from February addresses the hypothetical/question in my first comment:
    http://www.dividendgrowthinvestor.com/2010/02/dividend-growth-beats-dividend-yield-in.html

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