Long-term dividend investing has appeared to become more popular amongst the community of individual investors, both here on Seeking Alpha and elsewhere.
For many reasons, this is not surprising. We live in a world where interest rates are at all-time lows and reliable income cannot be found in fixed income securities. Don't believe me? Take a look:
- The 10-Year US government bond yield is at ~1.85%, up from 1.35% earlier this year
- The 30-Year US government bond yield is at ~2.62%, up from 2.09% earlier this year
- The 10-Year Canadian government bond yield is at ~1.25%, up from 0.95% earlier this year (as recently as September)
Source: Bloomberg Finance
This post is going to explore two encouraging pieces of evidence to support dividend growth investing as well as three actionable steps you can take to boost the current income of your dividend growth portfolio.
Evidence #1: The Dividend Drill
In a publication called The Dividend Drill: Evaluating Long-Term Total Returns, Morningstar DividendInvestor Editor Josh Peters provided a theoretical outline explaining why dividend growth plus dividend yield will converge to total return expectations over the long run.
His logic, which is very sound, says that total returns for common stock investments can be estimated using the following calculations:
Source: The Dividend Drill: Evaluating Long-Term Total Returns
He further elaborates with the following example:
"Imagine a stock trading at $57.75 per share with a $1.60 dividend, for a yield of 2.8%. Over the next 50 years, that dividend grows at 8.3% annually. If the authors of Triumph of the Optimists are right, this combination of yield and growth-11.1%-should account for most, if not nearly all, the annual return for this stock.
In fact, this is a real stock-General Electric GE, which at the end of 1955 sold for $57.75. Between 1955 and 2005, GE split its shares 7 times, so each original 1955 share is 96 shares today. And since then, GE has generated a compound annual total return of 11.6%. Fully 96% of this return is explained by initial dividend yield and subsequent dividend growth.
And what of the stock price? Unadjusted for splits, GE rose from $57.75 to $3,364.80 per share, an annual growth rate of 8.5%. What could drive growth like that? The dividend-it rose at a nearly identical 8.3% clip."
The bottom line here is that investing in stocks with healthy dividend yield and strong dividend growth prospects is a strong recipe for generating alpha over the long run. I strongly recommend you read this interesting publication - I believe it provides some solid and insightful evidence to support long-term dividend investing.
Evidence 2: Long-Term Historical Correlations
I was doing a bit of number crunching the other week and reading into the historical correlations in the Canadian financial markets. Namely, I was trying to answer the following question:
"Which fundamental financial metric is most closely associated with total return?"
Many (including myself) would have expected the answer was earnings per share. Surprisingly, the highest correlation actually existed between stock price and dividends per share. Here is the data:
Source: Publicly Available Financial Statements, author analysis
The data presented here is the correlation between stock prices and the financial metrics indicated in the column headings for the 16 fiscal years between 2000 and 2015. The data set in question is a sample of most of the largest companies in Canada (as measured by market cap).
If dividends have historically demonstrated high correlations with stock prices, then this further supports the validity of long-term dividend investing.
Now that I've explained two pieces of evidence to support dividend investing, I want to explain three actionable steps that you can take to boost the income of your portfolio today.
Income-Booster #1: Write Covered Calls or Cash-Protected Puts
Writing covered calls can be a great way to boost income from stocks that you already own. Similarly, writing cash-protected puts can be a great way to generate a commission for entering into a position in a stock if you think the price will drop.
Here I will provide a brief explanation of each strategy and an example for each, showing step-by-step how they can boost your portfolio income today.
Writing covered calls means you are selling an option that gives someone else the right to purchase your shares at a predetermined price before a specified date. Since you own the shares already, this is called writing "covered" calls, and collecting the option premium serves to boost the income you're already receiving from the dividend. Because your shares have the option of being purchased away, it's important to select a strike price where you would be happy to sell your stock.
To illustrate the income-boosting potential of writing covered calls, I will present an example of writing covered calls on Apple (NASDAQ:AAPL). They most recently closed at a stock price of $113.72. Looking at their options chain on Yahoo! Finance, you could sell covered calls expiring on December 16 for $2.29, which is $229 on a 100-share basis (typical for options contracts). Note that because of Apple's relatively high stock price, $11,372 of capital would need to be deployed to execute this strategy.
Source: Yahoo! Finance
Here, one of two things could happen. If Apple's stock were to rise past the $115 strike price, your shares would be purchased, which would guarantee you a 3.14% return before commissions, calculated as ($11,500-$11,372+$229)/$11,372. This is over a short 48-day period, so the equivalent annualized return is 26.5% if you can successfully execute on this strategy over and over.
The other possible event is that Apple does not rise above $115 before the expiration of the option on December 16. In this case, you would have benefitted from the income generated by the options premiums without having the limited upside from the stocks being called away. You also participate in all of the returns of Apple, boosted by the options premium.
Writing cash-protected puts is essentially the opposite of writing covered calls, and is a good way to collect option premiums in exchange for initiating a position in a stock you want to buy. With cash protected puts, you sell out-of-the-money put options that are secured against cash you hold in your portfolio. If the price of the underlying security drops below the strike price of the put options, you will be forced to deploy this capital and purchase the shares underlying the contract. If not, you earn the premium for letting the cash sit in your brokerage account.
Here I will walk you through a cash-protected put strategy using the SPDR S&P 500 ETF (NYSEARCA:SPY) as the underlying security. Looking at their options chain, you can sell cash-protected puts with a strike price of $205 expiring on March 17, 2017, for an option premium of $6.07 per share. For a contract bound to 100 shares, this means you would collect a $607 option premium.
Source: Yahoo! Finance
From a risk-reward perspective, this is generally quite attractive. You need to lay $20,500 of cash aside in your portfolio to purchase the ETF if the price drops, and you collect $607 for doing so. Keeping in mind that the options expire on March 17, this is a nominal return of 2.96%, which translates into an annualized return of 7.96%. Not bad for just having cash in your account! You obviously also get the benefit of potentially picking up some units of the ETF on the cheap.
Both call and put options provide a relatively easy way to increase both investment returns and portfolio income for the sophisticated investor. However, I would caution against using these strategies under two conditions:
- If you have portfolio holdings that have appreciated a great deal since your initial purchase, you may be sitting on significant unrealized capital gains. I would not advise to execute a covered call strategy on these securities because if the options are exercised then you will be obligated to sell the instruments and pay the tax.
- If you are holding smaller, less-popular stocks that do not have an active options chain, then this strategy might not be for you. The liquidity of a stock's option chain is generally measured by the "open interest," which is how many contracts are outstanding at the time of the quote. Large, liquid, widely-held companies like Apple are great stocks for an income-boosting option strategy because the options are easy to sell. You will notice in my examples, Apple and SPY had open interests of 43,150 and 42,588, respectively.
Income-Booster #2: Use Leverage
I've already demonstrated that interest rates are at all-time lows.
This means that money is cheap, and we can easily use other people's money to boost our investment returns. For instance, my stock broker is currently charging two percent for margin loans, which is remarkably cheap.
For an individual with a $100,000 in investable assets, purchasing units of the SPDR S&P 500 ETF which currently yields 2.07% would generate $2,070 in dividend income. Leveraging up by three times would generate $6,210 in dividend income while costing $4,000 in interest (at a 2% margin rate). In other words, you would generate $2,210 of dividend income and have much more opportunity to participate in the price appreciation of this ETF.
Applying this same philosophy to higher-yielding individual securities generates even better results. Let's say you had a portfolio with blue-chip dividend-growth companies like the following:
- Toronto-Dominion Bank (NYSE:TD): 3.63% dividend yield
- Canadian Imperial Bank of Commerce (NYSE:CM): 4.79% dividend yield
- Enbridge (NYSE:ENB): 3.60% dividend yield
- Brookfield Renewable Partners (NYSE:BEP): 5.74% distribution yield
Using these companies and others, it's not unreasonable to create a diversified portfolio with a 3.5% dividend yield. On the same $100,000 portfolio, you would generate $3,500 of annual dividend income. Leveraging up by three times means you would generate $10,500 of dividend income and incur the same $4,000 of interest, yielding a net dividend income of $6,500. As before, you also have the opportunity to participate in three times the long-term capital appreciation of the investment.
Please note that margin comes with its associated risks and you must perform your own due diligence before making any investment decisions.
Income-Booster #3: Selectively Purchase Higher Yielding Securities, and Use Limit Orders
As I've shown in the previous section, it isn't difficult to screen for higher-yield securities to boost the dividend yield of your overall portfolio. For investors in the United States, I recommend the stock screener on FinViz.com available here. For Canadian investors like myself, I have yet to find an equivalent for the Toronto Stock Exchange. That being said, there are plenty of good investment opportunities south of the border.
Some of my favorite dividend growth stocks in Canada at the moment are:
- The Toronto-Dominion Bank: 3.63% dividend yield
- Brookfield Renewable Partners : 5.72% dividend yield
- Enbridge Inc. : 3.63% dividend yield
- Canadian National Railway (NYSE:CNI): 1.78% dividend yield
- TELUS Corporation (NYSE:TU):4.25% dividend yield
I've linked each of those companies to recent analyses written by myself, which evaluate the dividend growth prospects of these stocks. Hint: They are all attractive.
One concern I want to emphasize is the importance of choosing stocks that do not trade future growth for current income. This phenomenon, often called "chasing yield," can be harmful to overall investment returns if not careful.
However, I believe with detailed scrutiny backed by in-depth fundamental analysis, it is actually quite feasible to construct a portfolio that has both a higher yield and higher dividend growth prospects than the S&P 500 Index.
The Bottom Line
With dividend growth investing becoming so popular, it's important to constantly evaluate the validity of this strategy. Luckily to us DG investors, the strategy is backed by empirical evidence.
Here I've also presented three techniques that I've personally used to boost portfolio income. I wish you all the best if you decide to implement them yourself.
Readers, what are your thoughts on the dividend growth investing strategy? Let me know in the comments section.
Disclosure: I am/we are long TD, ENB, TU.
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.