Dividend Growth Stocks May Be Overrated Investments

Includes: EEP, KO, MCD, NLY, PAA, PEP, T
by: Monty Spivak

Let’s start with the conclusion. I suggest that, based on yield only, the income-oriented investor is probably better-off buying a security with a higher, static dividend than one with dividend-growth. Many prominent Seeking Alpha authors have identified that dividend growth securities provide superior long-term overall returns and I am not debating this. In fact; I follow a few of the dividend-growth supporters, and enjoy their thoughtful articles.

This article is about dividend yield – not capital growth (for capital gains), or total return (yield plus capital growth); it is ONLY about dividend yield on the invested amount. Consider this analysis as though one is purchasing a Certificate of Deposit (CD) – for the Canadian readers, this is the equivalent of a Guaranteed Investment Certificate (GIC). This assumes that your goal is to receive 100% of your return as yield, with the return of your principle at the end of the investment period.
My challenge – and I am sure that many others share this - is that I want shares with both attributes; high current-yield and future-yield-growth. But when should one buy for current yield, and under what conditions should one buy for future income through dividend growth? For all of the comparisons, we will invest $1,000. I will use an annual baseline 3% dividend rate, and for present value calculations, a 2% discount rate, to create consistent results. Moreover, all investments assume that you will receive your investment amount when you sell your securities, with no capital gains or losses. I have also ignored the taxation aspect of the yield, as individual circumstances, location of residence, and other factors would come into play. Additionally, I will not compare the results to Money Market Accounts or Treasury Bills, as these yields have become irrelevant to income-oriented investors. We will examine 3 aspects of the yield:
  1. Simple sum of annual yields.
  2. Net Present Value (NPV) of the yields.
  3. The number of years that it takes to earn 50% of your investment through yield.
Dividend Growth Stocks
Let’s start with dividend growth stocks and benchmark them against dividend yield of the same amount. Many attractive dividend growth stocks are currently paying in the area of a 3% dividend, so I will use this as a baseline. As an initial analysis, I will use a like-to-like payout, and compare it to a 3% non-dividend-growth stock. The power of growth and its compounding is evident:
We see that the return for the dividend-grower outpaces the return from a static dividend stock, whether the analysis is based on the present-value or simple-sum of the dividends. As the dividend-growth supporters propose, the dividend-growth securities quickly outperform those that do not.
Baseline 3% Dividend Yield

Let’s assign a few example securities to our 3% dividend growth stock. There are many to choose from, and this is just a sample:
Securities with Approximately 3% Yield
Security Name (Ticker)
Mkt Cap
Coca Cola Co (NYSE:KO)
Consumer / Beverages
PepsiCo Inc (NYSE:PEP)
Consumer / Beverages
McDonalds Corp (NYSE:MCD)
Colgate Palmolive Co (NYSE:CL)
Consumer / Personal Prods
Procter & Gamble Co (NYSE:PG)
Consumer / Personal Prods
Clorox Co (NYSE:CLX)
Consumer / Personal Prods
Although we are not examining specific credit or insolvency risks, holding these securities will certainly let you sleep comfortably at night; they are large-cap, multinational, well-managed, growing companies, with marquis brands. The old adage, “slow and steady wins the race” has certainly applied to investors who have held these securities, as the combined (and growing) dividend yields and market values have benefited the long-term investors in these securities. Many dividend-growth oriented authors have described the benefits and provided excellent examples of these compounded yield returns and capital growth, so I will not explore this “baseline” scenario any further.
High Current Yield
As a next step in the analysis, we will ignore the capital growth and benchmark this yield-growth against some higher-yield alternatives. Let’s compare the 3% dividend-grower to a 6% and 7% (preferred share or other) static dividend. There are many attractive, high-yielding securities in the market. Although preferred shares, QUIBS, PINES, and some other classes of debt, hybrids, MLPs, and certain common stocks, often do not enjoy the capital growth of many common shares, they often have lower volatility, and typically come before common shareholders in recoveries should a company become insolvent.
Should the investor hold the securities for 5 years, the preferred shares will provide a much higher yield than the dividend champion. This is whether the value of the cashflow is discounted or simply summed. This proposes that if you do not hold the securities for a very long term, that you will generate a higher dividend return from securities, which provide a higher immediate yield – in other words, to maximize yield, do NOT invest in dividend-growth stocks for anything other than long-term investments. Investors with shorter-term income goals should buy securities, which pay them the cash up-front.

Baseline Compared to Pref Shares
Let’s take Pepsi (PEP), as an example. It is a dividend-growth stock; number two in its space - after Coka Cola (KO) – and frequently identified as a favoured investment. I looked at the data and analysis from some other Seeking Alpha authors, and the arguments for buying Pepsi are compelling. It is a world leader in convenient snacks, foods and beverages; has consistently paid dividends for 39 years; buys back billions in stock; has global brands; low debt and high cap; etc.. Personally, I would like to buy Pepsi, but not with the current yield of under 3%. After all, a yield-seeking investor should not buy Pepsi, when he or she can buy many safe, preferred shares and generate double this yield. I recognize that one would trade-off growth, but the only way to get the money from the growth into your pocket would be to sell the security. If you are a current-yield oriented investor, then perhaps you should sell your Pepsi holdings (when the time is right for you)?
Retirees, who are generally high-income-oriented investors, should be particularly concerned about holding dividend-growth securities. If your only goal is yield on investment, and you want your money soon, then it may be beneficial to reallocate your portfolio – perhaps divest part of your dividend-growth portfolio in order to reinvest it in (risk-neutral) higher-current-yield securities?
Some common shares, preferred shares, Trust Preferred Shares, Master Limited partnerships, Exchange Traded Debt Securities, and other securities, are reasonable examples of 6% and 7% yields. I have not included any US Royalty Trusts, as the yield paid to the investor extinguishes the asset – in other words, you are less likely to recover your invested capital, as they are paying it back to you as part of the yield. That said, there are many (some even large cap) securities, which provide an annual yield between 6% and 7% - a few examples include:
Securities with Approximately 6% - 7% Yield
Security Name (Ticker)
Mkt Cap
Approx Div Yield
Plains All American Pipeline LP (NYSE:PAA)
Oil and Gas Pipelines Industry
6 %
Enbridge Energy Partners LP (NYSE:EEP)
Oil and Gas Pipelines Industry
Energy Transfer Partners L.P. (NYSE:ETP)
Oil and Gas Pipelines Industry
Communication Services
Aspen Insurance Holdings Ltd (NYSE:AHL)
Insurance (Prop. & Casualty)
Morgan Stanley Capital Trust III, 6 1/4%, Cumulative Preferred (NYSE:MWR)
Financial Services
Vornado Realty PINES 7 7/8% (VNOD)
Real Estate Investment Trust
For a current-yield-oriented investor, AT&T (T) will provide more than double the yield of Pepsi (PEP) in the first year. Over a 20-year time horizon, this compresses to a total yield of only 50% more (assuming that AT&T keeps a static dividend, and that Pepsi grows their dividend 10% per year). That said, AT&T has also been a dividend-growth stock, so this investment may be more attractive than it appears on the surface. With its giant market capitalization and “steady eddie” business, this marquis-brand company may be the best of both worlds, from a yield-investor’s perspective.
I do not propose that everyone run out and sell their dividend-growth holdings, such as PEP, or buy AT&T, but suggest that there are many opportunities to improve yields and still maintain a reasonable level of risk in the portfolio.
There is certainly a trade-off between buying a dividend aristocrat/champion and buying a preferred share (or other security with a similar return). Dividends are not guaranteed in either case, but buying Pepsi (PEP) instead of Energy Transfer Partners L.P. (ETP) assumes that the valuation of the Pepsi shares will increase consistently by 4% per year (the percentage dividend yield that ETP provides over PEP). Assuming that both at least maintain their dividends, the holder of ETP is ensured of this 4% additional dividend return, whereas the holder of PEP needs to time his exit to realize the 4% per-year differential. Moreover, the Pepsi shareholder will need to sell his holdings to be able to spend his gain, whereas the ETP holder would still hold the security.
The impact on retirees is that the more current income oriented securities provide more cash now, higher returns, and more stability of income stream, than those which promise dividend growth and capital increase.
Very High Yield and Risk
The last scenario to look at is that of the very-high yield securities. These high-yielding securities are much riskier than the blue-chip, dividend-growing equities. In order to price-in the risks, I have provided 2 scenarios: 1. No dividend growth; and, 2. Annual decreases of the dividend by 5%.
The 5% dividend decreases in this example, represents the risk of not receiving the full value of your investment when you sell, and the risk that high-yield stocks may not provide sustainable dividends. These contrast with the dividend growers (Champions, Aristocrats, and other categorizations), which tend to maintain or appreciate in value, and typically grow the annual dividend. One must examine, on an individual security basis, whether the elevated return of a high-yield security will offset the long-term risk of reduced market price of the holding.
Despite the declining return, the investor gets paid more money, earlier. Even with a 20-year time horizon and 5% declining annual dividends, high-payers beat the dividend champion/aristocrat baseline!

Baseline Compared to Very High Yield
As you can see in the table and graph, the investor will enjoy triple the return of the baseline 3% yield-and-growth security, over 5 years, and double over 20 years. This explains the enthusiasm for these high-yield investments. Moreover, the high return securities pay you higher cash dividends sooner, which are worth more due to the time-value of money. The greatest risk of the high-dividend paying securities is that their value has a greater likelihood to decrease unless it is supported by an equally fast growing business.
Some current high-yield securities include financial companies, closed-end funds, mortgage REITs, and other high-risk investment vehicles:
Securities With Very High Yields
Security Name (Ticker)
Mkt Cap
Approx Div Yield
Chimera Investment Corp (NYSE:CIM)
Consumer Financial Services
Dynex Capital Inc (NYSE:DX)
Real Estate Securities
Annaly Capital Management Inc (NYSE:NLY)
Real Estate Securities
DOW 30 Enhanced Premium & Income Fund (DPO)
Closed-End Fund
ING Global Equity Dividend And Premium Opportunity Fund (NYSE:IGD)
Closed-End Fund
Vector Group Ltd (NYSE:VGR)
Annaly Capital Management Inc (NLY) is an excellent example. In the high-yield space, it is a relatively large-cap company, and is often the subject of various Seeking Alpha authors. This mortgage REIT buys government-guaranteed mortgages; NLY borrows money at low rates, and buys mortgage-backed securities (MBS) that pay 4, 5, or 6%. They leverage this (7 or 8 times) to generate high yields from relatively little equity. This is the classic high-risk, high-return (and very high-yield) model, although some debate the degree of risk based on the government counterparty. Increasing interest rates would negatively impact their leverage model and margins, so given that rates have nowhere to go but up, there is relative certainty that the yield will eventually decrease. That said, “eventually” may be a long time, and the rate of return may still remain very high relative to other securities. Therefore, for the risk tolerant, this may be a good yield opportunity in the short-term, and possibly in the longer-term.
An alternative perspective is the recent insolvency of The Great Atlantic & Pacific Tea Company Incorporated, (GAJ), which included the devaluation and cessation of interest payments on their exchange traded debt. This demonstrates the risk that investors would undertake to achieve such high yields. The diverse holdings and fund-management approaches of some closed-end funds can mitigate some of the risks while maintaining very-high yields, as the assets are diversified across many securities. The trade-off is the pyramid scheme nature of new equity supporting the dividend of current equity holders. Despite the trade-offs, certain closed-end funds may be an attractive choice when investing in this high-yield dividend space. If you choose not to use funds, you may want to diversify your holdings, and buy relatively small positions of various securities to mitigate the risky nature of these investments.
Term of Investment
The last area that we will cover is the impact of the term of your investment. Based on yield alone, the holding period for a security can be very long to recover 50% of the purchase cost. Even with 15% dividend growth on a 3% initial yield, it will take 11 years.
Term of Investment

As can be seen from this chart, the holding period for compounding dividends is very important – if you are not in for the long-term, then this type of investment would not maximize your yield.

Present Value of Dividend Yields
(Click chart to enlarge)
The 6% and 7% dividend-yield securities outperform the baseline, 3% dividend-growth scenarios – even over a 20-year time horizon. Perhaps surprisingly, these preferred shares also outperformed the 10%-but-declining yield in the very long-term. This suggests that if one invests in very-high-yield (and high risk) securities, then one should be prepared to exit the investment at an opportune time within a 5 to 10 year timeframe. Without this exit strategy, one would be better off with a preferred share portfolio. As well, this is not the buy and hold forever strategy that one associates with the well-known Dividend Champion portfolios, but would generate a higher yield.
The baseline dividend growth security does eventually narrow the dividend-yield gap, but the large initial payments of the higher-current dividend payers make it very difficult to catch up, based upon yield only. Therefore, if your dividend-grower does not enjoy reasonably-high capital growth, then you may be better off with a high current yield – possibly even on a total return basis.
What does all of this mean to the investor who is holding securities to maximize the present-value yield?
  1. Assuming that you get your investment back when you cash-in, the high-current-yield (preferred share) securities will give you a better return. This is because you get more money earlier in your investment timeframe. The present-value of the cashflow calculation discounts the value of future money and, therefore, the benefits associated with dividend-growing shares.
  2. Do not confuse yield-growth with the discounted cashflow value of the stream of dividend receipts. Dividend-growth stocks generate compounded returns, but a high-yield stock will generate immediate returns. An immediate return can outperform long-term growth, on a discounted cashflow basis. For example, the 3% dividend with 10% growth will pay you $3.30 on a $100 investment, after one year, so you are now earning a 3.3% yield on your investment. However, this payment is received one year in the future, so is not worth as much as $3.30 received today. A high-yield stock paying 7%, but with zero dividend growth, will pay you $7.00 at the end of one year. Eventually, the dividend growth stock will reach a 7% return, but you will have received many $7.00 payments (instead of $3.00 compounded payments), during the catch-up period. These $7.00 dividend payments are also worth more as they are received years earlier.
  3. Your choice between dividend-growth and current-yield on investments should depend upon the term that you hold the security. If you hold your investments for less than 10 years, then dividend-growth stocks are probably NOT a vehicle to maximize the present-value of your yield. If you are a longer-term investor, or an investor seeking growth or both growth and dividend growth, then your return may be greater with dividend-growth stocks. That said, it would be very important to pick the right stock.
  4. Yield typically corresponds to risk. Although we have not examined risk, the act of diversifying your investments out of highly-rated securities to obtain higher yields will elevate your risk and returns. Just as one should manage the risks of a bond portfolio, he should manage the risk (and therefore, the return) of a dividend-paying portfolio. Debt investors often prefer laddered maturities, geographic and industry diversification, and other mechanisms to manage risk and return. If you are holding your dividend-paying portfolio as a proxy for a fixed income investment, then you should also seek to build a diversified portfolio of current-yield and future-yield investments, in order to manage risks and improve average and annual returns.
  5. The price that you pay for your security is an important factor in your long-term return. Buying on dips will improve your long-term yield and return. Regardless of dividend pay-out style and reinvestment preferences, your return will be greater with a lower cost-base. For compounding growth calculations, small price differentials become exaggerated with each dividend increase on your static cost base.
I am not proposing that dividend-oriented investing is the only path to investment success, but there is evidence that it can provide an above-average return, if effectively managed. We all recognize that the total return from a stock is dividends plus capital appreciation; that said, capital appreciation has been uneven over the past few years, so dividend investing can provide a more reliable, if less spectacular, return. You will not realize any “triple-baggers,” but will continue to realize a yield far above that for T-Bills. Carefully managed, your portfolio can have a reasonable risk, with higher-than-average returns.
If your investment strategy is to maximize annual yield (and trade-off price growth), then the currently-paid dividend is the most important investment factor (after capital preservation). One other point needs to be stressed - dividends are neither risk-free or a sure thing; we have all seen many dividend cuts in the past few years. I recognize that dividend-growing companies have many attractive investment attributes in addition to the dividend yield. However, if yield is your only objective, then your dividend-paying portfolio should substantially diverge from the typical dividend-growth holdings. This may be particularly true for those approaching retirement, or who are retired.
The income-oriented investor is probably better off buying a security with a higher, static dividend than a dividend-growth security. As you approach retirement (or if you are already retired), your personal needs should be reflected in the composition of your stock portfolio; perhaps it should progressively become a fixed-income proxy. You should hold a basket of securities, with various types of dividend strategies, currencies, industries and yields, in order to generate income. Ignoring capital growth, the question is how to optimize the income-generating investments. This article proposes that you need to assess factors such as time-horizon and discounted cashflow value when deciding your allocation between high-current-yield and dividend-growth securities. Based upon yield alone, dividend growth stocks may be overrated investments.

Disclosure: I am long DPO, IGD.