Sunday, December 22, 2013

Yield Matters

One of my selection criteria for DivGro is dividend yield. I prefer a dividend yield of at least 2.75% for regular stocks and a distribution yield of a least 6.75% for MLP stocks. This year, most of my buys in DivGro had initial yields exceeding these minimum levels. The exceptions were TRV, with an initial Yield on Cost (YoC) of 2.32%, ACE (initial YoC of 2.45%), TGT (initial YoC of 2.73%), and WAG (initial YoC of 2.22%).

Of course, there are many more solid dividend payers with yields below 2.75%. In the list of Dividend Champions (stocks with 25 consecutive years of dividend increases), you'll find stocks like Lowe's (LOW), Wal-Mart (WMT), Archer Daniels Midland (ADM), 3M (MMM), T. Rowe Price (TROW), and Colgate-Palmolive (CL). Currently, they all yield less than 2.75%. Even stocks I've managed to buy while they offered yields above 2.75%, now offer smaller yields: XOM (2.55%) and AFL (2.25%).

Dividend yield is not my primary consideration when I'm evaluating candidates for DivGro. I consider many other factors, including dividend growth rate, free cash flow and payout ratio, debt to equity ratio, and price to earnings (P/E) ratio. I also determine a fair value estimate for candidates, preferring to purchase stocks when they trade at a discount.

Nevertheless, I think dividend yield is more important than people think. I've read many posts promoting the virtues of dividend growth over dividend yield. Some of these posts warn readers about the perils of chasing yield. I appreciate the reasoning behind these posts. Focusing on yield alone without considering other factors, is dangerous.

Consider two stocks, one with a yield of 2% and a 5-year compound annual growth rate (CAGR) of 8%, and another with a yield of 4% and a more modest 5-year CAGR of 4%. Assume similar future growth rates. Also assume similar earnings growth, payout and P/E ratios, and fair value estimates for these stocks. Which stock would you buy?

The accompanying spreadsheet shows expected dividend payments for these scenarios, for an initial investment of $1,000. The stock with a 2% initial yield growing at 8% is in blue, while the stock with a 4% initial yield growing at 4% is in red. 

Notice that it takes 20 years before the annual dividend payment of the blue stock exceeds that of the red stock. More importantly, it takes 30 years before cumulative dividends of the blue stock catch up with cumulative dividends of the red stock!

This comparison considers dividend payments only. If dividends were reinvested, the power of compounding would favor the red stock for an even longer time. 

Below are two graphs illustrating these scenarios. The first shows expected dividends; the second cumulative dividends. It is very clear that, eventually, the blue stock will overtake and outpace the red stock. But eventually is a long time...



By pointing out the superior initial performance of the red stock, I'm not trying to argue for favoring yield over growth. What I'm saying is that (initial) yield matters, and it matters a lot if your investment horizon is less than twenty years.

I'll continue to consider many factors when evaluating candidates for DivGro, including combining yield and growth according to the Chowder Dividend Rule. But I'll keep on demanding a solid initial yield, too!

Are you OK with yields of 2% or less? What is the lowest initial yield that you would find acceptable?


4 comments :

  1. Another great post, and I love you graphics! It's one thing to read the numbers but to see the data in a chart is easier to digest. Personally I pay a lot of attention to yield since I am over 40 now and simply don't have time to wait for that div growth to kick in. It's good to know stocks with more modest dividend growth rates can still be quite strong in terms of overall dividend performance.

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    Replies
    1. Thanks for stopping by, Captain Dividend! Like you, my age is one of the reasons I pay attention to yield!

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  2. Great Post. I look for YOC to be at least 2.50% I will however, go lower if I really like what I see from a company.

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    Replies
    1. Thanks, FFdividend! Seems like many dividend growth investors go for at least 2.5%. As I mentioned above, I also apply Chowders Dividend Rule, so in cases where I accept a lower yield, I require a higher CAGR.

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