Tuesday, September 2, 2014

Should I have a minimum yield requirement?

In my entry criteria, dividend yield is the last factor used to select dividend stocks. After I screen the list of dividend champions or dividend achievers, I look at each company in detail.

First I look for growing earnings per share, and attractive entry P/E ratios. Then I check if the dividend is going up above the rate of inflation. Finally, I check if entry yield is above 2.50%.

Using my screen parameters, I sometimes end up missing companies which have low yields but high dividend growth. However, by doing so, I am somewhat protected in the case I purchase a low yield but high growth stock, which subsequently lowers distributions growth or stalls it. I want to avoid at all costs getting carried away chasing dividend growth. Chasing growth could result in overpaying for a low yielding asset that grows earnings and dividends, and my total return ends up being limited to the modest initial yield for several years. My investment philosophy is to avoid losing money, and as a result I am fine missing out on potential gains if that reduces dividend income risk. Winning dividend positions typically take care of themselves, while losing positions are typically the higher risk ones that could make you lose sleep at night.

For example, investors who purchased stock in some great blue-chip dividend payers such as Coca-Cola (KO) or Wal-Mart Stores (WMT) during the 1999 – 2000 period, saw their share prices go nowhere for over a decade. The only return they received was in the form of dividends, which were initially very low. At the same time, both companies managed to significantly increase revenues, earnings and dividends during that time period. The reason behind the lackluster performance was the fact that these stocks were very overvalued in the late 1990’s and early 2000’s. The lesson from this exercise is that even the best dividend paying stocks in the world are not worth overpaying for.

Furthermore, while I may miss out on some companies like Raven Industries (RAVN) or Franklin Resources (BEN), I am going to still be able to select stocks in the sweet spot, which generate best returns for the risk i am taking. A company like Phillip Morris International (PM) or Kinder Morgan (KMI) that provides a good starting yield of 4% which grows at 8%-10% per year, is a much better candidate that a company yielding 1 - 2%, that grows dividends at 12%. The higher initial yield provides a margin of safety for the time in the future when dividend growth stalls. This could be tomorrow, or it could be 20 years from now. The issue with high growth is that it cannot continue forever. At some point, the growth will come down to a more reasonable and sustainable level.

The negative of what I am doing is that I will surely miss out on the next McDonald's (MCD) or Johnson & Johnson (JNJ) dividend growth success story. This is because companies in the early stage of dividend growth typically have low current yields, but manage to grow distributions at a very high clip. Those are the types of companies which will generate outstanding total returns, and double-digit yields on cost for anyone fortunate enough to believe in the company, and put their money there. This is one of the reasons why I purchased Visa (V) in 2011 and recently in 2014, despite the low current yield. I also purchased Casey's (CASY) in 2011 and YUM! Brands (YUM) in 2010 and 2013, when their yields were less than 2.50%. I was betting that above average dividend growth will continue, and I also wanted to beef up my portfolio exposure to the low yield and high dividend growth investments.

In the grand scheme of things, I am starting to believe more and more that initial attractive valuation of less than 20 times earnings is helpful. If this valuation is even lower, that could be very helpful for total returns and future yields on cost as well. The other equally important thing to consider is growth of earnings per share. After all, a quality business that keeps growing over time will eventually bail out the investor who might have slightly overpaid in the beginning. However, if I overpaid for a business that pays a high yield today, but fails to grow earnings per share, chances are that the dividend will not increase above the rate of inflation, and I will end up downgrading my standard of living quite regularly. Therefore, a business which has the potential to earn more in 15 - 20 years, coupled with an attractive valuation, is the type that will deliver investment success to its shareholders. Whether this business pays a 2.50% yield or a 1.50% yield at the time of investment might not be as relevant. However, if I am wrong about my assessment of the business, I will end up losing more under the lower yield scenario, since earnings will not grow by much leading the the price to stagnate, In addition, the business will only pay a paltry yield, that does not grow by much either. Since I use my dividends from companies to buy shares in other companies, this could mean less money to be put to work in the next great dividend growth success story.

This is why evaluating each business one at a time is so important. The investor has to take into consideration valuation, growth prospects, changes in industry or competitive landscape and evaluate that against their unique set of investment opportunities and expectations. Unfortunately, investing is not as black and white as most would make you believe.

Full Disclosure: Long KMI, PM, KO, WMT, YUM, V, CASY

Relevant Articles:

The importance of yield on cost
How to be a successful dividend investor
Types of dividend growth stocks
How to retire in 10 years with dividend stocks
Should Dividend Investors Worry About Rising Interest Rates?

15 comments:

  1. Your right DGI. I need to start making sure I am balancing good earnings growth with good dividend growth. That sweet spot company is more likely to keep at it then one with a high dividend growth rate or off the chart earnings.

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    Replies
    1. It is a balancing act, and it does depend on many factors. That's why investors need to gain a very good understanding behind a company, and then purchase it or not. There are no strike-outs called in investing

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  2. DGI,
    I am not disagreeing with any of the points that you make, but the growth in earnings is the biggest safety factor against overpaying for a stock IMO. If you overpay by 20%, but the company's earnings grow by 20% annually, you only have to wait a year to break even assuming the P/E ratio goes back to a normal value in that year's time. I will agree that earning plus dividend yield is actually the metric, so that a company that pays a 4% dividend only has to grow earnings 16% and, even though the stock price would decline by 4% (-20% for P/E normalization +16% for earnings growth), it is offset by the dividend yield. That is why I like companies such as SBUX, NKE, COST, V and MA even though the yield is low. It's even better if the dividend yield is growing at a rate that vastly exceeds the rate of inflation, and I believe all of the mentioned stocks will be doing that for the foreseeable future.

    And yes, I know that the math is off since a 20% decline requires a requisite 25% increase to get back to zero, but I didn't want to make it too confusing so I simplified. So, it probably takes a 20% increase in earnings plus a dividend yield of 4% compounded/reinvested to get back to even if you overpay by 20%.

    Good luck (not that you need it, you are doing great),
    KeithX

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  3. DGI,
    I don't know much about reverse stock splits but two of my stocks have done them in the past couple of years. They take 2 or 3 shares and give you one. This I understand but why does the dividend stay the same? It too should split. Is this the way they work or is this not a true reverse split or what?
    Great article. TY Suzanne

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    Replies
    1. Duke Energy DUK. They did a merger, a 1 for 3 reverse split on 7/3/12 but did not split the dividend, and actually raised the dividend. I don't understand this is this a real reverse split? I think they did a reverse split so they only had to pay the dividend to 1/3 of outstanding shares and they did it with the merger and raised the dividend so it would be less of a shock. But it still was crappy and I am not going to buy any more shares. I only have 20 and it will stay that way unless it becomes necessary to sell. Can't wait to read your next article. Suzanne

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    2. I haven't looked at DUK before. According to their website, they did the reverse split, but adjusted the dividend:

      http://www.duke-energy.com/investors/stock-information/dividend-history.asp

      There is more information on the reverse split on the company website:

      http://www.duke-energy.com/pdfs/Reverse-Stock-Split-FAQ.pdf

      As an individual investor, you need to be able to research those issues, and go to the company website, and find relevant information.

      Good luck

      DGI

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  4. Sorry, if my comments weren't clear, but I was pressed for time. I should have concluded that I favor stocks with lower yields and higher earnings growth, particularly if the dividends are growing at the same rate as earnings. Take 2 stocks as examples, both of which begin with the stock at $100. The first yields 3% and is growing at 7%. After 10 years, the dividend is 1.967 times as great, so the end dividend is $5.90. The second yields 1% and is growing at 15%. After 10 years, the dividend is 4.046 times the original and grew to $4.04 after 10 years. Not quite as much as the first stock, but now in the ballpark. The real difference is in the stock price even if we assume equivalent P/E ratios (and typically higher growth stocks command higher P/E ratios, which only favors the higher growth stock even more). So, at the numbers posted, both stocks started at $100. The first appreciated to $196.70, but the second appreciated to $404.60. Therefore, the higher safety factor against overpaying favors the growth stock. Just my thoughts FWIW.

    ReplyDelete
    Replies
    1. It is a balancing act.. Because if you overpay, and growth slows down, you are holding on to a company where you get initial low yield, that grows by little for an extended period of time. In addition, you might get a price depreciation also. Nothing is guaranteed, of course and capital gains are not earned evenly like dividend income.

      But the example you provided is one reason why I am considering whether I really do need a minimum yield requirement. Most of companies I have purchased and violated my minimum yield requirement ( but were fairly valued, dividend growth achievers or better, good businesses, good prospects), have done really well. In fact, if I stuck to the "entry rule" criteria, I would not have done as well as I have. So I keep tinkering. As I experience more, I update my investing accordingly. Unfortunately, a formula cannot replace stock picking. I need to evaluate companies one at a time.

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    2. When looking at stocks, just like you do I look for consistent revenue growth and all those other good characteristics. And I tend to look for those within two different groups for div yield;
      1) Do I want higher income right now to reinvest back into more stocks(so a high current yield)
      2) Do I want longer term dividend growth but a lower current yield.

      That sort of decision affects whether I look more into REITs or Telecoms compared to a buy like a bank or my recent buy of Suncor. With REITs/monthly players I can use the higher level of income to buy more shares or an ETF or two, whereas the div growth companies will provide more income in a few years.

      Happy investing!

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  5. DGI,
    Sir I was wondering how real V's dividend increase. Can a company continue to increase their dividend at even a 25% increase a year as long as business is healthy? If so the one share I purchased is going to be worth half a million dollars when I retire at V's dividend increase rate. I can see why you bought more. Suzanne

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    Replies
    1. I discussed Visa and expectations in the analysis I did on the stock:

      http://seekingalpha.com/article/2442935-visa-high-dividend-growth-stock-to-consider

      DGI

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    2. Ok I do not go to SA because they are so user unfriendly but I will try again. Suzanne

      Delete
  6. DGI,
    I think this is a good link that also somewhat fits the discussion. This is part II with a link in the beginning to part I. http://www.millennialinvest.com/blog/2014/7/9/consumer-staples-part-ii After that, I figured I'd buy some KRFT on loyal3 @ 3.6%.

    Also, I just read Siegel's book that was referenced, and I think the first part, which can be read in a bookstore, is interesting if you haven't read that.

    Regards,
    Stan

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  7. Agree on most of the stuff. It is very similar to my screening process.

    About P/E, I agree for 20 as an interesting point but personally I'm nervous when it is lower than 12. When something is looking to good to be real...

    Also, I start to look at the ratio P/(E+D)

    ReplyDelete

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