Dividend Growth Seekers: Don't Forget About Yield!

Morningstar

A version of the following article first appeared in the November 2013 issue of Morningstar DividendInvestor.

What is dividend growth investing?

That might seem like a strange question to ponder in the pages of DividendInvestor. Except for a few preferred stocks we bought on extremely favorable terms in 2009, we have always insisted on getting dividends that will grow over time. Since there is generally a trade-off between yield and growth, my conception of a dividend growth stock is any issue whose expected long-term dividend growth rate exceeds its current yield. On that basis, all 18 stocks in DividendInvestor's Builder Portfolio qualify as dividend growth stocks, as do eight of the 18 holdings of the Harvest.

However, I don't think our approach--even in the Builder--is the best reflection of what most investors think a dividend growth strategy is. Based on my reading of the market's collective consciousness, a dividend growth strategy seeks either 1) companies that have raised their dividends every year for at least 10 years in a row, or 2) double-digit rates of annual dividend growth over long time horizons.

All else being equal, it's very hard to argue against these attributes. I prefer a long history of dividend increases over a short one, and more dividend growth over less. Emphasizing dividend growth over current yield also seems to chime with the times. Investors are concerned about the impact of rising interest rates on high-yielding stocks, and it's plausible that more growth-oriented issues could outperform when the economy eventually moves out of first gear.

Yet all else is rarely equal. A clockworklike pattern of dividend hikes over the past 10 years can help us find and evaluate potentially worthwhile stocks, but far more important is what will happen over the next 10 years. Rapid dividend growth can be a meaningful driver of total returns' too, but the nature of rapid growth is that it eventually has to slow--and most fast-growing dividends provide below-average yields. As in so many other aspects of investing, we must deal with trade-offs.

Though I require dividend growth to round out a good total return, I strongly prefer above-average yields even if it means giving up some growth. It's not just about current income: The total returns strike me as more attractive given the risks.

Dividend Achievers: Past or Future?
The concept of "Dividend Achievers," companies with at least 10 years of uninterrupted dividend growth, was popularized by a division of Moody's that is now known as Mergent. Mergent continues to publish quarterly guides in book form. No less an authority than Peter Lynch said, "Buy the stocks on Mergent's list and stick with them as long as they stay on the list." Standard & Poor's later came up with its own "Dividend Aristocrats" list, requiring 25 years for companies in the S&P 500 or 20 years for members of the S&P 1500 (an index that combines the large-cap S&P 500, the mid-cap 400, and the small-cap 600). Lists like these have been used to create several exchange-traded funds, the largest of which is Vanguard Dividend Appreciation (VIG).

I like many of these "achievers" and "aristocrats" too; my intention here is anything but disrespect. Still, one essential element of their nature has never escaped my attention: All the stocks that make the list get there on the basis of past performance. Past may be prologue, but it's far short of a guarantee. Dozens of dividend growth streaks ended in ignominy in 2008 and 2009, including those for the vast majority of financial services firms. Moreover, it's not necessarily much of an achievement if all that matters to a company is staying on the list. Consolidated Edison (ED) has a 39-year streak of dividend growth going, but in the past 20 years the average annual dividend increase has been just 1.2%--half the rate of inflation.

Rummaging through the DividendInvestor portfolio archives, I discovered that only about half of our purchases qualified as dividend achievers when I first bought them. Of those that didn't have 10-year streaks in place, half of those hadn't yet been public companies for a full 10 years, which can't help but rule them out of an achiever approach. But as long as I am satisfied that earnings are going to grow and management will reward shareholders with rising dividends, I don't need to wait for a 10-year record to be established. Achiever status is helpful, but there's no reason it should be necessary.

In fact, had I required 10-year or longer records of dividend growth before buying, I could not have acquired any of the eight stocks that have turned out to be our best performers. This group is led by Magellan Midstream (MMP) (purchased in 2008, at which point its growth streak was eight years long), Compass Minerals (CMP) (purchased in 2005, less than two years after it came public), and Philip Morris International (PM) (spun off from Altria (MO) in 2008, purchased in 2010). Why would I have wanted to wait until 2018 for Philip Morris to mark 10 years of uninterrupted dividend growth when that was a highly probable outcome right from the start? Yet had I been using a 10-year dividend growth threshold, I still could have bought five of our eight worst-performing stocks, including Allstate (ALL), Developers Diversified Realty (now DDR (DDR)), and Associated Banc-Corp (ASBC).

Overall, stocks we bought that were not dividend achievers at the time have outperformed those that have--a conclusion that surprised even me. The achievers have provided an average total return of 18.5% while we've owned them, a result that fell 4.6% short of the S&P 500 over comparable holding periods. Meanwhile, the non-achievers (or achievers-to-be, in many cases) provided us with an average total return of 35.0%, beating the S&P by 10.1%.

Maybe I'm just not that good at selecting stocks from the ranks of dividend achievers. Sometimes I've been late to the party, such as in the case of McDonald's (MCD). I could and should have bought this dividend achiever many years before I finally did in October 2012, but since I climbed aboard, the company's profits have stagnated and the pace of dividend growth has dropped (temporarily, I think). But the Vanguard Dividend Appreciation ETF sets up an interesting test. Which is better, a pure-achiever strategy, or the more flexible DividendInvestor approach?

Since May 1, 2006--VIG's debut at $50 a share--the ETF has provided a total return of 63.1%, or 6.8% annualized. That beats the S&P 500 by a respectable margin (up 53.2% including dividends, 5.9% annualized). However, our portfolios have generated a combined return of 88.7% (8.9% annualized), beating VIG by slightly more than 2 percentage points annually and the S&P 500 by 3. Also, an analysis of beta (correlation of returns relative to the S&P 500) suggests we took less risk: Our monthly beta for this period was 0.74, compared with 0.83 for VIG.

Does this reflect brilliant stock-picking on my part? I don't think it's false modesty to decline any praise on this count. The key difference between VIG and our portfolios is not much more than our pursuit of current yield. Excluding dividends, VIG has scored a 40.7% cumulative capital gain, while our holdings have appreciated 33.4%. However, VIG has provided an annualized income return of only 2.0% since inception. That is actually slightly less than the S&P 500's 2.2%, partly because of VIG's (very low) management fees. The average yield of the DividendInvestor portfolios during the same period clocks in at 4.8%, which--with the compounding effect of reinvestment--makes up for the slight underperformance in capital gains and accounts for all of our outperformance.

5+5 Versus 2+8
I can't promise that our approach will continue to outperform VIG, and the dividend achievers approach has some legitimately attractive features. However imperfectly, it acts as a quality screen of sorts. In general, companies that pay dividends are better established and financially stronger than those that don't. VIG also generates some income, which is better than none at all. Instead, my point is that a disproportionate focus on dividend growth seems unlikely to optimize total return the way a more balanced view of growth and income should.

My good friend Dan Peris, comanager of the Federated Strategic Value Dividend Fund (SVAAX), describes his portfolio strategy as 5+5: 5% yields plus 5% annual dividend growth. The market isn't always priced to provide 5% yields in abundance; after expenses, his fund yields 3.3% on a trailing 12-month basis. Still, the math makes sense: A portfolio that yields 5% and whose income grows 5% a year through dividend increases should enjoy long-run capital appreciation averaging 5% a year and total returns around 10%. The same logic underlies the stated objectives of our Builder and Harvest portfolios. At the midpoint of our accounts' current targets for income and income growth, the Harvest's formula is 5.0+4.5, while the Builder's math is 3.5+7.5.

But does 2+8 work as well? That is more or less the value proposition of VIG or, for that matter, the S&P 500 as a whole. Backing a 2% yield out of a generic 10% long-run total return for stocks leaves 8% as the requirement for annual dividend growth and associated capital gains. Yet the market's own history is not encouraging on this front: Per-share dividends for the S&P 500 Index have grown only 5.5% a year over the past 50 years and just 4.3% for the past century, even though these historical periods include long stretches of inflation much higher than we face today.

Meanwhile, the variability of dividend growth rates and the even more exaggerated volatility of stock prices make a 2+8 strategy a tougher way to grind out good returns than 3+7, 4+6, or 5+5. Without a more meaningful yield as a backstop for stock valuations, future disappointments in growth--whether cyclical or secular in nature--hurt that much worse.

What About 2+10? Or 1+20?
Some stocks generate double-digit dividend growth year after year. Don't those stocks have merit? That depends on where the growth is coming from.

In terms of past performance, impressive growth might reflect nothing more than a very low base. UnitedHealth (UNH) has a blistering five-year dividend growth rate of 92.8%, the best in the S&P 500, but only because it paid just $0.03 a share in 2008. The stock has done well, but it certainly hasn't risen 90% a year, and even now the stock yields only 1.5%.

What else might drive hyperfast dividend growth?

An expanding payout ratio. With earnings per share growth for the S&P 500 having slumped into the low single digits, rising payout ratios are driving much of the dividend growth across the market right now. A strengthening commitment to dividends is a plus, but it doesn't necessarily drive total return the way consistent growth in both dividends and earnings can. To cite but one of many examples, Western Union's (WU) payout ratio has doubled from 18% to 35% since 2010, but earnings per share haven't grown at all, and neither has the stock price. When fat dividend increases are best characterized as remedial--that the company should have paid out more all along--don't be surprised if (as in the long-running case of Microsoft (MSFT)) the stock price fails to benefit. Share repurchases. IBM (IBM) has a five-year dividend growth rate of 17.1%, but roughly half of this growth came from share repurchases. Net income and especially revenues have grown much less quickly. If IBM paid bigger dividends, it wouldn't have bought back so many shares, and the dividend wouldn't have grown as much--but shareholders would have enjoyed much higher yields than the recent 2%.Old-fashioned internal growth (if you can find it). Fastenal (FAST) is one name that comes to mind: It currently yields 2%, and earnings per share have more than doubled in the past six years without leaning heavily on buybacks. Bellwethers member ITC Holdings (ITC) is another high-quality, high-growth story that an income-oriented investor could take seriously.But stories like these come loaded with caveats. With very high rates of dividend growth and very low yields, the yield-plus-growth conception of total returns is not very effective. Think of it this way: A stock that yields only 1% has to raise its dividend 20% to generate the same dollar increase in annual income that another stock yielding 4% can achieve with a mere 5% hike. And what will happen when rapid growth eventually slows? Just when the yield needs to rise in order to compensate investors for slowing expansion, dividend growth probably falls as well, leaving the stock price stagnant or worse.

I learned this lesson with 3M (MMM), Johnson & Johnson (JNJ), Sysco (SYY), and United Parcel Service (UPS). All were purchased with initial yields between 1.8% and 2.3% in hopes of hefty dividend growth, but when growth fell short of expectations, all produced subpar results. The good news is that Builder holdings J&J and UPS now offer higher yields that reflect more reasonable prospects for growth.

Bottom Line
If the dividend yield of a particular stock or strategy is 2% or less, it might make more sense to simply focus (like most investors) on the fickle fortunes of capital appreciation. After all, 419 of the 500 S&P constituents now pay dividends, up from just 351 in 2002. You might say the S&P 500 as a whole is a dividend growth strategy by definition, but only because the current income component remains historically poor.

So my take on dividend growth investing boils down to this: Don't just maximize dividend growth for its own sake. Instead, consider your personal need or preference for income--keeping in mind that high but safe yields limit the risk of decelerating growth--and optimize your total return with a good mix of dividend yield, growth, and quality.

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