Seeking Alpha

Big Dividend Growth Does Not Always Mean Big

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Includes: ABC, AOS, BEN, CPK, CSVI, CTAS, DCI, HP, HRL, JKHY, JNJ, LOW, MMM, NDSN, ROP, SHW, SUN, SYK, VFC, VIG
by: Kurtis Hemmerling
Summary

Investors may try to forecast dividend growth using numerous methods.

Trailing dividend growth is a poor estimator of future growth.

High trailing dividend growth usually assumes a large increase in payout ratio.

Investment riddle: When is big dividend growth not big?

You might be wondering what on earth I am talking about. Big dividend growth means big dividends and a massive future yield on cost. Or does it?

Buying stocks with growing dividends has been likened to watering a garden or raising backyard chickens.

You start small and watch them grow over time while collecting a large dividend stream at some future point. As some investors like to point out, you should optimize your income stream by analyzing the dividends themselves.

So what if I told you that you could buy stocks with an annualized 50% dividend growth rate and still have a meager pot of dividends in 20 years - would you believe me? I will revisit this portfolio later on in the article.

Beware of Sleight of Hand Tricks

To illustrate the dividend growth problem I will use the example of AmerisourceBergen Corp. (ABC), which currently has a 13-year dividend growth streak.

If you were to invest in ABC back in 2010, you would have noticed that this stock had a trailing dividend growth rate of more than 50% (using fiscal periods) at the time of purchase. Sure, the yield was small back then at just over 1%, but if that growth rate keeps up, you will have close to 30% yield on cost. Even if it drops you should still have an incredible yield on cost, better than average, right?

Over the next 8 years, the dividend growth rate worked out to over 25% annually. So while it slowed, growth remained moderately high. Great, right? Not so much. You now have a yield on cost of 4.75%. Should we expect a yield on cost of around 50% in 10 years?

Have a look at the dividend growth trajectory in this year-over-year chart (the growth is based on fiscal years and not calendar years).

Now we are looking at maybe 4% dividend growth based on the indicated dividend of $1.52 per share versus $1.46 for the past fiscal year.

The question is - did you really grow anything meaningful?

  • Contrast this with buying Johnson & Johnson (JNJ), which had a 3% dividend yield and a 14% annualized 5-year dividend growth rate back in 2010. The yield on cost is 4.06%.
  • Or Chesapeake Utilities Corp. (CPK), which had a 3.95% yield and a 1.76% growth rate in 2010 and now has a yield on cost of 5.8%.

The yield on cost numbers are in a fairly tight range regardless of the trailing dividend growth rate at the time of purchase.

Big Dividend Growth and Increasing Payout Ratios

The problem is that by purchasing stocks that have high trailing growth and projecting this forward (even with a slow-down factor) we might be overlooking the effect of an increasing payout ratio on our portfolio's actual long-term dividend growth.

To illustrate, I created a universe of stocks that have a trailing annualized 5-year dividend growth rate of at least 20%. Then I charted the median payout ratio (trailing 12 months) for this group of high dividend growth stocks.

The median payout ratio doubled. Even if earnings were completely flat, the annualized 5-year trailing dividend growth rate would be 15%, based solely on the increase in payout ratio. Increasing the payout ratio, in and of itself, is not sustainable or meaningful to our future yield on cost. Why not?

Consider the following example:

  • A company has a price-to-earnings ratio of 10 and their maximum future payout ratio will land at 75%
  • The stock has a current potential dividend yield of 7.5%
  • You buy the stock when the payout ratio is 10% for a 1% dividend yield
  • You hang on while payout ratio increases to 75% for a 7.5% yield in 10 years

Did you really grow anything? No. You could have the exact same yield on cost by just stuffing cash under your mattress and then buying the stock when the yield is at 7.5% with a 75% payout ratio in 10 years' time. Or you could have bought a stock 10 years ago that had a 7.5% yield and a 75% payout ratio. You didn’t need to wait 10 years. This increase in payout ratio was not meaningful to your yield on cost when compared to its peers.

Increasing the payout ratio is not real growth. But it does a wonderful job of fooling you in the early stages into thinking that your fast-growing chicks will turn into dinosaur birds in 20 years. But all you did was feed the chicks steroids so they grew to full size a bit quicker and then you are still left with an average-sized hen - while you could have saved yourself the trouble and bought a full-sized hen in the first place.

But What About 50% Trailing Growth Over 20 Years?

Remember that I said you could hold stocks that have 50% trailing dividend growth and over 20 years the yield on cost will still be unimpressive? How is that possible?

Let’s put this another way that is easier to digest.

  1. A price momentum investor may hold stocks which had the largest price run-up last year. Perhaps he buys stocks that appreciated at least 50% over the past 12 months.
  2. He surely does not expect to get 50% return after he buys the stocks. But he hopes that the momentum will continue for the next 3 to 12 months and that these stocks might outperform the market by 3-5% annually.
  3. The longer he holds, the less price momentum returns he generates until he gets just "average long-term returns" when reversion takes place.

Consider the "dividend growth momentum" investor.

  1. He purchases stocks that have high trailing dividend growth. The high growth typically only continues because the payout ratio is small. Once the payout ratio normalizes, he is holding an average growth stock with an average yield on cost. He gained nothing so far.
  2. So now he either needs to hold an average stock with an average yield with a similar yield on cost as everybody else (you went nowhere) or you need to replace these average growing stocks with new stocks that have high trailing dividend growth.
  3. And if you sell your stocks, the dividend growth you experienced no longer matters. The only thing that really matters when you sell is total returns!

You could hold stocks that experience 500% dividend growth annually and if you sold every year and had 0% total return growth, your portfolio would go absolutely nowhere from now until eternity.

So you don’t sell, right? But by not selling you simply bought a stock that increased its dividend from tiny to average and growth will normalize. You now are holding an average stock with an average yield and average growth prospects. Your yield on cost is no better than if you had chosen stocks with average dividend growth to begin with.

10 Stock Portfolio of Very High Trailing Dividend Growth

In this next simulation, I will hold the 10 stocks that have the highest trailing 5-year dividend growth rate since 1999. Stocks will be replaced annually. But first, look at the annualized 5-year trailing dividend growth rates of this portfolio.

The current basket of stocks we are holding has an average of 75% annualized trailing dividend growth (5-year look-back period). But when we look at our real annualized dividend growth rate over 18 years, how our actual dividend pot grew year over year, the number drops dramatically to less than 12%. Our initial yield on cost of just over 2% rose to over 16%. And if we remove the one current outlier of Sunoco (SUN), the yield on cost drops to less than 10% for an annualized real dividend growth rate of less than 10%.

Talk about past dividend growth performance not being indicative of future dividend growth performance!

Below is the total return equity curve of our portfolio vs. a dividend appreciation ETF (VIG), in case you were wondering if capital gains went through the roof. They didn’t.

Below is a list of Dividend Champions that have very high trailing dividend growth rates. While these might be good holdings for various reasons, you should not buy these stocks based on trailing dividend growth rates with the assumption that this will somehow inflate your future yield on cost by a substantial amount. There is no reason to believe that it will.

Company

Ticker

5 Year DGR%

Yield%

Helmerich & Payne Inc.

(HP)

58.5

4.2

A.O. Smith Corp.

(AOS)

25.5

1.1

Jack Henry & Associates

(JKHY)

21.9

1.2

Roper Technologies, Inc.

(ROP)

20.5

0.6

Lowe's Companies

(LOW)

20.4

1.9

Cintas Corp.

(CTAS)

20.4

0.9

V.F. Corp.

(VFC)

17.8

2.5

Hormel Foods Corp.

(HRL)

17.8

2.2

Computer Services, Inc.

(OTCQX:CSVI)

17.4

2.8

Franklin Resources

(BEN)

16.9

2.7

Sherwin-Williams Co.

(SHW)

16.9

0.9

Nordson Corp.

(NDSN)

16.8

0.9

Donaldson Company

(DCI)

15.2

1.6

Stryker Corp.

(SYK)

14.9

1.2

3M Company

(MMM)

14.8

2.5

*Above figures are taken from the David Fish CCC list.

Summary

Buying stocks with high trailing dividend growth means very little as regards your future yield on cost. High trailing dividend growth is usually a function of a low payout ratio being increased. This is a transient effect which has no meaningful impact on absolute yield on cost. You can watch your 1% yield grow to 5% over a short number of years, but after that you have an average growing stock. Why not just start with a slightly higher yielding stock to begin with, and get a head start?

The real question is - how can we forecast long-term future yield on cost? The answer is that we can't. Not yet. Not that I have seen. I would love to be proven wrong. Tell me how you do this and I will test it. Outline your forecasting formula. Then I will use my institutional grade point-in-time database to apply your formula to a random group of stocks 15 to 20 years ago and see how closely the formula forecast matches up to actual yield on cost.

My recommendation is to quit trying to estimate future growth rates altogether.

Attempt to look for fundamental factors that are linked to companies that outperform long-term (dividends and capital gains). For instance, my personal studies show that high-quality stocks with low volatility and larger dividend yields typically outperform their peers. But I do not try to make an actual forecast on future growth rates since changing economic conditions could make that yield on cost be at 15% or 50% in 20 years' time. I want to find superior stocks with superior fundamentals and hope that the market rewards me for this as they have in the past. But trying to come up with a concrete income projection for anything but a utility company or government bonds will almost always end up being wrong.

The key is to position yourself with the best of the best and forget about making absolute future projections of dividend streams.

Disclosure: I/we 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.