For investors that have come to the conclusion that dividends do matter, the next step in creating a sound income portfolio is to begin to think strategically about how investment income will be culled. For many, dividend growth represents a conservative method of growing income over time, and could serve as a primary or ancillary portfolio strategy. In today's market, where valuations have stretched and yields inversely fallen, the typical 2-5% yield that can be bought in "garden variety" blue chip stocks may not feel like a whole lot.
Those who seek the relative certainties of cash flow over the oscillations of equity share prices but have limited capital to work with may be considering the upper echelon of yield - which we will define as greater than 5 percent. Indeed, while dividend growth may be an ideal strategy, aging investors requiring elevated income won't be well served by exclusively buying dividend growth mainstays like Procter (NYSE:PG), Coke (NYSE:KO), and Colgate (NYSE:CL) at a 2-3% yield point.
When DGI Works
It takes simple math to figure that a portfolio of $500,000 and a current income need of $35,000 from that stash necessitates more than 2-5% yielding investments. Dividend growth succeeds as a sole strategy when there is enough capital available to achieve yield objectives. Younger investors going solely down the dividend growth path should recognize that dividend payers may have the ability to "beat" the market, as opposed to "pure" growth stocks, but that "home runs" may be few and far between.
Thus, my personal feel is that younger investors should take on a bit more risk, focus on earnings, try to grow capital and later transition to income focused strategies. It may be easier to set sights on an amount of desired capital to build to rather than trying to predict how much income might be needed later in life. The risk/reward of investing solely for capital growth, in my opinion, is much higher however, so only the individual can make the determination of which strategy makes sense for them early in life.
One of the decidedly positive attributes of investing in equity where there is a perception of income growth is the inflation-fighting factor. If one invests in dividend growth, YOY income gains help to protect purchase power. While a quick-fix on a higher yielding investment may make sense near-term, if it does not provide consistent cash flow growth, its benefit may wane over time. Immediate satisfaction may also be accompanied by uncertain or erratic future payments.
The biggest question one should ask themselves when assessing dividend growth options is what income will grow to over time. If you have another 20 years of life expectancy, do a simple compounding exercise to see if an investment merits consideration. Compound interest calculators like this one can help. If I start with a 2.75% yield and it grows 7.5% a year for 20 years, what's my yield on cost? Answer: 11.68%, 12.15% if dividends are compounded quarterly at a static annual yield rate. You may find given a limited investment time or expected life horizon that owning elevated yield assets, including bonds and/or higher yielding equity assets, makes more sense than waiting patiently for dividend growth to occur.
As I've oft said in the past, given my druthers and an optimal capital base, I'd select dividend growth as my weapon of choice in life's investment battle. But for many, if not most, it won't be that simple.
The Greater Battle
For those with income needs greater than what a conservative equity strategy may provide, the "dividend-growth-devoid" portfolio may need to be considered. The decision to invest solely in high dividend securities should not be taken lightly. Though the volatility of mREITs, BDCs, and leveraged ETNs, some of the more commonly utilized high-yield, limited-dividend-growth products, has seemingly been on the benign side near-term, investors should not become apathetic to the risks, both to income stream and capital invested.
Since they pay out most of their net investment income, the margin of error for these companies is typically very, very small. Even lower yielding equity REITs which are viewed as having a fairly "durable" income stream tend to pay out most of their AFFO, which leaves little room for misstep. While the risk is fairly difficult to quantify and certainly not wholesale, higher yielding companies are likely to see disruptions during interest rate upheaval/tightening, recessions, or otherwise difficult or less fluid business cycles.
There a few Seeking Alpha commenters who profess and swear by portfolios made of only high or double-digit yielding stocks. While it's conceivable that such a portfolio may be appropriate for some that understand the underlying risks, I'm not sure I'd want to be forced to hold such a portfolio during a nasty recession or market sell-off. The cash flow disruption and capital risk could be immense. And the fear factor of "will it ever come back," may be more than one can handle if cash flow becomes interrupted.
Another one of the redeeming factors of a dividend growth portfolio, especially one made of equities with low payout ratios, is its ability to withstand market volatility. While share prices may fluctuate, the income stream generally remains intact. And even if we embark upon a lengthy economic malaise, low payout equities may be able to raise dividends at a higher pace than their earnings during such a slump.
Who "Needs" A Dividend Growth Devoid Portfolio
So even though a "DG-devoid" high-yield portfolio can be constructed and diversified amongst different kinds of publicly traded assets, I would opine that it should be utilized only as a necessity. Unfortunately, investors that need elevated income the most are usually not in a position to weather income gyration and capital loss. I call that the veritable "between a rock and a hard place" position to be in.
But yield level alone should not be a pure determinate of risk in an asset or an overall portfolio. For example, diversified option-income closed-end funds trading at a discount to net asset value and yielding in the upper single digits may represent a more attractive risk-adjusted play for an income investor than one of the aforementioned expensive blue chip mainstays yielding only 3 percent. And sometimes high-yield stocks viewed as high-risk become low-yield and lower-risk over time, creating attractive total return. There are ways to mitigate the risk that a "high-yield by necessity" portfolio may superficially represent. Still, I'm not sure that loading up on assets with a "full" payout represents a prudent income investing philosophy for those that are not forced to employ it.
Thus I would opine that the portfolio devoid of dividend growth may not be as risky as conservative income investors might think it to be, but not as safe as its proponents make it out to be.
If you are the investor above with $500,000, but need to generate $35,000 off that stash, what should you do? You really have a variety of options to generate 7 percent. For elevated income and risk purposes I like to think in terms of investment pairings. You could consider a BDC like Prospect Capital (NASDAQ:PSEC) at a 12% yield point and pair it with a stock like Union Pacific (NYSE:UNP) at 2% to generate a blended 7 percent. UNP's dividend has doubled since 2011, but still represents roughly a mid 30s payout ($2 annualized dividend on $5.50 a share of expected earnings). Prospect is also negligibly increasing its dividend, but its payout is hovering right around NII.
You can also consider mid-range dividend plays like triple-net leasing gorilla American Capital Realty Properties (ARCP), which I see as a somewhat elevated-risk REIT currently undervalued by the market, at a 7.75%, monthly-pay yield point. Then there's 6.2% yielding Frontier Communications (NASDAQ:FTR), which continues to gain traction with the investment community.
To get to a 7% yield point, you need to take risk, but sector and security diversification should help to mitigate those risks. Further, it's certainly possible to achieve dividend growth, perhaps not of a robust level, but substantial nonetheless, by paring your high-dividend payers with blue chips like UNP, Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT), or Accenture (NYSE:ACN), all with payouts well below 50 percent.
Though consideration of a dividend growth devoid, high-yield portfolio may not present itself as an advantageous situation for investors, circumstance may dictate its use. A more advantageous situation may be one in which a variety of equities, dividend growth included, can be utilized, whereby a more mid-range blended yield is achieved. Optimally, one can retire with enough of a nest egg to purchase the least risky of income producing assets - dividend growth or otherwise - play golf every day, and hopefully forget about the stresses of managing an investment portfolio.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.
Disclosure: The author is long ACN, PSEC, ARCP, UNP, MSFT, CL, CSCO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.