Published October 11th, 2017
This is a guest contribution by Robert Kovacs. Robert Kovacs is the founder of uuptick.com, a premium stock analysis platform for retail investors. He is also an author on Seeking Alpha where he periodically publishes DGI investment research.
Fellow dividend growth investors (DGIers), how many times have you read online that you shouldn’t chase dividend yield but should instead focus on growth?
If you’re like me and my son Sam, you’ve seen this way too many times.
The idea has become a widely accepted mantra in the dividend investing world, but there’s a catch: nobody has ever backed up the claim… until now.
In this article, I will be running several simulations to settle the debate once and for all. You will be able to confidently assess which dividend stocks fit your profile based on the info in this article.
The short answer to the question in the title? It depends.
You want the long answer? Keep reading.
Before diving into the results of my research, I would like to open this article with one of my son’s favorite quotes.
“It’s not what you don’t know that gets you killed, it’s what you know for sure that just ain’t so”.
– Quote attribution disputed
This quote is extremely powerful when applying it as an investor. Badly founded beliefs are one of the first sources of costly mistakes when investing.
Common misconceptions about financial markets influence thousands of investors around the world every day. Such as:
- “Markets are efficient thus you cannot beat it”
- “You need to own bonds as well as stocks”
- “You need dozens of stocks do be diversified”
And finally, the one which interests us today:
- “Dividend growth is more important than dividend yield”
I am not sure of the exact reason this mantra was adopted unanimously by the community but it certainly happened somewhat like this.
- You learn about DGI.
- You get excited about companies paying out 10-12% dividends.
- You buy them thinking you get the deal of the decade, it is undeniable, you are the new George Soros.
- These stocks slash their dividend, and you’re left with an asset whose price has decreased dramatically.
- You sober up and buy Johnson and Johnson (JNJ) at a 2.5% yield. After all, if the dividend grows at a 7% rate for the next 20 years, your yield on cost (YOC) will be about 10% in 20 years.
You now experience less ups and downs, you are reassured by the rest of the community who tells you what you are doing is great, and you will have conservative, reasonable returns throughout the rest of your life.
“Once you start asking questions, innocence is gone.”
– Mary Astor
And it’s a reasonable choice. Some might even say you have learned your lesson and this is the sensible thing to do.
But is it the best thing to do? What if you want to optimize your earning potential?
It always seemed logical to me that two investments: one with a high dividend yield and low dividend growth, and one with the opposite attributes could be just as equally attractive investments.
It also seemed to make sense that over time that low dividend yield and high growth would eventually beat high yield and low growth investments.
But how much time is required? And what different growth-yield pairs lead to the same returns?
I decided to figure it out.
Since there are many variables which can impact total return from dividends over a lifetime I had to make some choices:
- I assume that stocks are bought once a year at the beginning of the year.
- I assume that the same amount of money is placed in the market every year. While this doesn’t effectively reflect real life situations, it makes computations easier.
- I assume in each scenario that the dividends are reinvested at the same yield for every given year.
- I decided that we would measure total dividends in the final year as the objective we are trying to maximize.
- I needed to determine a base scenario in order to find growth-yield pairs which would be equivalent to the base. I chose to use a 2% dividend yield and 5% dividend growth, which are the historical averages for the S&P 500, which looked like a good place to start.
I then redid everything by changing the base to a 3% dividend yield, which is a number a lot of DGIers look as a good yield to buy stocks at.
If you got this far keep reading, it’s about to get good.
The results of my research are displayed in tables, and are the property of my company Uuptick ltd.
How to read the tables:
Vertically you have the dividend yield at which purchases are made. Horizontally, you have the time horizon. So for each yield row, the percentage in the different columns is the required dividend growth for the investment to return the same in dividends in the final year as the baseline (green line). If the cell is blank, it means that no growth is required beyond the simple reinvesting of dividends to outperform the other scenarios.
Table 1: Beating the S&P 500
|10 years||15 years||20 years||25 years||30 years||35 years||40 years|
If over time we assume that the S&P 500 will have an average yield of 2% and dividends grow at 5% per year, what would you have to do to beat it (in so far as dividends are concerned) when you stop reinvesting and start cashing out?
Let’s assume like me, you’ll be done in give or take 15 years.
If I choose to invest in stocks yielding 1.5%, they will need to grow dividends each year for 15 years by at least 9.2%, nearly double the S&P 500 average.
On the other hand, if I choose to invest with stocks that have a yield of 2.75% or above, the simple reinvesting of these dividends will beat the base scenario, and get me more dividends than using a S&P 500 ETF as a retirement strategy.
But what if like me and many other DGIers, one of your rules is that you don’t invest in stocks with less than a 3% yield?
Table 2: Beating the DGIer (3% yield -5% growth)
|10 years||15 years||20 years||25 years||30 years||35 years||40 years|
I personally got more insights from this table. The base scenario simulates a solid blue-chip dividend stock and is a more appropriate point of comparison
Over 15 years, investing in stocks with a 2% yield would require an 11.1% annualized dividend growth (multiplying by 5 over 15 years) to match the base scenario.
On the other hand, anything yielding more than 4% will not require any growth to beat the base scenario.
Please play around with these, looking at your situation and what applies to you. If you retire in 17 years, you could extrapolate between the two columns.
It goes without saying that some of the annualized yields in these tables are too extreme to count on. I personally discard any option which requires my dividends to increase by more than 9% annually, since there is just too much uncertainty throughout a lifetime to bank on numbers which are that high.
Also, there is one catch in every scenario: it assumes you can spot dividend stocks which will continue paying a dividend from a long time. All the above tables don’t work if you invest in stocks which stop paying a dividend or go bankrupt.
But otherwise it is clear that if you can identify companies who have enough money to continue paying out their dividend, in most cases yield trumps growth.
Here are a few guidelines, depending on how long you have left to go:
5 years or less: At this point adding low yielding dividend stocks to your portfolio won’t do much for you, try identifying stocks with slightly higher yields to boost your income.
10-20 years: You could consider investing in stocks yielding as low as 2.75% but yields above 4.25% will provide better returns.
20-30 years: You have a bit more time ahead of you, and the compounding will do wonders if you invest in stocks which can grow their dividend. Keep in mind that stocks you buy in the 3-4% range will need to be able to consistently increase their dividend, albeit at a lower rate.
30-40 years: The world is your oyster, and even relatively low yielding stocks, as low as 1.5%, could do the job for your portfolio. This can be great to add some more expensive growth stocks which also pay a dividend.
I hope you get something from these tables, and that it might have inspired you to tweak some of your dividend growth investments.