The challenge before us is notorious: there are literally thousands upon thousands of individual stocks, ETFs and mutual funds in perfect opposition to a scarce amount of capital. The difficulty that we all must confront in this scenario is the fact that we can only choose a few specified selections. Whether this means going with a limited amount of individual equities or else devoting all of your funds to a low cost index fund, it is an unavoidable complexity. In this way, our investing objective should be to maximize the power of our limited resources. Here's the bad news: exactly 100% of us aren't going to make the best possible decisions. Here's the good news: nearly all of us still stand a great chance in creating financial fulfillment. Fortunately the investing universe is filled with many more winners than losers.
However it remains that it is not possible, or even advisable, for us to review every single investing opportunity. So what are we to do? We could just throw money here and there; hoping that everything eventually works out. But given the stake of your investing decisions, it's likely that you'll want to pay a bit more attention than that. So the solution for most, especially when buying individual stocks, is to run a screen. Now there are figuratively infinite amounts of stock screens, on theoretically infinite investment strategies, that one might run. But to keep this article going I'll press on with my strategy, dividend growth investing, as an illustrative example. This strategy is not mine alone, as many Seeking Alpha authors share the same ideology.
A DG screen would likely look something like this: a minimum number of years of increasing the dividend, a payout ratio below a certain level, specific yield requirements, past grow rate floors, earnings power, relative economic moat and perhaps the Warren Buffett test of "buying what you know." Surely there are many more possibilities, but it isn't hard to see that pretty soon we're down to a memorable list of companies. The screen criteria that I would like to address here is a minimum dividend yield requirement. Most people have one, or at least a general range of where they would like to be purchasing securities. And while it is a good idea run scenario analysis on all of your criteria; the effect of this one is relatively straight forward. My contention is that we shouldn't limit ourselves, with say a 3% or 4% minimum dividend yield requirement, right off the bat.
Let's run through an example to make this proposition a bit more tangible. Say you're a dividend growth investor with the specific goal of making the most income in the next 10 years. Now it is overwhelming difficult to predict what the future holds, but we can work through a past illustration to see how it might affect our decisions moving forward. Turn back the clock to 2003 and imagine that you have a minimum yield requirement of say 3.5%. One opportunity that would be available to you is AT&T (NYSE:T). In the beginning of 2003, AT&T was trading around $30 with a current yield close to 3.7%. In addition, T had increased its dividend for 17 straight years; and while the iPhone wasn't quite on your radar yet, it wouldn't be unimaginable that you thought people would be still want to talk to each other in 10 years time. Here's what a $10,000 investment in AT&T would have looked like at the beginning of 2003:
Not bad. Your $10,000 investment is now worth a little over $12,300 and you received nearly 50% of your initial investment back in the form of dividends. But if you're primarily focused on income, then you probably wouldn't care about what the stock price happens to be. Instead, your focus would be on whether or not that was the most amount of income you could have made and will continue to make in the future. (Note: that second bit is fundamental such that everyone doesn't simply chose the highest yield possible in the short-term) A stock that wouldn't have been on your radar in 2003, however, is McDonald's (NYSE:MCD). With a $0.40 dividend and a $23 share price, MCD had a current yield of just 1.7%. In practice you might not even consider this yield as a competitor against that of AT&T's, especially in such a short time horizon. But let's see how $10,000 invested in MCD instead of T does:
Instead of $4,900 in payouts for AT&T, we see almost $6,700 worth of income from McDonald's. Granted it takes 5 years for MCD to overtake T in yearly payouts and 7 years for MCD to take control in total payouts; but it is noteworthy that McDonald's starts with a 1.7% yield against AT&T's 3.7% and still handily distributes more income over a decade. Of course the underlying reason for this is McDonald's substantial dividend growth of about 24% a year, versus just over 5% annual growth for AT&T. Incidentally, due to the price run up in MCD; we see that McDonald's doesn't have a single instance of having a higher current yield than T.
Obviously, the counter argument to this scenario is that one receives greater payouts in the beginning with T and thus could use the higher initial amounts more opportunistically. That is, simply comparing the nominal payments doesn't tell you much; as the time value of money is being ignored. There are a few ways to correct for this, including making a reinvested dividends example, but a quicker way would be to discount the cash flows:
|NPV 3%||NPV 5%||NPV 8%||NPV 10%||NPV 15%|
|2.3% yield & 15% growth||$4,669.86||$3,853.03||$3,412.33||$2,871.31||$2,574.79||$2,000.00|
|3% yield & 8% growth||$4,345.97||$3,638.66||$3,253.93||$2,777.78||$2,514.61||$1,998.63|
|4% yield & 1% growth||$4,184.89||$3,561.15||$3,218.58||$2,790.55||$2,551.65||$2,077.01|
Here we see that even if we discount the nominal cash flows by 3%, 5%, 8%, 10% and 15%, McDonald's still earns more time-adjusted income. It is true that you would have to consider taxes as well, but this method still favors MCD. In addition to MCD and T, I also included some other examples. We see that a 2.3% yield growing at 15% will provide greater time-adjusted income than a 3% yield that grows at 8% over a 10-year time period. In turn, the 3% yield would oust a 4% yield growing at 1% in the lower discount stages, but lose out when you value the payouts at higher discount rates. While these were theoretical in practice, they were based off of the potential yield and growth rates of Target (NYSE:TGT), PepsiCo (NYSE:PEP) and Consolidated Edison (NYSE:ED) respectively,
In addition, I added Walgreen (WAG) to the table to indicate the validity of one's gut reaction to low yields. In 2003, Walgreen had a yield of just 0.56%. It is true that WAG was able to grow this payout by over 22% a year, yet this wasn't enough to make up for the beginning deficiency. This example suggests that it is overwhelmingly possible that a 2.3% yield could provide more time-adjusted income than a 3% yield; or for that matter a 4% yield. So we know that minimum thresholds can limit our potential income in the future, but as seen with WAG in 2003, they shouldn't be ignored altogether. That is, a reasonable yield only gives way to a lesser yield if the lower yield is able to grow at a compensating rate.
In the end, we're looking for the "dividend growth sweet spot" whereby one can balance the allure of a current yield with the income boosting prospect of a higher payout growth rate. The take away is that while screens can be useful, it can also be helpful to run scenario analyses on our definitive criterion. A minimum yield of say 3% or 4% might be practical in general terms. But it is paramount to realize that it is inherently likely that a security that only reaches the 2.9% or 3.9% yield level could provide more adjusted income over time. For that matter, the 2.5% or 3.5% yields could have just as legitimate chance of outpacing the higher yields that do fit your criteria. Over the long-term, a low relative current yield does not necessarily equate to a lower level of income. If you do the applicable math, perhaps your criteria will find what so many tight jeans and tense personalities lack: they just need to be loosened up a bit.
Disclosure: I am long T, MCD, WAG, TGT, PEP. 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.