Start A Portfolio With High Yield Or With Dividend Growth?

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Includes: JNJ, NLY
by: Dividend Living

Summary

Starting a portfolio with high yield is risky, but allows for substantial dividend reinvestment into more stable dividend growth stocks over time.

Four scenario's are analyzed: High Yield DRIP, DGI DRIP, High yield DRIP to DGI, DGI DRIP to high yield.

Pros and Cons of each strategy are discussed.

A recent article by Adam Alosi "Retirees: Risk 10% Now or Hope for 10% Later?" reviewed the pros and cons of choosing high yield or traditional growth stocks for retirees. Inspired by his article, I wanted to see if those just starting out in saving for retirement should start a portfolio with high yield or with dividend growth as the foundational investment.

Young investors are often told they can take more risk at the beginning of their investing timeframe and transition to less risk as retirement approaches. Entire lifecycle funds are committed to this philosophy. The thinking is that the young have time to recover from any setbacks and they can ride some of the emerging growth companies on their upward climb to build a large base of capital for when they near retirement and transition to less risk and a more income-focused account. This usually takes the form (in lifecycle funds) of owning mutual funds or ETFs that start out heavy on stocks and light on bonds and transition nearer retirement to heavy on bonds and light on stocks. For the more adventurous, this risk could be taken by trying to pick out some good growth stocks directly or through small and medium cap or growth-focused ETFs or mutual funds. I will explore if the early portfolio risk could also be taken by venturing into the high yield space.

I will run a hypothetical test if establishing a large initial position in a high yielder to provide dividend income which is reinvested into a dividend growth stock over time is better than establishing a large initial position in a dividend growth stock to provide dividend income which is invested into a high yielder over time. Four scenarios were created with enough similarity to make a valid comparison.

Scenario 1: (HY-DG) Initially invest $100,000 into a hypothetical high yield stock yielding 10% with no price appreciation and a stable dividend. Use all the dividends from the high yield stock to invest yearly into a dividend growth stock yielding 3% with 5% dividend growth per year and 5% price appreciation per year. DRIP the dividends from the growth stock into itself. Invest $10,000 into the dividend growth stock each year.

Scenario 2: (DG-HY) Initially invest $100,000 into a hypothetical dividend growth stock yielding 3% with 5% dividend growth per year and 5% price appreciation per year. Use all dividends from the dividend growth stock to invest yearly into a high yield stock yielding 10% with no price appreciation and a stable dividend. DRIP the dividends from the high yield stock into itself. Invest new money of $10,000 into the dividend growth stock each year.

Scenario 3: (HY) Initially invest $100,000 into a hypothetical high yield stock yielding 10% with no price appreciation and a stable dividend. DRIP dividends back into the stock and invest new money of $10,000 into the high yields stock every year.

Scenario 4: (DG) Initially invest $100,000 into a dividend growth stock yielding 3% with a 5% dividend growth rate per year and a 5% price appreciation per year. DRIP dividends back into the stock and invest $10,000 of new money into the dividend growth stock every year.

For simplicity's sake, each stock pays the dividend once per year and it is reinvested once per year. Below are the 20 year graphs comparing each scenario in regards to total portfolio value and yearly dividend income.

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Of note is the crossover point near 13 years when DG-HY surpasses HY-DG in income. This is a result of the compounding effect of DRIPing into a high yield fund. DRIPing into the dividend growth stock will always have a yield of 3% on the new money whereas DRIPing into the high yield will always have a yield of 10% on the new money. This overcomes any benefit of the rising dividend in the dividend growth stock.

Taking the scenario out to 50 years looks like this

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Although it is hard to see in the graphs, there is a point at year 26 where DG-HY surpasses HY-DG in portfolio value. Again this is the result of the power of compounding in a high yield stock that overcomes the dividend growth and price appreciation of the dividend growth stock.

We will look at a few representative stocks in each category Annaly (NLY and Johnson & Johnson JNJ) to see how scenario 3 and scenario 4 would have played out in the real world over the last 19 years. The price graphs below show that NLY did not ultimately have any price appreciation while JNJ had a fairly steady rise in price.

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Source: Google Finance

Below is a total return graph of NLY following the scenario 3 protocol outlined above for 19 years (length of time NLY has been a public stock). NLY becomes much less volatile when you included DRIPed dividends. There were only had a few major setbacks on its climb upward. This shows the power of compounding dividends in high yield stocks.

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Source: DQYDJ (link)

I also made a total return graph of JNJ following the protocol for Scenario 4 . The total return is ~ $100,000 less than the total return for NLY over the same time period.

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Hindsight is 20/20 and picking these two stocks in 1997 would have been difficult, but I think picking JNJ would have been easier than picking NLY as JNJ already had 34 years of dividend growth under its belt. Despite what the hypothetical scenarios show, the volatility in price and dividends even in a seasoned high yield stock like NLY can cause it to almost fail to beat a very stable dividend growth stock like JNJ. Think how much better you would have slept at night with JNJ instead of NLY for 19 years. Would you have never sold NLY even when the floor was dropping out from under it and it seemed like its future was questionable? Here is how these two stocks compared in total returns and income to how the hypothetical scenarios 3 and 4 predicted at year 19.

Portfolio Value Yearly Income
Scenario 3 - HY $1,011,983.46 $101,198.35
NLY $1,212,955.52 $145,119.30
Scenario 4 - DG $774,383.32 $23,238.52
JNJ $1,111,065.64 $30,220.23
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In order to mitigate some risk, diversification would be an option. You would chose a few high yielding stocks that combined have your desired yield. Some stocks that come to mind that could possibly work for this strategy are NRZ, STWD, BXMT or an index fund like MORT for mREITs, MAIN for business development companies. CCP or SNR for healthcare REITs, STON for Master limited Partnerships, and PFL for Closed-End Funds. Diversifying takes off some of the risk, but there are movements in higher in interest rates that typically affect all high yield stock prices negatively.

Another aspect that comes into play is doing your due diligence over time to make sure the stocks you have chosen are doing what they are intended to do. Its likely that there may have to be some shuffling around as stocks have serious impediments or get bought out or merged.

Finding a mix of stocks for the dividend growth portion is a decision with many options. A good place to start is David Fish's monthly dividend growth stocks list (link). Again, diversification is usually desired so that one stock's problems don't bring down the whole plan.

My own investing strategy has closely followed Scenario 2 (initial high yield DRIPing to dividend growth stocks). I like the high initial income and the slow transition to more stable dividend growth stocks over time. I had some difficulties at first holding onto the high yield stocks when things got volatile and I sold some of my holdings at the wrong time. Over time I have become less panicky and mostly happy with my high yield picks and let the dividends fuel my dividend growth portfolio.

My investing experience certainly hasn't worked out as well as the hypothetical scenario would suggest. Many of my high yield stocks cut the dividend after the taper tantrum in 2013 and have never recovered the dividend to what they were paying before. The high yield pick I like the most so far has been NRZ while some of my worst picks due to volatility and slashing dividends have been NYMT, WMC and MORL, although I had (when I sold) or currently have a positive return on all three of them. The price declines and dividend cuts have eaten into the expected returns.

My dividend growth stock portfolio has outperformed my high yield portfolio by a wide margin with a lot of that outperformance being the result of being overweight Realty Income (NYSE:O). Some other good performers have been MDU, SON, SYY, and JNJ.

The volatility in the high yield space I experienced may just be a product of the taper tantrum and resulting fallout in prices, but there is no guarantee that this kind of volatility will not happen in the future. High yield in the majority of cases means more risk. I believe you could build a great portfolio without high yield stocks from the mREIT, BDC, MLP and CEF spaces that could outperform the scenarios outlined here that include high yield. In fact, O beats NLY in total returns including DRIPed dividends over the life of NLY as a public stock as I described in a previous article.

Perhaps a better option for avoiding some volatility in the high yield portion is to go with some middle ground stocks like OHI or WPC which have a 6%-7% yield that is growing. I have been building up these middle ground stocks over time and am happy with the stability and yield so far. I am not buying any more >10% yield stocks at the moment, I want more stability over time.

I don't think these scenarios give definitive answers as to what is ultimately a better long term investing strategy, but it did reveal some interesting characteristics of how DRIP in a high yield with time overcomes modest dividend growth and price appreciation in a DRIPed dividend growth stock, if only that high yield stock can maintain a stable dividend and price.

Would you start a long-term portfolio with a large initial position in high yield or stick with more stable dividend growth stocks? How would you DRIP high yields stocks?

Disclosure: I am/we are long JNJ, NRZ, STWD, BXMT, MAIN, CCP, SNR, NYMT, MORL, O, MDU, SON, SYY, OHI, WPC.

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.