Income Investors: Should You Buy Higher Dividends Or Dividend Growth In 2019?

|
Includes: AMLP, ARCC, BIZD, BPR, T, VNQ
by: Rida Morwa
Summary

“Higher Dividend” and “Dividend Growth” investing are both good strategies to generate income.

With lower earnings growth, lower inflation and interest rate expectations in 2019, we expect Higher ('fatter') dividend stocks to become increasingly valuable.

A dividend in the hand is more valuable than one in the bush.

Given a slower economic backdrop, investors can play defense and invest in high cash flow companies with higher dividends, rather than dividend growth stocks which trade at loftier valuations.

We outline a strategy on how to generate 'Dividend Growth' by investing in low-growth 'Higher Dividend Stocks'.

Co-produced with PendragonY for High Dividend Opportunities.

Dividend paying stocks have historically produced massively higher total returns than other non-dividend paying growth stocks:

Image result for dividend investing growth investing

source

This is one of the reasons why at High Dividend Opportunities, our focus is mainly on dividend-paying stocks with a preference for the two following market segments:

  • 'Higher Dividend' refers to investment opportunities with exceptionally high dividend yields but slower growth.
  • 'Dividend Growth' refers to investment opportunities with lower dividend yield but anticipated dividend hikes in the coming years.

Both approaches have proven to produce strong total returns along with high income.

Today, as we move into 2019, we look for important investment themes, we compare valuations and seek to determine which segment is likely to produce the best results going forward.

Higher Dividend or Dividend Growth: How do they compare?

"Higher Dividend Stocks" and "Dividend Growth" stocks are similar in that they both generate a sizable portion of their total returns from dividend income. Total returns are the sum of:

  1. Dividend income
  2. Price appreciation

The return generated from dividend income is very easily computed with the dividend yield.

The appreciation potential is however less certain and comes from cash flow growth and multiple expansion.

In this sense, the main difference between both approaches is how returns are generated.

Dividend growth stocks are more focused on growth and appreciation, whereas Higher Dividend stocks are pulling most of their returns from the dividend only.

Since the market is forward-looking, this differentiator will often has a deep effect on the valuation of the shares with low growth companies (Higher Dividend Stocks) usually valued pessimistically and awarded a low P/E ratios. In contrast companies with growth expectations (Dividend Growth Stocks) are valued more optimistically (high valuations).

Higher Dividend

Dividend Growth

High dividend yield with little growth

Lower dividend yield with higher growth

Good current profitability

Good future potential

Often undervalued

Often overvalued

Low price/earnings and Low price-to-book ratios

High price/earnings ratio and high price-to-book ratios

Both approaches are equally valid and can generate high total returns. The best approach to pick is mostly a question of:

  • Personal preferences
  • Investment themes
  • Current valuations
  • Current economic outlook

Important Themes for Income Investors in 2019

Today, we are seeing two large themes play out in the capital markets:

  1. Lower growth: GDP growth will be trending lower and as a result, earnings growth will be decelerating in 2019. This isn’t too surprising considering the phenomenal earnings in 2018. We expect a gradual slow-down with lower growth in every quarter of 2019.
  2. Lesser interest rate hikes: With slower growth and lower inflation, the Fed will become increasingly cautious with further interest rate hikes. Currently only two hikes are expected in 2019 (compared to four in 2018) and we would not be surprised if even this outlook was cut to only one or none. If we look at the 10-year Treasury yield, it has pulled back from 3.2% to 2.7% meaning the markets are already factoring in lower inflation and lower interest rate expectations.

We believe that this change in market leadership will have a profound effect on the investment performance of different investment strategies. Investors will become less confident about future growth and will see greater value in high-yielding stocks with stable cash flow. This goes in favor of “Higher Dividend” stocks and less so for “Dividend Growth” stocks, especially if and when we factor in that the valuation differential is sizable.

Our Preference is for Higher Dividends in 2019

Our Core Portfolio currently has a a good exposure to both "higher dividends" and "dividend growth" stocks, but with move overweight towards higher-yielding investments. The reasons we prefer high-yield/low-growth to low-yield/good-growth for four simple reasons:

1. Favorable Macro Picture

Lower earnings growth coupled with lower interest rate hikes provides a very favorable backdrop for higher dividend stocks, much more so than most other sectors. Many higher yielding stocks generate stable cash flow from infrastructure-like assets with long contractual agreements. Therefore, a slowdown in economic growth is not expected to greatly affect their fundamentals in the near term. On other hand, dividend growth stocks are more reliant on a strong economy to continue growing cash flow and generating high returns.

Moreover, many higher yielding sectors such as Property REITs (VNQ), Midstream MLPs (AMLP) and BDCs (BIZD) have significantly underperformed in the past 2 years due to fears of rising interest rates. Now that future hikes are expected to slow down, the focus of the market will change and generate demand for these sectors.

2. Large Valuation Differentials

“Higher Dividend” stocks have been clearly out-of-favor since 2016 and have lagged the market. Even after the recent market correction, “growth” stocks continue to trade at sizable spreads to “value” stocks and there are plenty of opportunities to be found in high-yielding sectors.

Exceptions of course exist, and we also find opportunities in dividend growth stocks, but generally speaking, we find that high yield often comes at a deeper discount in terms of cash flow multiple and price to book. In the future as earnings growth decelerates, this should provide additional downside protection to Higher Dividend stocks.

3. Appeal of Immediate High Income

This argument is more psychological in nature but remains nonetheless very relevant in today’s day and age. Receiving cash NOW is more reliable and guaranteed than forecasted growth that is always more uncertain and may not materialize. We much rather get a 10% yield now than a 3% yield while “hoping” for dividend hikes to occur.

In other words, we see in some cases that yield as the "bird in the hand" and growth as the "bird in the bush". Everyone knows that a bird in the hand is worth two in the bush. This is especially true when you expect future growth to become increasingly uncertain.

4. Limited Downside and Amplified Upside

Should dividend growth companies see their earnings impacted by the current economic conditions, they would underperform due to disappointing earnings. Thus investors could be risking overpaying for the forecasted growth.

On the other hand, high-yielding companies with little growth, not only trade based on low valuations, but are priced based on conservative (and even pessimistic) scenario. There is no expectation for growth and as such, there is a lesser risk of earnings disappointment. Moreover, in the event of a positive surprise such as a return to faster growth, the upside potential is amplified due to the pessimistic market expectations.

Source

Investor Takeaway

“Dividend Growth” companies have outperformed "Higher Dividend" companies during periods of high economic growth; However today the situation is different. "Higher Dividend" companies are set outperform in 2019 and forward because:

  • They enjoy a better macro-economical backdrop during decelerating economic conditions.
  • Their valuations are usually inherently low. They are even more opportunistic today after lagging the markets during the last few years.
  • A dividend in the hand is worth more than one in the bush.
  • Higher-yielding stocks in general have limited downside in case of an earnings miss, and an amplified upside in the case of a positive surprise.

This investment theme has actually been highlighted this weekend by Barrons recommending to overweight Midstream MLPs and high-dividend lower growth stock such as AT&T (T) as part of their best income investment ideas for 2019.

What is interesting here is that higher-dividend stocks can be used as dividend growth vehicles and this is how:

How to Generate Dividend Growth with Higher-Dividend Stocks

Dividend growth investing is very popular because it has historically outperformed almost all other investment approaches and allowed to grow ever larger streams of income over time.

As such if you were to compare a stock with a flat 10% dividend yield with one that pays only 5% but grows at 5% every year, it would take only 15 years for the lower yielding company to catch up and start generating greater income than the flat 10%:

Source: Author’s work

This simple chart has led masses to believe that Dividend Growth is the far superior approach for long term-oriented investors. It is however misleading in that it assumes the high yield investor does not reinvest any of the dividends and simply spends it all.

If you instead assumed that the high yield investor reinvested half of the dividend streams into more shares, the low yielding company would never catch up to it. You would essentially create your “own dividend growth” by buying more and more shares every year thanks to the higher yield.

Example:

  • Case 1 Invest in Dividend Growth Stock: you invest $100,000 at a 5% yield and the $5,000 dividend is spent. The dividend keeps rising at 5% per year.
  • Case 2 Invest in a Higher Dividend Stock: you invest $100,000 at a 10% yield, and you spend $5,000 and reinvest the remaining $5,000 in more shares. In this case, the dividend also keeps rising at 5% per year.

These are truly comparable at the end of the day, and assuming all else is held equal, the performance would be identical.

However, in the case of the higher yielding investment you get the option to reinvest the dividend where you find the best opportunity at the moment. This may allow you to better take advantage of market sell-offs and boost long term income even further. You are also less reliant on future growth that may disappoint and enjoy immediate high cash returns.

Readjusting Our Portfolio

In 2019, we will continue to recommend both 'Higher Dividend' stocks as well as “Dividend Growth', but most of our picks will be in favor of the former. By hand-picking only the very best high dividend opportunities, we aim to achieve a high on-going yield with some added upside potential.

Ares Capital (ARCC) is a great example of the type of companies that we like to target. ARCC is a battle tested “Business Development Company” with a solid history of outperformance. The business is built to generate very consistent cash flow from a loan portfolio, and due its entity structure, it must by law pay out 90% of its taxable income in dividends. As a result, the company is today yielding 9.5%. Even better, the company has managed to grow, albeit slowly, providing additional upside on top of its fat dividend.

https://static.seekingalpha.com/uploads/2018/4/1/16392-15226201199663005.png

Brookfield Property REIT (BPR) is another attractive example of a high yielding company going into 2019. The REIT entity structure also forces companies (by law) to pay 90% of their taxable income in the form of dividends and BPR is currently yielding a hefty 7.5% (and was yielding 8.4% when we recommended it). This is not as high as ARCC, but with exceptions that the dividend will be hiked by 5-7% per year – making it a wonderful holding for both dividend growth and high yield seeking investors.

Image result for brookfield property partners

Another great way to generate higher dividend which will not be impacted by economic growth is by investing in Preferred Stocks. The preferred stock space is one of the most defensive and conservative ways to get exposure to high-yield stocks. Because all the dividends on preferred shares have to be paid before any dividends can be paid to common shareholders, the dividend payment is also safer on preferred shares. Furthermore, preferred stocks carry substantially less price volatility than common shares, and thus can be more suitable for conservative investors and retirees. Investors are here sacrificing growth for yield, but in today's environment a safe yield with no growth is a much better proposition.

Bottom Line

The financial market is ever evolving in its nature. The past 3 years favored growth stocks, but today as growth slows down and interest rate hikes decrease, we expect capital to rotate back towards "value stocks".

This has important implications for income-seeking investors who will likely find better performance in the “Higher Dividend” segment rather than the “Dividend Growth” market.

Our Core Portfolio currently yields north of 10% and therefore, we do not rely on growth assumptions to generate attractive results. In fact, even with zero growth, we should be able to continue to generate double-digit returns as long as our investments maintain their dividends at the current levels. This same cannot be said about many dividend growth stocks which rely on continuous strong execution to keep posting dividend growth. Investors who decide to buy "Higher Dividend Stocks" can re-invest the dividends and end up with a dividend growth portfolio that is growing even faster than just investing in dividend growth stocks. This is the beauty of this strategy, and as a plus get to buy these higher dividend stocks at very cheap valuations!

With a decreasing GDP growth rate heading into 2019, investing in growth stocks could become less favored and the outcome less predictable. On the other hand, by investing in those stocks that generate 7%, 8%, 9% yields or higher, we expect the dividend to become more valuable relative to a low but possibly-growing one.

Note: I am currently sharing the full list of my dividend stocks with our members along with a report entitled "Our Best Picks for 2019".

Disclosure: I am/we are long ARCC, T, BPR. 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.