I had such a pleasant experience writing my first article, and received such informative and helpful feedback, I decided to give it another shot. This time, though, I am setting out to prove whether high yield investments can keep up with dividend growth stocks for the long term.
There is a constant flow of articles on SA not only about the power of compounding via dividend growth investing ("DGI"), but also the simple fact that DGI may provide protection (oftentimes completely) against inflation; if your income is growing at a faster rate than inflation, you will actually be "richer" notwithstanding the increased cost of living. On the other hand, even if you were to hold a high yield investment, it may be suffice for the time being, but in a few short years, inflation will eat away at the benefit of your holdings.
Yield is not most important, but may be in determining strategy.
My hope in running some numbers was to find that this conclusion was not entirely accurate, because it doesn't leave for room a lot of diversity among asset classes for a long investment horizon. My findings, however, strongly support the conclusion that DGI guarantees investing success as much as anything (in terms of building capital/income, without taking risks into consideration).
The table below compares the compounding value of a (relatively) high yielding CEF, Eaton Vance Tax-Managed Diversified Equity Income (NYSE:ETY), a Dividend Champion in Automatic Data Processing (NASDAQ:ADP), and a Dividend Contender in Enbridge Inc. (NYSE:ENB). I chose ETY because it is an equity based fund distributing a hefty 9.99% on market value as of Friday February 15, 2013 (according to the company's website); I chose the two equities from David Fish's list (for which I will briefly express my appreciation for producing such a valuable tool, for free no less!) merely for their track record of dividend streaks and growth. I used the combined CCC tab to find the approximate median of each of the 10-year dividend growth rate and the yield percentage. ADP's dividend growth rate (as of the 12/31/13 list) was 13.1%, and its yield was a (higher than expected) 3.06%. ENB's 10-year growth rate was a not-too-shabby 11.5%, with a current yield of 2.91%. (As an aside, I think that ADP's 10-year growth is amazing considering its dividend growth streak is a long 38 years.)
As you can see, if your time horizon is not too long, than compounding a higher yield will likely prove more financially prudent. However, your ADP "investment" will surpass ETY in value after only 18 years, and ENB will surpass after year 21. For someone like myself, who does not plan on retiring for over 30 years (unless my investing really takes off!), the dividend growth may really be too powerful to let it pass by.
When you look at the bottom half of the 2 equity columns, specifically ADP, you will notice how great the increase in yield percentage is, and hence the investment value, grows from year to year. I don't think this is likely to happen. However, that should not affect the analysis too much; the point being the power of dividend growth has been clearly made.
Many of you are probably scratching your heads right about now, thinking, I don't invest in this stuff to let it sit compounding for the next 30 years. I need my income now. YH, how will this little game play out if you don't reinvest all the distributions? Well, I'm glad you asked.
Above, you will see what distributions would look like on ADP v. ENB v. ETY. It is evident that in such a scenario that the DG plays a stronger role sooner; without the compounding of the much greater ETY yield, that investment gets surpassed after 11 and 13 years.
Nevertheless, the pro-high yield part of you should have pointed out that I seemingly have failed to account for all the extra distributions earned over the first several years on the high yield investment. In the following table, we "own" ETY while trying to match the distributions of ADP. ADP's yield is "only" 3.06%, as compared to ETY's 9.99%. That extra 6.93% is now going to be reinvested in ETY and will compound for us. Doing it this way, ETY's value lasts much longer. It isn't until after the 17th year that you will have to raid your principal, and you can continue doing that until the end of year 26. Again, the choice to do something like this depends a lot on your horizon (and how many relatives you have!); personally, it doesn't sound very enticing.
In the following table, we compare in similar fashion ENB's distributions with an ETY distribution match, with the remainder going toward reinvestment. With the slower growth (and lower original yield), you can produce as much income for 22 years until you have to start raiding your investment, and you can continue raiding until 31 years. That is significantly longer than ADP, but I can't say it's a much brighter prospect.
A fair question would be, if you're just trying to match DG, why not just invest in DG?
My goal is attempting to poke holes in the DG strategy; if I can match its performance with something else, it may not be better than that alternative strategy. (This is not a knock on DG or those who "practice" it. It is merely my way of understanding it better and becoming more convinced of its veracity.)
Further, as has been discussed within these forum walls in the past, there is always a give and take between a bird in the hand and 2 in the bush when it comes to investing. Assuming dividends are in the hand, growth may be in the bush. If that's not too off the mark, there is certainly something to be said about currently-high yield.
Additionally, dividend growth will likely be accompanied by (if not causative of) increased market price. This will, in turn, weaken the "growth" aspect of the reinvestment phase, of which I hope to be in for some time. As the price goes up, my relative purchasing power will remain the same and not increase, slowing my compound rate. (This argument also assumes that the high yield investment won't have share price increases to similarly lower the reinvestment power.)
Finally, even in the scenario in which I try to match DG distributions by reinvesting the surplus high yield distributions, there is definitely a positive to having (1) the option of using the greater distributions "today" if the circumstances warrant it, and (2) having the extra equity to raid or use as collateral if the circumstances warrant it.
But, after all is said and done, I definitely cannot state that I should invest my money in a high yield vehicle. Unfortunately, as there are certain advantages to currently-high yield, I am not convinced that DGI should be the only strategy employed in my portfolio, either. With G-d's help, though, my investment horizon will be long enough that DGI is the better fit, even if I have to redeploy capital later on because of unforeseen circumstances.
In conclusion, although I don't think either side clearly "won" because there are too many fact-sensitive issues to consider in each person's situation, there is a certain power to DGI which I am only recently beginning to realize. It's not just compounding; it's compounded compounding! It's a breathtaking concept, in my opinion, and it's certainly going to occupy a large space in my portfolio in the coming years. High yield is the ultimate goal, and now I know of 2 ways to get there.
After concluding that which many on SA already know as fact, I hope this still has value to some readers. Minimally, it has helped me come to this stark realization going forward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am making no recommendations on any of the 3 securities mentioned herein; they are used for illustrative purposes only.