Dividend growth investing is a common strategy employed by investors to build a steady annual dividend stream. Dividend growth portfolios are built with the intention of withstanding turbulent markets while continuing to grow the annual income. The strategy is based upon selecting high quality stocks with reputations and records of annually increasing dividends at rates greater than inflation. By selecting stocks of high quality companies with histories of growing dividends, investors can virtually guarantee themselves a growing income stream. DGI investing is not a one size fits all investment strategy, and investors must make decisions on how to construct their portfolios in order to maximize their returns.
Investors following a DGI strategy are often faced with a decision on how to structure their portfolio. Some investors prefer to select only stocks with high yields, potentially ignoring stocks with yields below 3% or some other figure that they identify, while others choose to seek out stocks with current low yields that may be able to grow dividends for years to come at higher rates. Neither strategy is inherently right or wrong, but rather they are dependent upon the circumstances of each investor.
Stocks with higher yields, for example Verizon (NYSE:VZ) and AT&T (NYSE:T) paying 4.5% and 4.6% respectively, provide investors with a larger annual income return than those with lower yields. The challenge with stocks with high yields such as these telecom giants is with long term growth of the dividend. While both stocks have long and storied histories of paying and increasing annual dividends, the most recent increases (2.56% for VZ and 2.33% for T) would leave a DGI investor a bit underwhelmed. Both of these stocks also sport payout ratios in excess of 100% of annual earnings, so the continued growth of these large dividends and health of the companies will be in question in years to come. Although this is not always the case with high yielding stocks, a high dividend yield is not often a sign of great health for a company. Dividend yields increase as share prices go down, so high yield can reflect poor company performance and low future growth prospects.
On the opposite end of the spectrum are stocks with lower yields, like high end jewelry maker Tiffany & Co. (NYSE:TIF) or sports and apparel maker Nike (NYSE:NKE), yielding 2.07% and 1.48% respectively, which may not provide substantial immediate income, but can grow an investor's capital and income stream for years to come. These companies have established themselves as companies that pay and increase dividends annually and have been able to grow them significantly in the past year. TIF has increased its annual dividend by 10%, and NKE by 16%. These companies sport low payout ratios of 37% and 30% of earnings, respectively, allowing the dividends to grow for years to come.
While not all companies with high yield will be unable to grow investor's income streams, and not all companies with low yield will bring investors great capital appreciation and dividend growth, it pays for investors to look on both sides of the fence when planning investments. Investors with years until they tap their dividend streams may look to lower yielding stocks with higher growth to build their portfolios over time. For investors closer to retirement and seeking an immediate increase in their income, high yielding dividend stocks may be the answer.
Below is an example using the stocks we looked at earlier that examines dividend growth versus yield. Our example investor puts $10,000 into each stock, and year one dividends are based upon the stock's current yields. In this example, we are negating stock price appreciation and making the assumption that dividend growth rate will be equal to that of the past year, while it is highly unlikely that companies like NKE and TIF can sustain the high dividend growth rates over the long term, this is merely to demonstrate a point. As you can see with higher dividend growth, annual dividend payments for NKE surpass both VZ and T after 10 years, and 13 years for TIF. However, the cumulative dividends received for VZ and T are still higher than those of both NKE and TIF after this period.
Annual Dividend Payment
Growth versus yield is a question that each DGI investor must answer for themselves. Each investor's personal situation will affect the investment choices they make, and investors need to conduct due diligence before purchasing any stock to ensure it matches their needs and strategy. While high quality stocks may offer a combination of high yield and high growth, it is difficult for companies to maintain both over the long term. The challenge for investors becomes identifying which companies will be able to perform best for them and their investment goals.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.