Dividend investors can make hours of chummy chit-chat. We rhapsodize endlessly about rising yield-on-cost, low payout ratios, inflation-beating income and related marvels that somehow elude other investors.
But trouble lurks beneath this pleasant facade. Two dividend camps, high-yield fans and dividend-growth lovers, sometimes seem to feud like Hatfields and McCoys.
“How can you write about a 2% yield!?! I need 6%,” the high-yield fans protest.
“But with dividend growth your dividends will climb even higher,” the other side counters.
Ok, let’s settle this old fashioned way. With numbers. We’ll look at three different objectives: high current income, building a future income stream and investing for total return.
It turns out, perhaps surprisingly, there’s a clear-cut winner for only one of these three.
High Current Income
There’s no need for suspense on this one, investors who want high current income from their stocks will want higher yields. Of course, if high-yield income doesn’t grow then inflation eventually eats it up. For every $100 of income ten years ago, you need $125 to buy the same stuff today.
But a flat 6% yield typically produces more income for many years than 3% and growing. Moreover Dividend Champions and Contenders, stocks with 10+ years of dividend growth, include high yielders like Altria (NYSE:MO), Buckeye Partners, (NYSE:BPL), CenturyLink (NYSE:CTL) and others, so high-yield doesn’t have to mean stagnant income.
Building a Future Income Stream
Perhaps more surprising are some numbers for building a future income stream, one that won’t be tapped for decades, usually when the investor reaches retirement.
Many dividend-growth fans (myself included until I researched this article) conclude that dividend growers take the prize here. After all, dividend income that grows for decades outpaces initially higher but flat dividends by the time the investor taps the income stream, right?
Well … mostly. But if you re-invest dividends to create that future income stream, higher initial yields can build such a big head start that moderate, growing dividends don’t catch up until longer than you might imagine.
For example, start with $10,000 yielding a static 6% with dividends re-invested. In Year 1 you generate $600, the next year $636 ($10,600*.06), then $674 and so forth. The dividends buy 6% more shares each year, and those shares themselves generate another 6% the following year.
Meanwhile, $10,000 at a 3% yield and 7.5% dividend growth, about the average current yield and 10-year growth rate for the Dividend Champions (stocks with at least 25 years of dividend growth), produces $300, $332 ($10,300*.0323), $369 and so on.
Quite a difference. The dividend growers’ income stream begins to surpass the high yielders’ in Year 13. I say “begins to surpass” because that’s when the Year 1 principal investment ($10,000) generates higher annual income. For any Year 2 investments the magic happens in Year 14, then Year 15 for Year 3 investments and … you get the drift.
And even then the high yield investor gets to chuckle. Because although Year 13 marks the turning point for annual income from the initial investment, those first 12 years of higher yield still produced more cumulative dividends. Specifically, by Year 13 the high yielders had generated over $21,000 of dividends on that initial $10,000. The dividend growers pulled in just over $18,000. It will be Year 19 before the score starts to even on that measure.
Those numbers can certainly work for early birds with long time horizons. But they can get tough for late starters, particularly those investing ever-larger principal amounts during their peak earning and saving years, say when their age hits the late 40s or 50s.
Of course, this one illustration hardly covers the whole canvas. Changing the dividend-growth rate or the yields changes the results. (More about that later.) But moving to ever higher static yields can get hairy compared to swapping a 3% dividend grower for one near 4%, for example. That’s because there’s some evidence that high static yields bring higher risks. For one, yields that rise due to falling stock prices, rather than dividend hikes, can warn of a dividend cut.
And what about the evidence for total return? Let’s look at that now.
First, there’s little doubt that over the long run (but not every short sprint) dividend stocks, especially those with growing dividends, outperform the market and clobber non-dividend payers. But reports comparing total return based on yields are surprisingly unclear.
Investment firm Credit Suisse conducted often cited yet widely misunderstood research (pdf) on this, concluding:
“Stocks with high yields generally outperformed those with low yields … the maximum performance was delivered by companies with high dividend yields and low payout ratios.”
Yes, but …
In their updated 2001 through 2010 study, Credit Suisse designated as “high yield” anything above 2.7%. Even smaller “high yields” qualified in their original 1990 through 2006 research. And their winning “high-yield, low payout” group topped out at a 5.8% yield. Achieving any higher yield required at least a “medium” payout ratio. (“Low” yields ranged from .1% to 1.3%, with “medium” yields filling the donut hole.)
Still good stuff, but the real story is the numbers, not the CS researchers’ bold quote: the best performers comprised stocks yielding 2.7% to 5.8% with payout ratios of 56% or less. That covers a lot of territory, much of it not what dividend investors would call high yield.
Another study during an overlapping time period, 1993 through 2007, showed similar results. That research, by investment firm Miller-Howard, found stocks with 3% to 6% yields beat both higher and lower yielders, and with less volatility. Over this generally good period for stocks, these top performers averaged an annual total return near 13%, compared with 11% for stocks with 6%+ yields. Stocks yielding below 3% nudged past the high-yielders as well, averaging nearly 12% annually.
So for total return, these studies might favor moderate-yielding dividend classics such as Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG), for example, or a relative newcomer like Darden Restaurants (NYSE:DRI), along with higher-yielding Dividend Champions like AT&T (NYSE:T). Unfortunately, though, both studies were conducted over roughly the same 15 to 20 years so don’t provide as broad or varied a timeframe as I like.
Further muddying total-return results are several studies (pdf) summarized by investment group Tweedy Browne. These show higher-yielding groups often outperform when stocks are ranked by yield. But, shades of Credit Suisse, it’s not clear what “high yield” means in some of these summaries. Meanwhile, other comparisons (pdf) flip-flop these results.
And so …
So what might a practical investor do about all this?
Those who want high current income from their stocks will no doubt stick with high yields. But adding some high yielders with small but steady dividend growth will help offset inflation while likely pointing the investor toward higher quality companies.
Next, investors purely focused on building future income via re-investing growing dividends might be missing some big opportunities. So run the numbers yourself on a few high-quality high-yielders, even if their dividend growth rates look small.
Finally, dividend-growth stocks make good sense for long-run total return. It also makes sense that fundamental measures of growth, financial health and valuation might impact these stocks’ long-run return more than initial yield does.
On that note, experienced investors often judge that high yielders, as a group, might underperform simply because they include slow-growers and unhealthy companies. But what about those medium yielders outpacing presumably faster growing low yielders? Some evidence suggests this might result from valuation, with the lowest yields reflecting too high stock prices.
In any case, due diligence always requires looking beyond the yield, whatever its level. Dividend investors chat a lot about that too.
Disclosure: I am long DRI, JNJ, PG and a number of other dividend stocks.