High Yield Or High Growth: Which Belongs In Your Portfolio?

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Includes: BDX, D, WBA, WTR, XEL
by: Eric Landis

Summary

Are higher-yield or higher-growth stocks better for your portfolio?

What considerations should be made when answering that question?

This research will look at projected total returns, yield on cost, and income for varying dividend yields and growth rates over multiple time periods.

The Chowder Rule is also examined to show how it works as a quick scan for potential investments.

Should I be investing in stocks that have high yield to provide future income or would I be better off buying high growth companies for the capital gains they provide?

This is an often debated question on Seeking Alpha, and thearm wrestle discussion can actually get fairly heated from time to time in the comment threads following articles.

For example, following this recent article, member David Stein stated that it is better for a retired investor to own a preferred stock with a 6% yield and zero growth than a growth stock with a 3% yield and a 4% dividend growth rate. He was quickly rebuked by others who said the growth stock is better because it is hedged against inflation and provides a growing income. To which he responded that inflation protection isn't really needed because the preferred offers twice the initial yield.

This dialogue went back and forth for some time, with neither side really doing much to convince the other to change their minds. It turns out, neither of them were really wrong either, because the investing goals for each of them is different. Mr. Stein is in his late 60's and relying on his portfolio for income, while the others are still a few years off and are still accumulating their nest eggs. Different circumstances lead to different viewpoints on what the ideal investment is for an individual's portfolio.

I had been thinking of writing on this topic for some time, and had some extra motivation after another reader, BeatlesRockerTom, contacted me in late April with a request to further expand on the differences between investing in high growth/low yield and low growth/high yield stocks over extended time frames.

Here is his inquiry, with some formatting/editing done by me to more clearly present his thoughts:

Hey Eric, Tom "Beatles Rocker" here.

Regarding your two articles on the Chowder Rule of 7/12/13 and 10/29/15, you wrote on a topic I've researched a bit: the impact of dividend reinvestment with varying rates of yield and growth rates. Your articles explore the outcomes 20 years later of such investing. I've wondered why no one has written on this further on this (I've not found it).

I wondered why dividend-reinvest investors invest in companies knowing their yield and 5-year DGR, without forecasting the 25 year outcome, but rather just hoping their choices would result in great future annual dividend income and end valuation. So why not prepare 2 matrices of outcomes showing for yields of 1-8% and same for DGR's for year 25 dividend income and end valuation using dividend reinvestment. I've done that, using 25 years since I'm in my early 60's thinking I would live to at least 85, I hope!

In summary, Tom is a near-retiree in his early 60's who is trying to project what his dividend income will look like over the next 25 years. This is a similar situation to David Stein above, with the difference being that Mr. Stein was late-60's and already drawing income, while Tom still has a few years until he will need to start drawing from his portfolio for retirement.

These are two scenarios of older investors, but there are also others in my situation who are in their mid-30's with roughly 30 years until full retirement. Then finally, there are the millennials, who are in their 20's, starting their careers, and just beginning to put money away for a retirement that may be 40 years away.

So, in the spirit of Tom's inquiry, I will take things a bit further than my previous articles did, and look at several different time periods and return metrics to cover multiple different scenarios for investors.

I will present 10YR, 20YR, and 30YR matrices of varying initial yields and earnings per share "EPS" and dividend growth rates to show what future yield on cost "YOC" is produced. The YOC numbers will be shown for both organic growth of the dividend, as well as for reinvestment of dividends. This YOC metric is relevant to investors who plan to live off of their dividend income at retirement and are less concerned with maximizing capital gains.

I realize there are also plenty of investors who are looking for building maximum wealth as well, so I will also show the total returns for each scenario. This will give an idea on what the effect that different growth rates have on long term returns, and what an investor may be giving up by focusing solely on income.

Ten Year Projections

Before we proceed any further, let me throw out the big ole' disclaimer on the fact that these are simply projections and theoretical returns to be used for comparison purposes only. Stocks don't grow in a straight line, and it's very difficult to pick stocks that can sustain high growth rates or high dividend yields over long time periods.

However, I still think this is important information to think about, and the matrices are an excellent way to look at and compare different investment options for a portfolio.

With that out of the way, lets now take a look at the ten year holding period to see the income potential that is possible at different initial yields and growth rates.

Ten Year Yield On Cost Projections At Various Dividend Growth Rates Click to enlarge

These two tables show what the yield on cost "YOC" would be at the end of the ten year period. The second row of numbers shows the initial yields, ranging from 0.5% to 6.0%, while the far left column shows the EPS and dividend growth rates, ranging from 0 to 20%. The cells in the green are the yield on cost projections that exceed the no growth, 6% yield, "base case" that was mentioned by David Stein and served as the impetus for this article. Finally, the Chowder numbers along the bottom are the minimum numbers required to meet that base case for each initial yield.

The table on the left is more relevant for those who are relying on their dividends for income, as the calculations assume that dividends are being spent rather than reinvested. Here you can see that an initial yield of 3% would have to grow at better than 7% annually to produce a higher income at the end of the period than the 6% base case. Also, a 2% initial yield would have to grow at 12% and a 1% yield 20% annually to meet that 6% mark.

Meanwhile, the right table assumes that dividends are being reinvested back into more shares, (or being compounded as simple interest in the zero growth scenario), which accelerates the yield on cost and grows income at a greater rate. This table is more relevant to those who are still building their portfolios, but are wanting to start withdrawals at the ten year mark. Here you can see that a 3% initial yield would now have to grow at nearly 11% to match the future income, while a 2% yield would have to grow at 17%. Needless to say, it is tough for a lower yield stock to catch up to the income produced by a high yield stock in ten year's time.

Another important consideration is the total income received, which is shown in the table below and is depicted as a percentage of investment returned.

Cumulative Income Received At Differing Yields And Growth Rates Click to enlarge

This metric shows even more how powerful that 6% yield is, and how much growth is required from lower levels to match its income over the ten year period.

For an investor like Mr. Stein, who is in his late 60's and spending his dividends, its pretty obvious why he would prefer the 6% no-growth option over a 3% stock growing at a single-digit rate: The dividend income doesn't catch up! The outcome begins to change if he lives to 80, 90, or 100, but we'll get to those possibilities later.

Now let's take a look at the total returns that can be expected for these different scenarios, with the yield/growth combinations that produce a minimum 10% CAGR total return highlighted in green.

10 Year Total Returns At Various EPS and Dividend Growth Rates Click to enlarge

Now is where the tables start to tilt towards the growthier option's favor. As expected, a 6% yield with no growth over ten years produces a 60% total return, while that same yield with reinvested dividends produces a 79% gain. However, a stock with a 3% initial yield growing earnings and dividends at 4% annually produces an 84% total return, and 99% with dividend reinvestment. In this case, investors with a longer time horizon will likely be attracted to the higher growth stocks rather than the higher initial yield.

An important observation is that with reinvestment of dividends, the expected total annual return matches the Chowder Number for the different growth rates. In other words, a 1% yielding company that grows its dividend and earnings at 9% annually has the same expected 10% annual returns as a 6% yielding company that grows at 4% or a 3% yielding company growing at 7%. This makes the number a nice quick screen when comparing potential investments, especially for those worried about capital gains. However, for those investing more for income, it appears the rule is a bit less useful.

Twenty Year Projections

The twenty year projections are interesting in that they start to really show the differences between the high growth/high yield debate. There are few ways to look at the longer projections, and their relevance for investors.

First of all, I think it is important to consider what type of investment vehicle the investor is using for the different strategies. Are the holdings in a tax advantaged account like an IRA, 401(k) or ESA? If so, going with a higher yielding REIT that sees distributions taxed as normal income are more attractive than for someone investing in a cash account. If one is attracted to MLP's, they may want to keep them out of the IRA and in a cash account to avoid UBTI implications. For someone in a lower tax bracket, qualified dividends in a cash account may be more attractive than in a tax deferred IRA that sees withdrawals taxed as regular income. I won't attempt to cover all the possible scenarios, as that could be another article in itself, but these are questions investors should be asking themselves while doing research on potential investments.

Secondly, I think the investor's goals for the portfolio need to be considered. An investor who already has a large portfolio and is more worried about preservation of capital than growth of capital will likely look at things quite differently than one who is still working to build their nest egg. In other words, someone who already has several million dollars and enough dividend income to live on is more worried about keeping that income stream safe and isn't nearly as concerned with maximizing returns. On the other hand, investors like myself (working class with a growing family and 20+ years until retirement), are looking for the best of both worlds: capital gains and a future income stream.

Finally, one must consider his or her risk tolerance when choosing investment types. Some people are more resilient when it comes to swings in their portfolios than others. While I may be completely comfortable with oil & gas, technology or biotech price volatility (and adding to them when they dip), others may more suited for low or no growth avenues like preferred dividends, bonds, or utilities.

Keeping those thoughts in mind, here are the income projections for the 20YR period.

20 Year Yield On Cost Projections For Various Dividend Growth Rates Click to enlarge

For these tables, I have used the 6% initial yield at 3% growth as the baseline for the green shaded areas. As you can see, to match the future income from this combo, a 3% initial yield would require 7% annual growth while a 2% yield would take 9% growth. When factoring the reinvestment of dividends, a 3% initial yield would need 10% annual growth to catch up while a 2% yield would take 13%.

One thing that catches my eye with these tables is the huge effect that dividend reinvestment has after 20 years, especially when looking at the higher initial yields. For example, a 6% yield with 3% growth sees a YOC of over 10.8% without dividend reinvestment, but if dividends are reinvested the YOC becomes 33.6%, a three-fold increase. On the other hand, a 2% yield growing at 9% gives a 11.2% YOC without dividend reinvestment and 16.1% with, which is just a 44% increase.

Another consideration is the importance of valuations when buying new positions, which can be difficult to accomplish in the current market. For example, utility stock valuations are exceedingly high today, with many of the current dividend yields at the 3% level compared to historical yields in the 4-5% range. Consider a company like Xcel Energy (NYSE:XEL) which currently yields a bit over 3% and has grown dividends at about 4% over the last decade, compared to a normal yield of around 4%. Looking at a the 20YR projection, a 4% initial yield growing at 4% has an expected YOC of 18.6% compared with 11.6% for a 3% initial yield, a difference of 60%!

Next, take a look at the cumulative dividend income for the 20YR period:

20 Year Income Projection For Varying Yields & Dividend Growth Rates Click to enlarge

Here you can see that the 6% yield, zero growth base case is still in the lead over the 3% yield, 4% growth alternative that was presented by Mr. Stein. In fact, that 3% initial yield would have to grow at 7% per year for 20 years to create more total income over the period than the zero growth 6% option.

Here are the total return projections, with the >10% annualized returns shaded in green:

20 Year Total Returns For Varying Yields And Dividend Growth Rates Click to enlarge

Looking at our 6% yield versus 3% yield, 4% growth scenario, you can see where the other side of the argument now has a leg to stand on. The 3%/4% option provides 208% total returns compared to 120% for the 6%/0% choice, an outperformance of 73%.

This chart reinforces to me why boring tobacco stocks, utilities, and REITs can be such tremendous long-term investments when dividends are being reinvested. 10% annualized gains requires just a 3-4% initial yield growing at a 6-7% annual rate.

Consider the case of the water utility Aqua America Inc. (NYSE:WTR), which has seen 8.2% EPS and 7.4% dividend growth since 1998 on top of an initial yield of 3.0%. This was good enough to create an annualized ROR of 10.2% without dividend reinvestment, and 11.9% with. Not too shabby for a boring water company!

Aqua America (<a href='http://seekingalpha.com/symbol/WTR' title='Aqua America, Inc.'>WTR</a>) Total Returns Click to enlarge

Source: F.A.S.T. Graphs

Thirty Year Projections

We now come to the situation that I am in, a 37 year old with 30 years until full retirement. With my personal portfolio, I have chosen a diversified strategy of dividend growth investing: a mix of high yield/low growth, low yield/high growth, and mid-yield/mid-growth companies. In addition to the diversification across yield types, I also have exposure to most sectors: discretionary, staples, financials, industrials, energy, health care, technology, telecommunications, REITs, and utilities. This has proven beneficial in building and maintaining my portfolio, as I can always find something trading at fair valuations as sectors goes in and out of favor in the overall market.

Looking at the 30-year YOC projections, you can see how these different yields/growth rates can each accomplish the same goal of a growing income. A 6% yield with 3% growth rate was again used as the baseline for the green shaded areas.

30 Year Yield On Cost Projections At Various Growth Rates Click to enlarge

An important consideration with these charts is how difficult it is to find companies able to produce high growth rates over long periods of time, especially once you start to work your way down the green shaded areas. However, there are still plenty of companies that have done it.

Fellow Seeking Alpha contributor Robert Allan Schwartz's website shows that there are 227 companies that have a produced a dividend CAGR of over 5% since 1985, 100 over 10%, 26 over 15%, and just 6 that have passed the 20% mark. The trick is finding companies that have the sustainable and repeatable businesses that can continue those streaks into the future.

Another aspect that I feel is often overlooked by dividend growth investors, especially those who invest in tax-advantaged accounts, is the fact that lower yield companies can still get your income where it needs to be for retirement. An investor who holds a 1% yielding company in a ROTH can sell those shares at retirement (tax free) and instantly double, triple or quadruple their income by shifting funds into a REIT, staple or utility. For instance, a 1% yielding stock that has grown at 15% annually has a YOC of 86% after 30 years. If that stock is then sold and rolled into a basket of 4% yielding utilities, tobacco companies, and telecoms the new YOC instantly becomes 344%. There are plenty of roads that can lead to the same destination, sometimes we just need to get creative on creating our path.

Here are the 30 year income projections:

30 Year Cumulative Dividends Without Reinvestment Click to enlarge

Here we are, 30 years later, and the 6% yield, zero growth base case STILL has produced more cumulative income than the 3% yield, 4% growth alternative. As Mr Stein stated, he is currently in his late 60's, meaning that when he is in his late 90's he will still be better off from an overall income perspective by going with the zero growth preferred shares.

But wait! The 3%/4% has been growing all of this time, and is now producing a YOC of 10%, compared with the 6% that hasn't grown. In that respect, his current income would be 67% higher with the alternative. Additionally, as you can see below, his capital also would have grown at a 4% rate, leading to total returns of 393% compared with the 180% income return from the zero growth option. When it's all said and done, Mr Stein may have preferred the higher total income from the 6% investment, but his heirs would sure like the alternative.

Projected 30 Year Total Returns For Varying Growth Rates Click to enlarge

Looking at total returns, there begins to be some insane returns towards the bottom of the charts. Obviously, as you move towards the right, some of those returns are pretty much impossible to accomplish, as there simply aren't any companies that can produce those kinds of yields and growth rates over the long term.

My focus is finding companies that can straddle the green/red line and produce 10% annual returns over the long run, and I've tried to do this with various company types. For example, Walgreens Boots Alliance (NASDAQ:WBA) has been able to grow earnings at a 12.9% annual rate over the last 18 years and is projected to grow EPS at a 12.6% rate going forward.

Walgreens Boots Alliance WBA 18-Year Chart Click to enlarge

A current yield of 1.7% and a growth rate of 12.6% provides a Chowder # of 14.3, which is well above what is needed to beat the 10% total return threshold.

Similarly, Becton, Dickinson & Company (NYSE:BDX) has grown EPS at a 9.3% rate over the last 18 years and is projected to grow at 11.5% going forward. That coupled with a 1.6% yield also provides a Chowder # above the cutoff.

BDX FAST Graph Click to enlarge

For higher yield, a company like Dominion Resources (NYSE:D) has grown EPS at a 6.4% rate over the last 18 years and is projected to grow at 6.1% going forward. With a current yield of 3.8%, and Chowder # of 9.9, it too is right at the mark.

D FAST Graph Click to enlarge

Finally, Church & Dwight (NYSE:CHD) has grown at a 15.6% rate over the last 18 years and is projected to grow at 9.8% going forward, which along with a yield of 1.4% beats the Chowder # target.

CHD FAST Graph Click to enlarge

These companies are all provided as examples from my personal portfolio, and aren't meant to be buy recommendations by any means. Church & Dwight in particular is overvalued at current prices. However, they are just a few of the types of companies I am invested in that have shown a long track record of consistent earnings and dividend growth, that I believe can continue into the future.

Observations & Closing Thoughts

Here are a few thoughts that have come to mind as I've gone through the numbers and put together the different tables.

  • When investing for the long term, finding high quality companies with consistent and reliable earnings makes holding through market volatility much more palatable.
  • Avoiding cyclical sectors like energy and materials, and certain portions of the consumer discretionary, financial, and industrials sectors can also help to reduce your volatility.
  • Reaching for high yield can be just as damaging as reaching for high growth. Recent examples being SeaDrill Limited (NYSE:SDRL), Linn Energy (LINE), TAL International (NYSE:TAL), and BHP Billiton (NYSE:BHP).
  • The type of investment account being used for your holdings as well as your current and future tax bracket should be considered when selecting stocks for your portfolio. Take advantage of ROTH's, 401(k)'s if applicable and if in a lower tax bracket, the nice tax breaks on qualified dividends and long term capital gains.
  • The Chowder Number is a nice quick way to screen potential investments, but is more relevant for long term total returns than it is for income and future yield on cost projections.
  • Be aware that past performance does not guarantee future results. Just because a company has done well in the last 20 years, doesn't mean its business prospects are the same going forward. A former fast grower may be a future slower growing blue chip (like Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT)) or may see its business disrupted (like J.C. Penney (NYSE:JCP) or Sears Holding (NASDAQ:SHLD)).
  • Don't discount the income power of higher, zero growth yields at retirement; but also don't ignore the fact that your retirement may last 30 years and you may need dividend growth to maintain your lifestyle in the future.
  • Valuation matters, especially with the currently inflated market. Buying something at a 3% initial yield rather than a 4% yield doesn't sound like much of a difference now, but compounded for 20 or 30 years it can become substantial.
  • Know yourself and have fun! If you are more comfortable with the utilities and staples rather than the potential volatility of tech or consumer discretionary, by all means load up! In the same spirit, it's okay to eschew higher yielding companies now and go for growth. You can always trade out when you get closer to retirement to up your income when you need it.

I hope this research provides some new insight on the question of yield vs. growth. Both options can provide avenues to a comfortable retirement, in the end I believe it comes down to an investor's comfort level and personal choice. The important thing is to get going and keep your money working for you, make a plan, and stick to it.

Happy Investing!

Disclosure: I am/we are long BDX, WBA, XEL, D.

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.

Additional disclosure: I am a Civil Engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.