Why Dividend Growth Is More Important Than Yield (Don't Be A Yield Vigilante)

by: Skyler Greene

Strawberries aren't really berries at all. According to Wikipedia, they're an "aggregate accessory fruit," a term which doesn't mean anything to me despite more hours spent studying for college biology than I care to remember. (I tend to suppress traumatic memories.)

Berry or not, strawberries were my very first introduction to the concept of investing. My parents liked to grow things, and when I was little, they decided to enlist me in the process of growing strawberries - and a pear tree.

I don't remember a lot about being six years old, but I do remember that I didn't like gardening very much. I planted the seeds and the little pear sapling, and had to go out and water them every so often. It was pretty pointless, or so I thought. For what seemed like "forever" in six year old time, the strawberry patch was nothing more than dirt.

Well, finally, some little green plants sprouted. Still, they were rather boring. Yet after months (millennia in six-year-old time), it was finally summer, and the first little green "berries" started to appear. Soon enough they turned red, and I picked them all off - and ate them. (I love strawberries.) And they kept growing, and growing, and growing - and with no further effort, I got to enjoy the "fruits of my labor." Literally.

The strawberries died off the next year, but the pear tree didn't. By the time I was in middle school, I had more pears than I knew what to do with - again, with no effort. If the strawberries were a nice payoff, the pears were an even better one. There were so many of them. They were the best pears around, and being the entrepreneurial sort, I made movie money selling them to my friends.

If you're wondering what my childhood memories have to do with investing, the point is that growth over time pays off. And while growth in general is nice, you want your long-term investments to be pears, not strawberries. Even if they're not-so-interesting at first, you want them to last and grow forever and ever, rather than give you a huge bounty at first and then die off.

This analogy is particularly applicable in the current environment, where yields are scarce and many investors are obsessed with chasing yield-as-a-number. I've noticed this trend pop up in comments to many of my articles - most concerningly, in articles about retirement investing strategies. Many folks saving for retirement seem to be in a "yield-chasing" mentality. If a 3% dividend is good, a 6% dividend is doubly good, right?

Maybe not so much. Investors chasing yield have driven prices on typically-staid utilities up to eye-popping valuations:

Normally, utilities stocks have a price-to-earnings ratio of 26% less than the S&P 500, Stovall says. Today, utilities stocks sport a 14.2 P-E, vs. 12 for the S&P 500. And S&P estimates that utilities' earnings will fall 2% next year.

Investors aren't just chasing yield in utilities, however. Investors have been loving REITs, an asset class known for juicy yields and strong returns:

[T]he U.S. REIT industry outperformed the broader equity market in the first half of 2012. The FTSE NAREIT All Equity REIT Index reported total returns of 16.11% as of July 2, 2012 vs. a 13.28% and 8.58% for the NASDAQ Composite, and the S&P 500 Index, respectively.

Now, I have nothing against REITs. I hold shares in the Vanguard REIT ETF (VNQ). The FTSE NAREIT All Equity REITs Index outperformed the S&P 500 over the past 15-, 20-, 25-, 30-, and 35-year periods. But it's important to note that like all things in the stock market, this performance isn't guaranteed. Again, while I have nothing against REITs, I've seen dangerous advice floating around - for example, one article I saw was encouraging RETIREMENT investors to build a portfolio entirely out of super-yieldering mREITs like Annaly Capital Management (NLY), which has a mind-boggling 13% yield. But investors should be wary. The 13% yield comes with a price-tag of increased volatility and risk. And guess what? The lower-yielding equity REITs actually performed significantly better than mREITS over a 27-year stretch, according to an International Real Estate Review paper by three college professors in 2003:

... both equity and mortgage REITs underperformed the stock and bond markets during the entire sample period of January 1972 through December 1998. The mean monthly return for mortgage REITs (MREIT) was 0.55%. For equity REITs (EREIT), the mean monthly return was 1.08%, still below the mean monthly stock market return (1.14%).

Now, admittedly, stocks got a little bubbly during the end of the '90s, so equity REIT and stock returns are essentially comparable. But the complete underperformance of mREITs is interesting. Higher yield, but lower performance? Hmm.

While it's definitely very tempting to chase yield, it's also important to realize that yield isn't always the most important factor over the long term. For example, consider two stocks that are equal in all respects but two: stock A has a 4.0% dividend and a dividend growth rate of 4%, while stock B has a 3.0% dividend but a dividend growth rate of 8%. Which stock do you choose?

Depends how long you're planning to hold it. If you're planning to hold it until retirement, I'd definitely go with Stock B.

Regardless of whether dividends are reinvested or not, Stock B provides much better dividends over the long term. Of course, this is just focusing on the dividends: if you consider the dividend yield to be relatively constant over time (the stock isn't going to stay flat, it'll gain with the dividend) you also get a very nice capital gain from Stock B and its 3% dividend.

Of course, the best solution is to find an attractive entry point so you get a great dividend grower at the highest possible current dividend yield (and value), so it maximizes your return over time. For more ideas on this strategy, see Market Timing for Dividend Investors.

So in the end, it seems that stocks with a history of dividend growth -- stocks like McDonald's (MCD), ConocoPhillips (COP), Walgreen Co (WAG), Procter & Gamble (PG), Target Corp (TGT), Chevron (CVX), Kellogg (K), Johnson & Johnson (JNJ), McCormick and Company (MKC), Intel (INTC), Exxon-Mobil (XOM), and Coca Cola (KO) - are your best long-term bets for core portfolio holdings. Even though strawberries may be tastier than pears (in my opinion, anyway) you want to invest in the pear tree rather than the strawberry plant. Why? You want long-term growth, not a flash in the pan.

So while there's absolutely nothing wrong with allocating a small part of your portfolio to mREITs or other high-yielding instruments, don't go crazy chasing yield. In the long run, dividend growth trumps dividend yield, especially on a risk-adjusted return basis.

Disclosure: I am long INTC, PG, JNJ, VNQ.