This week when browsing the Dividends and Income section here on Seeking Alpha I ran across this article titled "High -Yield Dividend Investing Misconceptions" by Dividend Growth Investor which inspired me to conduct research and write this article. The article was well written focusing on the long term horizon of DGI investing. But, it wasn't the article that truly sparked my interest. It was the lengthy discussion that spawned from the content that forced me to think. There was a common theme being argued by proponents of the high-yielding stocks: that over the long haul they can stack up equally against the supposed dividend champions. The two most common ticker symbols being thrown around in this argument were Annaly (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC). I was a skeptic who also really liked the sound of a 15% yield. I knew that some research was in order.
I have always been drawn to perceived safety when investing. I don't like to put my capital into situations that carry unnecessary risk. I've never put a lot of thought into investing with the very high yielding mREITs because I viewed these double digit yields as too good to be true over the long haul. What I mean is, if it was so easy to ensure a +10% annual return why wouldn't all investors own stocks like Annaly Capital Management Inc. or American Capital Agency Corporation? I know that mREITs function differently than most of the beloved dividend aristocrat stocks because of their mandated payout structure which leads towards very high levels of shareholder return. I typically follow stocks with long streaks of annual dividend increases for the accountability and predictability that I believe they offer me moving forward. But after reading so many success stories pertaining to these high-yielding stocks my curiosity got the best of me. I like the idea of boosting my portfolio's average yield with high-yielding stocks but I knew that I would have to take a deep look at these mREITs so that the proverbial cat is not killed.
So, what I decided to do was compare NLY and AGNC to several of the classic DGI stocks using historical data focusing on capital appreciation and dividend reinvestment. To do so I used Chuck Carnevale's wonderful F.A.S.T. Graphs system which he has so graciously given me permission to use. I own Coke (NYSE:KO) and McCormick (NYSE:MKC) in my Seeking Alpha experiment portfolio. I decided to use these two stocks which have paid an increasing dividend for 50 and 27 consecutive years respectively as a part of my comparison. I also decided to use Procter & Gamble (NYSE:PG) and 3M Company (NYSE:MMM), two companies that I do not own in my portfolio that boast 50+ year streaks of dividend increases: 56 and 55 respectively. The predicable nature of these dividend aristocrats does not exist, in my opinion, for the mREITs. There are too many variables involving government policy and potential rising interest rates. As an investor this worries me. However, after having compiled historical data I was surprised to see the comparative performance results between these two groups of stocks.
I should also note that I have decided to use the longest possible data set for each company. This means that the cumulative data collected is from different time spans: 17 years for NLY, 6 years for AGNC, and 21 years for each of the traditional DGI stalwarts that I've chosen. Because of this, the total return from initial investment statistic might be misleading. In these comparisons, I am focused on annualized percentages as I believe this to be the best way to track a stock's data and make comparisons over time.
NLY 17 Year Cumulative Data:
As you can see, the long term dividend reinvestment for NLY is quite impressive. For the purposes of this experiment I tracked all of the companies starting with an initial $1,000 investment. Over the 17 year period of data available for NLY the company provided shareholders with a 14% annualized rate of return. The initial $1,000 investment turned into $7,573.39 with share count rising from 95.28 to 484.23.
What I found interesting is that this growth happened with a very volatile dividend growth rate. 7 out of the 15 years tracked the company posted negative divided growth. To a traditional DGI investor putting money into a company with this sort of track record would be blasphemous. It should be noted that negative years withstanding, NLY's 14 year average dividend growth rate is a very respectable 14.3%. Because of the reinvestment of such a high yield (the company's current dividend yield is 11.51%) the yield on cost of the dividends alone was over 100% after 13 years holding the stock. This is the power of compounding. And it goes to show that consistent dividend growth isn't necessary for the long term effects of compounding to be great.
AGNC 6 Year Cumulative Data:
American Capital Agency Corp, is one of the highest yielding options that investors have today: 15.72%, is also able to boast impressive capital appreciation numbers. The company began trading publicly in 2008 and an initial investment into AGNC then of $1,000 would be worth $3,800.12 today. This growth represents as annualized shareholder rate of return of 31.4%. The S&P 500's annualized rate of return during the same period of time is 3.8%. The reinvested dividends since 2008 will have turned 54.09 original shares into 119.50 today. The annual yield on cost percentage of dividends collected is growing rapidly as well: from 7% in year one to 55.2% in 2012.
Like NLY, AGNC cannot be viewed as a true DGI company. Since increasing its dividend 278% in 2009 the company has posted two negative growth years. AGNC's 4 year average dividend growth rate is 70.2%. Obviously this cannot be maintained. The trend for the company's dividend payment is negative. In 2011 the company posted a -4% dividend payment and in 2012 this trend continued with a -6% dividend. But, what investors must ask themselves is, does this truly matter? If the dividend is drastically cut then the answer is yes. In this situation, not only does your compounding power lose its effectiveness but more than likely share price will fall and your total invested capital will be at risk. However, if the company's current single digit decline trend continues and the yield falls from 15% to something in the low double digits investors are still able to reap the benefits of high-yield investing which was shown in a historical sense by the longer term data collected on NLY.
Now, lets take a look at a few of the more traditional DGI options and how these stocks have appreciated over a similar time frame.
Coke 21 Year Cumulative Data:
I will begin with Coke which I have designated as a core holding in the Seeking Alpha Experiment. Over the 21 year period of time tracked, the original $1,000 investment in Coke shares gave the investor a 9.75 annualized rate of return. Now, the $1,000 is worth $6,405.86. Due to reinvestment the initial 102.79 shares purchased have grown to 150.16 shares.
The major difference between KO and the two mREIT companies discussed above is the historical dividend growth rates. Coke has posted steady dividend growth between 6% and 21% during this time frame. With this being said, an interesting comparison arises between Coke's predicable divided growth and the volatility of Annaly's dividend growth. KO's 20 year average divided growth rate is 10.6% (much lower than NLY's 14 year 14.3 average).
I was surprised to see this. I had wrongly assumed that consistent growth over a long period of time out eventually outpace the volatile movement of mREIT dividend payments. In this situation the hare beat the tortoise. This unexpected trend continued as I ran through data on the other traditional DGI companies.
Procter and Gamble 21Year Cumulative Data:
(click to enlarge)
PG's 20 year average dividend growth rate is 11.1%, slightly better than Coke's but still below that of NLY. Like KO, PG gave investors a steady increase in its dividend ranging from 7% to 14% growth.
The original investment of $1,000 in PG is now worth $10,217.06. This represents a 12.3% annualized rate of return. The initial 81.85 shares bought grew to 125.47 with dividend reinvestment. Over the 21 year period the yield on cost percentage of dividends collected has grown to 25.9%.
3M Company 21 Year Cumulative Data:
MMM boasts one of the longest consecutive annual dividend increases in the market. 3M's 20 year average dividend growth rate is 5.6%. The initial investment of $1,000 in MMM has an annualized shareholder rate of return similar to that of the other companies I've discussed: 9.7%. However, due to its small (but dependable) yield, the yield on cost percentage of dividends collected lags behind the other companies.
McCormick 21 Year Cumulative Data:
By now, the data comparison has become predictable. The original investment of $1,000 in MKC has turned into 9,530.21, representing a 11.9% annualized rate of return. The initial 86.32 shares purchased grew into 131.81 with dividends reinvested. After 21 years the total dividends collected annually has grown to a 16.1 yield on cost percentage. MKC's 20 year dividend average growth rate is 9.9%.
What has become clear to me is that over the long term mREIT companies like NLY and AGNC can in fact outperform their DGI counter parts. The data collected in this experiment, especially in regard to NYL, speaks for itself. When focusing on yield on cost the mREIT companies I examined shine brightest. Because of rising inflation, yield on cost is not an effective way to gauge the performance of a portfolio over time. Although it can be comforting to the psyche and when combined with dividend reinvestment it becomes a powerful tracking tool.
Now, I believe that this situation can be summarized by the saying, "with high risk comes high reward." I think that Dividend Growth Investor could very well be right in saying:
"Investors who today are purchasing high yielding telecom stocks such as Frontier (NASDAQ:FTR) or mREITs such as American Capital Agency without understanding their risks, might find out that they have been playing with fire in a few years."
I also acknowledge the fact that this statement could be wrong and those who maintain their holdings in companies like NLY and AGNC could continue to reap the very ripe benefits that mREITs have offered to investors in the recent past far into the future.
Like any other investment, the investor must be aware of the associated risk that his capital will be exposed to. It is true that no investment in the stock market comes with zero risk. Many people believe that companies like Coke and Procter & Gamble are as close to a sure thing as you can get due to their dependable natures and predictable futures. But, because of this perceived accountability dividend champion-like companies often trade with high P/E multiples. The fact that their expected risk is low is priced into the stock. On the other hand, the high risk of the mREIT companies is priced into their stocks as well, lowering their P/E ratios. Market value is relative; investors must remember this.
It must be acknowledged that however predicable a future might seem, the future is in its essence unpredictable and processed historical data can at best allow an investor to make a hypothesis. Because of this I have come to the conclusion that having a portion of your dividend focused portfolio dedicated to high-yield stocks is a prudent measure to take when thinking about long term growth. I do not agree with focusing primarily on high-yield stocks due to their volatility. However, I can imagine that for someone with more risk tolerance than me, this could be a very profitable strategy. Something that investors need to consider when building a dividend focused portfolio is what percentage of their capital growth they expect to come directly in the form of dividends. Looking at the long term graphs pertaining to the mREIT and DGI stocks it was clear that value of the more predictable low yielding stocks grew at an accelerated rate over time. However, so long as the payouts of the high-yield stocks were reinvested, the annualized shareholder return in these investments was greater
Every single stock that I focused on in this article out performed the S&P 500 during the period of time being examined. I think as dividend investors we should take pride and comfort in this. I also think that those of us who have only focused on dividend champion type stocks should open our minds to the idea of owning high-yielding stocks with highly volatile payout ratios and periodically declining dividend payments. I know - that still doesn't feel right rolling off of my tongue but the data from this experiment does not lie.
So, did I solve the argument regarding high-yield versus predicable growth? No. Will this debate rage on amongst those who feel strongly one way or the other? Yes. If I had to pick one or the other I would stick to my gut and continue investing with a DGI strategy. However, I do not have to pick one. None of us do. I do not currently own any high-yield stocks in the Seeking Alpha Experiment but I now plan on adding a position or two of stocks that fall into this category in the near future. This experiment has caused me to become quite interested in owning NLY but I will perform more comparisons before making a final decision.
Disclosure: I am long MKC. 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.