Wednesday, January 25, 2012

Active Dividend Growth Investing

My strategy relates to buying quality dividend stocks which fit my criteria, then sit back and hold on until one of these three events happens. However, there are other ways for investors to actively generate income from dividend paying stocks. Although they are mostly for sophisticated investors, everyone should be aware of them.

One such strategy is active dividend investing. This relates to selling a stock when its current yield drops below a certain threshold. For example, back in 2009, investors could have purchased shares of Aflac (AFL) at $20 or less per share. As a result they would be earning a yield on cost of 6%. However, given the steep run up in the share price since then, the current yield is 2.80%.

The question that some investors ask themselves is whether it makes sense to sell a company yielding 2.80% today, and substituting it for a company which has a higher current yield. After all, this would only increase the current income that the portfolio generates. For investors who are in the distribution phase of their dividend investing lifecycle, any boost in the dividend income could be seen as a nice bonus.

I typically worry about replacing dividend stocks after I sell dividend stocks when one of these three events occur. The reason why I don’t sell stocks that have gone up so much, that their current yield is low, is because I would not want to miss out on any dividend growth potential.
For example, investors holding onto Yum! Brands (YUM), might be disappointed with the low current yield of the stock. I purchased the stock last year at $41/share. My yield on cost is almost 2.80%. The current yield on the stock is 1.80%. Theoretically, if I sold my Yum! Brands stock, and purchased shares of McDonald’s (MCD) with the proceeds, I would increase my dividend income by 50%. The current yield on McDonald’s (MCD) is 2.80%. However, I am careful not to focus too much on one aspect, which is yield. You can read more about choosing between dividend stocks in a previous article on the topic. In a potential decision of whether to sell or hold on-to Yum! Stock includes:

- Total returns

The main reason why I invest in stocks with growing dividends is the rising stream of passive income over time. The beauty of dividend growth stocks is that the increased dividends tend to lead to share price appreciation. While this process is not as linear as that of consistent dividend increases, total returns will increase your portfolio value, while also maintaining purchasing power of your principal. I believe that both McDonald’s (MCD) and Yum! Brands (YUM) have the potential to deliver strong total returns. However, given Yum! Brands strong position in China, I would expect them to slightly outperform the golden arches.

- Valuation

Valuation is important as well. Right now McDonald’s (MCD) is trading at 20 times earnings, while Yum! Brands (YUM) is trading at 24.50 times earnings. Valuation also drives total returns over time. Overpaying for stocks could result in subpar performance. Since Yum! was spun off from PepsiCo (PEP) in 1997, it has handily outperformed Mcdonald’s (MCD). Over the past five years however, McDonald’s (MCD) was able to deliver stronger price gains in comparison to Yum!.

- Dividend Growth

Over the past five year, MCD has managed to increase dividends per share at 27.50% per year and has raised distributions for 35 years in a row. YUM has been able to deliver 32.60% dividend growth over the same time frame, but has only raised distributions for eight consecutive years. The latest dividend increases of Yum! Brands however have been much higher than those for McDonald’s. In addition to that, the dividend payout ratio for Yum! Brands is much lower than the payout ratio for McDonald’s (MCD). Investors should also evaluate the risk of dividend cut, particularly if the dividend payout ratio is overextended above 60% for one of the companies.

- Earnings Growth

Over the past decade, MCD has managed to increase earnings per share at 20.70% per year. YUM has been able to deliver 13% EPS growth over the same time frame. McDonald’s generates 2.5 times the amount of sales that Yum! generates. In addition to that, the golden arches have a market capitalization that is three times the size of its rival. The future earnings growth, the expectations behind earnings growth are the fundamental factors that are going to drive dividend increases, share price growth over time. No two analysts have the same opinions on who will perform better over the next decade. This is exactly why picking one company over the other is more complicated.

- Diversification

I always stress diversification in as many sectors as possible. I also try to be exposed to several issues within a sector, in order to avoid any losses in income or principal stemming from a few bad apples. Investing is all about making assumptions and having a set of estimates of what might happen. Whether your theory materializes or not, is yet to be seen. However, by owning shares in two fast-food companies with global operations, you are better positioned than owning just one fast food company.

For example, investors who owned Wal-Mart (WMT) over the past decade have seen very little in terms of total returns. On the other hand, investors who owned Target (TGT) shares, did very during the same period. Back in the year 2000, it would have been impossible to determine which of these two companies would have outperformed the other. That’s why having an allocation to both could be a winning strategy after all.

In addition, investors who favored British Petroleum (BP) in 2009 over Chevron (CVX) for example, would have been in for a nasty surprise when BP was involved in the Gulf of Mexico oil spill. This resulted in steep declines in the company’s share price, as well as a suspension of its quarterly dividend.

Full Disclosure: Long AFL, YUM, MCD, PEP, WMT

Relevant Articles:

Popular Posts