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sagitarius84 (< 20)

Dividend yield or dividend growth?

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July 28, 2010 – Comments (4) | RELATED TICKERS: JNJ , KMP , T

                                              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 stock 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,

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

4 Comments – Post Your Own

#1) On July 28, 2010 at 9:34 AM, sagitarius84 (< 20) wrote:

Dividend Yield or Dividend Growth - do you use both or not?

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#2) On July 28, 2010 at 5:41 PM, goalie37 (91.09) wrote:

It sounds like we're twins when it comes to investing.

The solution to the question of current dividends versus future dividend growth that I have come up with is to build a portfolio of both.  I have a REIT that pays quite nicely now, but with little room for growth.  I also own some companies with very low payout ratios that I believe will be able to increase the dividend at a rate higher than their earnings growth.  In the middle I have many of the same types of companies that you mentioned - strong current yield with a nice track record of increasing their payouts. 

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#3) On July 29, 2010 at 10:04 AM, Gemini846 (50.38) wrote:

The thing about saying the current yield is too low and ignoring the chance for growth is basically saying the stock is overpriced. In 2008 JnJ was 3% because the share price had dropped through the floor. It was a steal without the dividend.

I shop for overall value, so I'm more inclined to look at the current yield and cash flow to sustain that yield over the chances of it increasing.

Personally I think its time for AAPL to pay a dividend, else they end up like GOOG.

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#4) On July 29, 2010 at 11:52 AM, sagitarius84 (< 20) wrote:

AAPL used to pay a dividend until it got in trouble in 1996. Otherwise I agree that tech companies have way too much cash on their Balance Sheets. More often than not an excess hoard of cash leads to poor capital allocation decisions..

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