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A lot of articles I read relate to dividend investing and more specifically to dividend growth investing. The main idea is that if you invest for the long run in stocks of companies that constantly pay and raise their annual dividend, you will be able to rely on an ever increasing stream of dividends.

This type of investment is described as one of the best ways to prepare for retirement. Instead of buying some low interest annuity, buy (while you are as young as possible) the correct dividend growth stocks, get paid a relatively low income now, and get a quarterly income that will increase year-in year-out.

If you want turbo injection for your retirement income stream, as long as you have enough regular income from your day job, reinvest your dividends now instead of spending them on clothes, wide-screen T.V etc. Dividend reinvestment will take advantage of the enormous power of compounding dividends and dramatically brighten your future.

My intention in this article is not to rule out this investment approach. On the contrary, I am a firm believer that this is one of the best ways to secure your retirement. However, I would like to re-examine this approach and suggest another way to look at it.

If you search for dividend growth companies, the first place should be dividend achievers or dividend aristocrats. These companies are the ones that have constantly increased their dividends – every year for the last 10 years (achievers) or 25 years (aristocrats). Their current dividend yield will usually be around 2% - 3.5%. These are usually large to mega cap companies, many of them are yesterday's high-growth companies. Identifying them in advance seems like a near impossible job.

There is a good chance that we will see many of them keep raising dividends over the next years, however high growth is not so probable. These companies usually raise their annual dividend at rates that can reach 10% and rarely even more. When you consider a 10% income annual hike for your retirement, I have to say-- it sounds appealing.

Let's assume you invest $10,000 in a 3% yielding stock. The following table shows sensitivity results of what will happen to your annual dividend over the next 15 years at different annual dividend hike rates (without dividend reinvesting):

3%

5%

8%

10%

15%

Year 1

300

300

300

300

300

Year 2

309

315

324

330

345

Year 3

318

331

350

363

397

Year 4

328

347

378

399

456

Year 5

338

365

408

439

525

Year 6

348

383

441

483

603

Year 7

358

402

476

531

694

Year 8

369

422

514

585

798

Year 9

380

443

555

643

918

Year 10

391

465

600

707

1,055

Year 11

403

489

648

778

1,214

Year 12

415

513

699

856

1,396

Year 13

428

539

755

942

1,605

Year 14

441

566

816

1,036

1,846

Year 15

454

594

881

1,139

2,123

Total

5,580

6,474

8,146

9,532

14,274

You can see that if the company you invested in will increase by "only" 3% each year for the next 15 years, you will eventually receive an annual dividend that is 4.5% on your original investment. At 8% annually your yield on cost will be 8.81% after 15 years. The last row shows that total of all the dividends along the years (regular sum, not future value).

Now here's another thought:

What if, instead of these stocks that handsomely increase your dividends, you invested your $10,000 in stocks with a relatively high but constant (or very slowly rising) dividend yield?

Initial Dividend Yield

5%

7%

5%

7%

Annual Increase

0%

0%

1%

1%

year 1

500

700

500

700

year 2

500

700

505

707

year 3

500

700

510

714

year 4

500

700

515

721

year 5

500

700

520

728

year 6

500

700

526

736

year 7

500

700

531

743

year 8

500

700

536

750

year 9

500

700

541

758

year 10

500

700

547

766

year 11

500

700

552

773

year 12

500

700

558

781

year 13

500

700

563

789

year 14

500

700

569

797

year 15

500

700

575

805

Total

7,500

10,500

8,048

11,268

Take a look first at the result with an 0% annual dividend increase: You can see the constant 5% yielding stock paid you over the 15 years period almost like the one paying 3% and raising it by 8% annually, the constant 7% payer paid you a total that is higher than the one raising its dividend by 10% per year. Additionally, and more importantly, you can see how long it will take the growing dividends to reach the constant level paid annually in the second table.

If instead of 0% you place an annual increase of just 1%, the results would obviously be much nicer.

This brings me to the main point – when you invest in a stock that pays a constant but high dividend on your cost, you get a serious head start on the dividend growth stocks for many years. So if you look from the retiree's point of view and wish to live off of your dividends, it will take many years for the average dividend achievers or aristocrats to reach the level of dividends you get from day 1 from a high but constant dividend paying stock.

Another point that has to be considered is what happens to the price of the underlying stock. Will the price of the dividend achiever or aristocrat tend to rise more than the price of the constant dividend payer, thus compensating for years of lower dividends?

In many cases, I think the answer will be no. The dividend achievers and aristocrats are usually well established companies way after their high growth days and appear on the radar screen of each Wall Street analyst (meaning – often fully priced). They will usually grow at relatively low annual rates when compared to solid, good and growing companies that have not yet made it to the dividend achievers status.

In order to compare the two types of stocks, I chose the following ones:

On the dividend aristocrats side: Coca-Cola (NYSE:KO), 3M (NYSE:MMM), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ) and Abbott Labs (NYSE:ABT).

On the other side I chose the REIT Senior Housing Properties (NYSE:SNH), one of my favorite stocks.

I compared several parameters over the period of February 2002 – November 2011, here are the results:

SNH

PG

MMM

JNJ

ABT

KO

Original dividend rate:

13.4%

1.9%

2.5%

1.4%

1.9%

1.6%

Average Dividend Increase Rate:

2.0%

12.0%

6.1%

12.5%

28.6%

9.7%

Average Dividend Increase Rate-excluding special dividends:

2.0%

10.8%

6.1%

12.5%

8.9%

9.7%

Current Dividend Yield

7.4%

3.4%

2.9%

3.7%

3.7%

2.9%

Yield on Cost

18.1%

4.6%

4.8%

6.0%

6.0%

3.7%

Total Dividend Income since February 2000 on a $10,000 Investment:

18,890

3,366

4,244

4,204

4,530

2,757

Stock Growth:

151%

36%

70%

65%

64%

29%

SNH is not a dividend aristocrat; it has raised its dividend constantly since 2001, although it has done so at a relatively slow rate. All the dividend aristocrats in the table above have raised their dividends by at least 6% per year.

However, even though the dividend aristocrats raised their dividends at a much faster rate, none of them has made it in terms of yield on cost to SNH's original (or even current) yield. You can see for yourself the impact of the different yield hike rates on the yield on cost results and on the dividends accumulated.

The results are a clear cut – SNH would have been much better for you than the alternatives, both in dividend income and price appreciation. Please note – although in the table above its price appreciation is the best - SNH is not a high flyer growth stock like Google (NASDAQ:GOOG) or Apple (NASDAQ:AAPL), and has never been one. It is a real estate investment trust with a solid business model that has been able to pay its high dividends on a constant basis. I expect it to continue doing so in the future.

So, you see that over the period I chose for comparison (the last 12 years), a stock that pays a high but slowly rising dividend was much better for your portfolio than some of THE biggest names among dividend aristocrats – in terms of dividend income and stock price appreciation.

The main arguments against what I just suggested might be:

1. High yield dividends are riskier and have more chances of being reduces or cut. I disagree with this argument. You have to perform adequate due-diligence before investing. This way you can maximize the chances that your dividends will keep flowing.

2. I chose a period of time that is too short for the comparison. If you wait enough years, the growing dividend will be much higher than the constant one. While this argument is correct, even with a proper due-diligence I find it impossible to choose today a stock for the next 15-20 years. You always have to check your portfolio at least once a quarter and perform necessary changes. Look at what happened to Bank of America (NYSE:BAC) or General Electric (NYSE:GE) – both dividend aristocrats that raised dividends an extremely long period before cutting them in 2009 and almost going bankrupt.

3. I chose specific stocks that support my suggestion, while other stocks may prove the exact opposite. That argument is correct. Take a look at Realty Income (NYSE:O), another one of my favorite stocks, and a dividend aristocrat. O has made it over the exact same period to achieve price appreciation of 266% while paying dividends of over $16,000 along the way. That beats the results of SNH. My intention was not to argue that you should dump all your dividend aristocrats or dividend achievers. I intend to make a point that mathematically, a higher dividend yielding stock has a huge head start on dividend achievers or aristocrats that have a lower current yield. If you choose wisely, it may also provide you with better growth of the underlying stock price.

Conclusion:

As I said above, by no means am I trying to convince you to sell your dividend growth stocks and buy SNH or other high-yielding-but-slowly-growing-their-dividend stocks. I think the dividend achievers and aristocrats should have their substantial place in your portfolio, especially (perhaps only?) if bought at the low valuations. They can provide your portfolio with stability and safety during rough times and may raise your income substantially during retirement.

All I tried to show in this article is that you may want to give considerable room for the other type of stocks – the ones that yield a high dividend that is not expected to rise sharply, but also not expected to decline in the future. Even if they do not yet belong to the exclusive club of dividend achievers, and maybe because of that, they can actually prove to better reward your portfolio – both terms of income and stock price.

Whether you agree with me or not doesn't really matter. I just hope I made you rethink the dividend growth approach and the stocks that are worthy of being included in your portfolio.

Source: Another Look At Dividend Growth Investing