I recently posted an article with my portfolio. It created quite a controversy especially from the hardcore dividend growth investors and conservative investors who think I am being too risky. Maybe I am, maybe I'm not. Only time will truly tell. In response though, I decided to compare and contrast high yield no growth, low yield good growth, and very low yield fast growth stock portfolios. I hold Dividend Growth stocks as well as riskier high yield stocks in my portfolio. I try to diversify among industry, yield, growth, etc. I am overweight in certain areas but like to have at least one bite of each cookie. I have the allocation specifically to hit a certain portfolio yield. After the firestorm my previous article created I started thinking more and more about the differences between high yield stocks and dividend growth stocks and in what circumstances one would be better than the other. This article will explore the outcome of some of this research and I'll make some suggestions on strategies for different circumstances.
You can visit my first article or second article to see what I hold in my portfolio. My second article which was an update for my portfolio was just published and data is current as of the end of last week.
The three main factors that determine the success of a strategy are: inflation, Dividend Growth Rate (DGR), Starting Dividend Yield. I will break each one of these down individually and explain how each one positively or negatively affects each type of portfolio, Dividend Growth and High Yield. The three different types of portfolios I'll be analyzing and comparing are: High yield (10%), no growth (0%); low yield (3%), moderate growth (10%); and lastly, very low yield (1.5%), fast growth (14%).
Inflation is a silent killer of portfolio profitability. If you aren't aware or don't pay attention to inflation it'll break you without even knowing. With inflation at a moderate 2.5%, a product will double in price in 30 years. So, from the time you start working until when you die at 2.5% inflation you can expect the prices of things to roughly quadruple. At 3.0% inflation, you are looking at prices doubling every 25 years. That could be close to prices increasing by a factor of 8 by the time you die. Inflation is one huge reason why we can't put our money under the mattress or in a low yield account. My thesis or assumption going into this was that inflation affects a dividend growth portfolio and a high yield portfolio differently especially depending on what your assumption is on the inflation rate going forward. The higher you expect inflation the more difference it has on both portfolios. I was surprised to see once I started running the numbers there isn't any comparative difference on any of the three portfolios. The numbers were just smaller and adjusted for inflation but the effects of inflation affected each portfolio the same.
The below graphs show inflation in the various different portfolios with only an initial investment of $1,000.
Dividend Growth Rate and Starting Yield
The long term dividend growth rate of a stock and therefore a portfolio is going to be hard to judge accurately. However, I've used several rates here that many stocks have and can manage. The key to picking stocks like these would be good quality companies with a meaningful competitive advantage. Some examples of stocks in a low yield, high growth rate portfolio include McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG), and Philip Morris (NYSE:PM). Some examples of a high yield with no growth rate are Prospect Capital (NASDAQ:PSEC), Annaly Capital Management (NYSE:NLY), and many other mREITs and BDCs.
Generally, as I've depicted, the higher a yield the lower the growth rate and vice versa. That is not to say you couldn't have a stock yielding 5% or 6% and growing at 10% DGR or have a stock yielding 1.5% and only growing at a 4% DGR. All stocks are going to have a range that their yield usually stays in based on their assessed risk and what the market is willing to pay, etc. As I've already said due to their leverage and perceived risk many REITs, specifically mREITs pay over 10%. Many blue chip dividend aristocrats pay 3% to 5%.
General principles can be pulled out about the difference between high yield stocks (that can maintain that yield) and high growth stocks (that can maintain that growth rate). High yield stocks are going to be able to beat and stay ahead of inflation from the get go. 4% inflation will only take a bite out of a 10% yield but there will still be plenty to reinvest left over. A lower yield will be hit much harder by inflation initially but will eventually catch up with the growth rate and will eventually blast off like a rocket.
Another key thing to think about; current yield is current. My expectation on getting that current yield is pretty high. It is a lot harder to predict what will happen 5, 10, 20 years down the road. I say this because this is also a consideration with high yield and dividend growth. One of them is paying/rewarding me currently and another one I'm betting/hoping on down the road. There are risks involved with that such as unpredictable events that could happen years down the road.
The assumptions in the scenarios are of course based in a vacuum. We do not live in a vacuum so there will be outside forces that affect your outcome. The graphs and portfolios do not take into account capital appreciation or loss. This is merely to test the difference in yields and growth rates so all other factors are controlled or ignored. The portfolios are based on $1,000 invested each year in each portfolio for a total invested amount of $30,000.
High Yield Portfolio (Portfolio A)
The first option based on the graphs and data is a high yield portfolio. This portfolio will perform and beat inflation right away. It will continue to grow as long as inflation remains below the yield of the stocks/portfolio which should be pretty easy with a yield of 8% to 10%. Dividends in this portfolio will increase and the overall value of the portfolio will increase as well. Since there is no growth and thus no compounded growth there is no potential for this portfolio to "blast off" but you do have considerable starting income which continues to increase. This might be useful for someone nearing retirement who does not have quite enough income otherwise and wishes to increase their income. Creating a high yield portfolio is by nature more risky than an otherwise lower yielding portfolio. Certain steps can still be taken to reduce the risk but it will be a higher risk than someone may feel comfortable with. A high current yield in the right circumstances is good. It's current so that money is soon to be in your pocket. The farther into the future you look for dividends the more unpredictable things become.
Dividend Growth Portfolio (Portfolio B)
The dividend growth portfolio starts off slow. The tortoise always wins the race though. As can be seen in the graphs the dividends coming from a dividend growth portfolio fall behind a high yield portfolio for most of its early life. Depending on the exact growth and yield it'll vary but based on the graph in these examples the dividend growth portfolio surpasses the high yield portfolio in dividends around years 22 to 24. Note that in the dividend growth portfolio as long as dividends can grow at that high rate for 20+ years the dividends and portfolio value "blast off" around 24 years. This portfolio composition is better for individuals that are younger since it takes a little time for the dividends and the value to show significant progress. If you are nearing retirement do you want to wait 20 years or more to see significant dividends? The other issue here is the dividend timeline is based on when the investment was made. A huge factor then becomes the distribution of the contributions over your life. If you were only able to invest a little the first 20 years and then ten years away from retirement is when most of your money was invested you'll be worse off than if you invested a lot earlier on. This goes back to the principle of starting to save as much as you can early because it gives the dividends time to grow. In the 3% yield, 10% growth example it takes roughly 14 years for the yield on cost to approach 10%.
Another note here, because I've seen it talked about and mentioned recently, is how low of a yield you should be willing to accept. It depends. With a 1.5% starting yield and 14% growth it takes 9 years for the yield on cost to break 4%. That's a long time and decent growth for only 4% yield. For a 3% yield and 10% growth it only takes 5 years to break 4% and by 9 years you are over 6%. That's much better. It all comes down to the company and what you expect from them in the future. Like I said above I like to get paid today or soon. The lower the current yield is the farther out in the future you are expecting a significant reward. That to me is high risk because the farther into the future you go the more unpredictable it is.
Hybrid Portfolio (Portfolio C)
To me this portfolio is the best of both worlds. You can get some current income to help stay above inflation short term while also investing for long term growth. This provides a mix of current income and long term growth that neither one can provide on its own. It provides a middle ground for those wanting more current income than a strictly dividend growth portfolio but also looking for some long term gain.
As the data and graphs above have shown there are reasons for a high yield portfolio and for a dividend growth portfolio depending on your investing style, perceived risks going forward, time from retirement, life expectancy, risk acceptance level and many factors.
With my personal investing style and my desire to retire in the next five to ten years but also to have longer term growth potential for a little later in retirement I've decided I like the hybrid approach. With this approach I'm able to enjoy a slightly higher level of income sooner (to meet the early retirement goal) but also have longer, later in life income growth potential (with the dividend growth stocks). I'm willing to accept a larger risk with this portfolio over a strict dividend growth portfolio.