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I enjoy the concept of Dividend Growth Investing. I followed it for so many months as an engaged reader, but now it is time for me to pay my dues and contribute to this field in a more meaningful way. After looking over the CCC charts maintained by SA author David Fish, I realized I would do this by measuring just how important dividend growth is to an income-oriented investor.

High Yield

There are no shortage of companies that offer higher-than-average yields. The problem with many of them, such as AT&T (T), Kinder Morgan Energy (NYSE:KMP), and Communication Systems (NASDAQ:JCS) is that they have ridiculous payout ratios. A payout ratio over 100% is not really sustainable in my opinion. What ends up happening is that they either a) increase earnings just to maintain the dividend payment, or b) reduce the dividend to maintain their balance sheet. Needless to say, it is not guaranteed that the current levels of dividend payments will be sustained into the future.

The other problem with high-yielding companies is that there is no growth. Companies such as Mercury General (NYSE:MCY) which have a nice yield, (almost 6%) have almost no growth. Over the past 5 years, dividend growth in this company has come to a standstill, averaging less than 2% growth.

(click to enlarge)MCY Dividend Chart

MCY Dividend data by YCharts

High Growth

Don't you ever wish that the markets weren't so efficient? It seems like any stock worth having is usually overpriced. I like Coca-Cola, but its yield is only 2.5%. Without the markets always trying to price everything in, I could make some decent money! Unfortunately that is how it is, and it won't change very soon. However, what if I told you that these stocks yielding less than 3% were still a buy? Dividend Growth can show how that is possible. To see the ratios for dividend growth, I would recommend seeing the CCC lists for yourself. Looking over the lists, I found a company worth reporting.

Walgreen Company (WAG) has an attractive dividend growth profile. At a current yield of 3% it also doesn't have that bad of an initial yield. Where it gets good is the historical dividend growth. Over 10 years it has increased its dividend by 18% annually. Last year alone it increased its dividend by 28% though. If it increases by 15% next year (a conservative projection) and the price stayed constant, the yield would then be 3.5%.

(click to enlarge)WAG Chart

WAG data by YCharts

Chasing dividend yield has a separate benefit. As the dividend continues to grow, the stock will grow in value as a result. This is, of course averaged over time. The reasoning behind this is as the dividend continues to grow, so too would the yield. However, you do not see companies that stay static in price while the yield goes through the roof. The stock will tend to have around the same yield, so the price must move to catch up with the increasing dividends.

Comparing Performance

So what is better, a stock that initially yields high with little to no growth, or a stock that will grow its dividend consistently but starts at a lower yield? Both have their uses. Here is a table to compare the two:

MCY's dividend is increasing at a rate of 2% annually, WAG is increasing at 15%. All yield calculations are done with the dividend on the chart and the purchase price. This chart makes no effort to predict the future price of any stock, and is used as a theoretical example. Also, as the chart goes down to the next row, one "year" has passed.

MCY WAG
DividendYieldDividendYield

2.44

6.31%1.103.02%
2.486.44%1.263.47%
2.536.57%1.453.99%
2.596.70%1.674.59%
2.646.83%1.925.28%
2.696.97%2.216.07%
2.747.11%2.546.98%
2.807.25%2.928.03%
2.857.40%3.369.23%
2.917.54%3.8610.62%
2.977.70%4.4512.21%
3.037.85%5.1114.04%
3.098.01%5.8816.15%
3.158.17%6.7618.57%
3.218.33%7.7821.36%

The higher-yielding stock produced a higher yield for the first 8 years, at which point the growth stock began producing an incrementally higher yield, jumping from 8% to 9.2% then to 10.62%. The dividend growth stock began being more effective at the 9th year. This is perfect for the typical dividend growth investor, who prefers to hold on to his assets for life (or as long as the stock continues meeting the requirements).

For some short-term investors (traders?) this may seem like a vindication of investing in the high yielding stocks of the time, even when they have no dividend growth. This is not true. In my last article I discussed the merits of using the current yield as an indicator to buy or sell. This was meant as a small jab toward using yield on cost as a reason to sell or keep. While i still maintain that using YOC should not be used as a reason to sell or not to sell, it can be a powerful predictive tool to determine forward-yields. The thing is, you can never find a quality dividend growth stock yielding 20%. You can't even find one yielding 4-5% lately (Except Altria, which I suspect is because of moral reasons, with it being a tobacco company and all). So if the stock won't yield more than 4% on a given day, one of two things must have happened. Either the dividend dropped or stayed constant (this is unlikely because we are investing in companies that have grown their dividends reliably), or the share price increased to match the growth in the dividend (which is more likely). To take a quick example, Walgreens at the end of 15 years might give $7 in dividends per share. To stay yielding 4%, the stock would need to get to $175. That is a massive upside from current levels around $33. I will not do the percent gain calculation, because it is the concept I am trying to prove. The dividend growth stock will also see generous capital appreciation. The high-yielding stock may see capital appreciation, but it will be less.

Conclusion

It is better to put money to work in an average-yielding dividend growth stock now, rather than later. The stock price will likely increase with the dividend. This makes it feasible to realize a significant capital gain, as well as generous dividends in the immediate future. High-yielding stocks aren't that lucky though. The stock could gain in price to revert back to a sustainable yield, but that would require a catalyst. Something that not all stocks have. In which case there would be a significant capital gain, but that is it. In my opinion, it is better to invest into solid dividend-growth stocks to take advantage of the future dividend increases of the company. This way, any risk to the stock is minimal compared to both non-dividend-paying stocks and high-yield/no-growth stocks. These stocks are reliable, and isn't that what we are looking for?

Source: Dividend Growth: More Important Than Yield?