Wednesday, February 10, 2010

Dividend Growth beats Dividend Yield in the long run

As an individual investor and blogger I do what I preach. I have a dividend portfolio which consists of almost 40 individual issues, most of them dividend achievers or aristocrats. I often get criticized by readers for writing about stocks which many seem to have a low current yield, despite having a history of increasing in dividends. Those readers believe that finding a high yielding stock is the best income play for the long term. In other words stocks that pay over 8% but do not raise distributions are viewed favorably than stocks which currently yield 2%-3%, but grow their dividends consistently.

The reason why I consider dividend growth investing a superior investment strategy is because it focuses not only on delivering a rising stream of income but also on total returns. To the untrained eye it might appear that investing in Abbott Labs (ABT) or Johnson & Johnson (JNJ) is a poor choice, especially since these companies yield 3%. The main advantage of these companies of course is that they have always paid a low current dividend yield, but have grown their payment in the process. The stock price typically adjusts upward, which decreases the current yield to a normal range. Thus these dividend growth stocks deliver total returns which high yielders cannot match in the long run. In addition to that the rising dividend payment increases the yield on cost on the original investment.

Let’s illustrate this with an example. Abbott Labs (ABT) is a dividend aristocrat which has raised distributions for 37 years in a row. It yields 3% right now, but has a ten year dividend growth rate of 9%. At this rate the company would double its dividend every 8 years. The growth has slowed over the past decade however – since 1983 the dividend growth was almost 13.1% per annum. The stock yielded 2.2% in 1983, which was hardly under the radar of any yield chaser. In fact the current yield at year-end for Abbott fluctuated between a low of 1.20% in 1998 and a high of 2.89% in 2009. The visionary investor who purchased Abbott at the end of 1983 achieved a yield on cost of 10% in 1992 in addition to holding onto a five-bagger. Twenty six years later this investor would have achieved a yield on cost of 55%, which is something that even the highest yielding stock out there cannot match.

An investor in a high yielding stock in 1983 would have most likely kept on receiving a high current yield for a long period of time. The main issue with this scenario is that the purchasing power of the flat dividend payment would have been cut in half over the past quarter of a century. Similarly an investor in 30 year US Treasury Bonds would have kept receiving the same amount of income each year. Check my analysis of Abbott Labs.

Other companies which have a long history of raising dividends while also delivering a strong dividend growth, plus being attractively valued at the moment include Johnson & Johnson (JNJ) and Clorox (CLX).

Johnson & Johnson (JNJ) has raised distributions for 47 years in a row. The company has achieved a 10 year dividend growth rate of 13.30%. The latest dividend increase was 6.50% in 2009. The dividend payout ratio is at 43%, which makes it adequately covered. Check my analysis of the stock.

Clorox (CLX) has boosted dividends for 32 consecutive years. The company has achieved a ten year compound dividend growth rate of 9.60%. The company last raised its payout by 8.7% in 2009. Its dividend payout is at 50% right now, which means that the dividend is well-covered from earnings. Check my analysis of the stock.

Full Disclosure: Long ABT, CLX and JNJ

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  1. I would add that retirees are loath to sell assets to live on, so while total return is attractive, it's cash flow that carries they day. Unfortunately, most didn't start buying dividend growers like ABT 30 years ago, so they naturally gravitate to the higher payers when they switch from growth stocks at retirement.

    It would be interesting to chart a high yielder or two next to ABT and track both income and total return. How long does it take for ABT to pull ahead?

    Instructive post, thanks.

  2. I agree with the previous post about charting a high yielder next to ABT, but I'd take it a step further. This may be outside of the scope of your resources, maybe something for an academic study, but have you seen any analysis that dividend growth beats dividend yield on a broad basis? Not just one stock, but maybe all stocks with 9+% dividend growth vs. all stocks with 5+% dividend yield, or something like that?

  3. Um, do you have any hard data backing your assertion? I mean, picking one stock in retrospective and then claiming "look, I'm right, this stock proves it" is not a convincing argument, actually it's no argument at all.

    All I would have to do to counter is point out BoA, which was a dividend aristocrat until last year, and now doesn't pay a dividend at all.

    For starters, it doesn't have to be scientific data. Maybe two different portfolios to compare, one based on dividend growth, the other on dividend yield?

  4. I think the time horizon of the investor is the key. With a short horizon, a low current yield/high growth pick (e.g., WMT) won't "catch up" to something with a higher current yield (e.g., ED). ED is also less price volatile than WMT -- potentially a plus for people near retirement or saving for a specific near-term goal like college tuition.

    As someone with a 30 yr time horizon, I'm a believer in the growth approach. As I get older, circumstances permitting, I'll sit on my original positions in companies like JNJ, but I'd put increasingly more new moneys into higher current yield choices (all within the context of whole-portfolio asset allocations).

    One thing to ask yourself, however, is if you believe that a company's next 30 years are likely to have similar growth opportunities as it had in its past 30 years. Can WMT continue to grow at the rate it had been? Are some companies too mature and too big to keep up its growth pace? Can tobacco companies continue to increase earnings for the foreseeable future? An investor should at least consider these and not be tempted by the high dividend growth, and more than an investor should be tempted by a high current yield.

  5. I agree retirees are reluctant to sell assets, but that would seem to be a better approach than just buying riskier securities with questionable abilities to sustain yields.

    The underlying point of the importance of dividend growth is a great one. Even someone retiring in their 60's may live another 20+ years and benefit from long term income growth. If someone is not comfortable owning lower yielding stocks, maybe they can go halfway and own a group of higher yielding stocks with sustainable but slower growing dividends mixed in with stocks with somewhat higher growth rates.

    A portfolio of:
    MO,VZ,T,HCN,EPD,O,NNN,SO,BMY,LLY,COP,BP,PAYX,LEG,SYY,MCD,EXC,KFT,KMB,GPC yields about 5.5% and has a good chance of growing their dividends enough to keep up with inflation.


  6. I agree with the 2 other posters, to be fair you must chart it against higher dividend stock and assume that the difference in yield of the higher yielding stock be invested in more stock. It a stock yielding 3% with divided growing at 10% 18 years to pass a stock that does not grow its dividend but yields 8% if the difference in yield is reinvested.

    Yield Div growth rate Yield
    1 40 $1.20 3.00% 10.00% 40.00 8.00% $3.20
    2 40 $1.32 3.30% 10.00% 42.00 8.00% $3.36
    3 40 $1.45 3.63% 10.00% 44.04 8.00% $3.52
    4 40 $1.60 3.99% 10.00% 46.11 8.00% $3.69
    5 40 $1.76 4.39% 10.00% 48.20 8.00% $3.86
    6 40 $1.93 4.83% 10.00% 50.30 8.00% $4.02
    7 40 $2.13 5.31% 10.00% 52.39 8.00% $4.19
    8 40 $2.34 5.85% 10.00% 54.46 8.00% $4.36
    9 40 $2.57 6.43% 10.00% 56.48 8.00% $4.52
    10 40 $2.83 7.07% 10.00% 58.42 8.00% $4.67
    11 40 $3.11 7.78% 10.00% 60.27 8.00% $4.82
    12 40 $3.42 8.56% 10.00% 61.98 8.00% $4.96
    13 40 $3.77 9.42% 10.00% 63.51 8.00% $5.08
    14 40 $4.14 10.36% 10.00% 64.83 8.00% $5.19
    15 40 $4.56 11.39% 10.00% 65.87 8.00% $5.27
    16 40 $5.01 12.53% 10.00% 66.58 8.00% $5.33
    17 40 $5.51 13.78% 10.00% 66.90 8.00% $5.35
    18 40 $6.07 15.16% 10.00% 66.73 8.00% $5.34
    19 40 $6.67 16.68% 10.00% 66.01 8.00% $5.28
    20 40 $7.34 18.35% 10.00% 64.62 8.00% $5.17

  7. Dividend investing is a great way to 'smooth' out your ups and downs in the market. Dividend growers that pay a steady year-over-year increase are consistent investments that will have great long term effects in your portfolio. I am not at retirement age, so I reinvest all dividends back into the company through their DRIPs. In addition, I sell put and call options on the same companies to create income.

  8. I agree with the previous post about charting a high yielder next to ABT. It would be interesting to chart a high yielder or two next to ABT and track both income and total return. Novated lease


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