3 Stocks Near The Dividend Growth Sweet Spot?

by: Eli Inkrot

When talking about dividend paying stocks - especially dividend growth stocks - the discussion often comes down to a single fork in the road: "Do I choose high-yield and low growth, or low-yield and higher growth?" Obviously you'd love to find securities offering high-yields and high dividend growth rates, but alas, the investing world doesn't offer too many chances at 5% yields coupled with the potential for double digit growth rates.

Within this discussion there are a plethora of rules, guidelines and theories. In fact, if you do a Google search for "Dividend Growth Sweet Spot" my own previous article tops the search results. So I'm not going to redefine the discussion; rather, I'd like to use this platform as a means to describe how one might think about the process.

To me something like Walgreen (WAG) in 2012 was within striking of the "dividend growth sweet spot." It offered something to the tune of a 3.7% yield with the potential to raise its dividend dramatically. True to form, the company increased its dividend by almost 15% last year and appears poised to continue its nearly 4 decade streak of increasing payouts. At the moment, with a quoted yield around 2.2%, it seems the initial payout is slightly lacking. That is, if growth prospects stay relatively constant the sweet spot tends to moves inversely with price.

Incidentally, for the naysayers suggesting that dividend growth investors are hamstrung by primarily focusing on income, I think WAG provides a solid counterargument. As I previously detailed, my focus in partnering with WAG was indeed a result of the prospective income stream it could provide. Yet this does not exclude one from capital appreciation - in just a year and a half my total return has effectively doubled. In fact, discovering solid income machines often translates to finding solid and dependable businesses at reasonable prices - to a large extent they can be one in the same.

With that backdrop in mind, I would like to highlight 3 companies that are relatively close to what some people might believe to be a "sweet spot" - or at the very least a practical compromise. The companies are: Chevron (NYSE:CVX), McDonald's (NYSE:MCD) and General Electric (NYSE:GE).

I should be explicitly clear in suggesting that this is in no way a blanket recommendation. However, at today's valuations, these three companies all have quoted yields in the 3.4 - 3.5% arena. Now I could have chosen any one of a plethora of options, but these companies provide a unique cross-section. All are known well enough such that I don't have to explain the business models. At the same time, they come from different industries, with dissimilar P/E ratios, payout ratios and histories. Despite this, they carry nearly identical annualized yields and have arguably similar dividend growth prospects. For the sake of this article, let's assume that collectively a 3.5% yield and 8% dividend growth rate is reasonable. The question becomes: is this the sweet spot?

As you likely guessed, the answer is adult diapers (it depends). Yet here's how I would go about contemplating the problem: what does this intersection of yield and potential payout growth mean in relation to my other possibilities? Granted, there's literally an infinite amount of potential combinations, but generally there are 4 basic alternatives.

The first deals with companies that are somewhat similar to CVX, MCD and GE but might have different projections. Take Diebold (NYSE:DBD) and Sysco (NYSE:SYY), having increased their dividend for 60 and 44 years, with respective annualized yields of 3.5% and 3.3%. If you believe that MCD's dividend growth prospects are better than DBD's then the hamburger franchiser wins out on an income basis. The same holds true for a company like Coca-Cola (NYSE:KO) yielding 2.8 - 3%. If you believe that Coke's dividend growth prospects are precisely equal to Chevron's for instance, then an investor solely focused on income would always choose CVX.

The second alternative is companies with a higher initial yield, but likely slower growth rate. Take AT&T (NYSE:T) or Consolidated Edison (NYSE:ED) with their respective 5.5% and 4.7% annualized yields. So which would you rather have a 5.1% yield with a 2% growth rate or a 3.5% yield with an 8% growth rate? Well, it's not altogether clear cut. Obviously if your income time horizon is only a year, you pick the 5.1% yield and go on with your day. But most of us have multi-year - if not decade - time frames. In this case, it would take the 3.5% yield 8 years to reach the same payout as the 5.1% yield. In addition, it would take another 5 years for the nominal payouts of the 3.5% yield to aggregate higher than the 5.1% yield. Moreover, one would have to account for the idea that you reinvest more dollars with the higher yield to begin with. All in all, with everything else being equal, it could take 15 years or so for the lower yield to win out.

A third option would be an even higher yield but no payout growth, such as J.P. Morgan (NYSE:JPM) Preferred Equity, Series P (JPM-A) which has a current yield of 6.4%. In this scenario it would take the lower yield 9 years to reach the 6.4% mark and 16 years to make up the nominal aggregate difference. Again, if you add in the benefit of being able to reinvest the higher yield to start, then perhaps the realized advantage of the fast growing yield takes 20 years or so. Which - given that the next two years are uncertain much less the next two decades -this might be all the more reason to consider the role of preferred equity in a DGI world.

Finally, a fourth alternative would be companies that yield less than GE, CVX or MCD but have the potential to grow their payouts even faster. Take IBM (NYSE:IBM) or Wal-Mart (NYSE:WMT) with their annualized yields of 2.2% and 2.5% as examples. For illustrative purposes, we'll call it a 2.4% yield growing at 13% a year. In this case, the 3.5% yield wins out on a payout basis for 10 years and on a nominal aggregate basis for 15 years - effectively flip-flopping with the previous example. Obviously after these points are breached the higher payout growth must win out, but it would be prudent to remain cautious on the idea of long-term sustainable high dividend growth.

Yet that's not to suggest that it's not possible. Whatever your conclusion about comparing yields happens to be, I would like to highlight the misconception that a low yield automatically equates to low income. For instance, take IBM as an example: at the end of 1994 one could have bought shares of IBM with an annualized yield of 1.4%. Today, as described, that yield sits at 2.2%. From an outside prospective it appears that the income investor was left wanting. Yet take a look at what actually happened during that time period:

The dividend increased dramatically and would now provide that same investor with a 20% yield on cost, or roughly $2,000 in annual dividends for each $10,000 investment. Of course this is a direct result of strong earnings growth: the investor's annual income went from $136 to $2,000+ while the annualized yield seemingly stayed stagnant.

The bottom line is that current yields and one time comparisons can be quite misleading. Yet there is a solution at hand: do the math. When in doubt, always do the applicable math. So are Chevron, McDonald's and General Electric near the dividend growth sweet spot today? Perhaps for some, but in all likelihood you need to consider your alternatives. In general if you have a shorter income time frame to reach your goals - say 5 or 10 years - the higher yields appear quite attractive. On the other hand, if you have a few decades on your side a fast growing dividend can make up for a lot of initial hesitations. Whether or not any investment is in the "sweet spot" is hard to tell - as we have discovered that this process is likely to be a highly individualized. And if you're still scratching your head, you can rest easy knowing that there are worse things in the world than partnering with a couple dozen of the most profitable businesses in the world. That is, you don't have to just pick one alternative. So, have you found your sweet spot yet?

Disclosure: I am long CVX, IBM, T, KO, WAG, MCD, WMT, GE. 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.