The following is an explanation and visualization of the topic discussed in Episode 2 of The Dividend Mailbox – Dividend Behavior: Growth or Yield?
Visualizing the difference between a growing dividend and a high-yielding dividend is important to understanding the dividend growth investment strategy. At first glance, an investor may think that having a high dividend that also grows at a moderate pace would boost overall return. While in theory, this is ideal, in practice, it is much more challenging to accomplish. If the company does and can continue to do so, it’s probably an attractive investment. The one thing to be cautious of is the whole “continue to do so” aspect. More often than not, trying to support a high-yield dividend, much less growing it at an acceptable rate, is difficult long term.
Rarely do companies that have high dividend yields, (say in the range of 4% or higher), possess the capability to also grow that dividend. This is simply due to difficulties in growing top-line revenue to support this dividend policy. When organic growth is just not there, companies take on larger and larger amounts of debt or make expensive mergers/acquisitions to boost profitability. This, in turn, can result in low return on invested capital and other operational or balance sheet issues. Thus, continuing to pay a large dividend while simultaneously increasing it is burdensome and dividend payouts can grow to a level that is just unsustainable. Eventually, companies are faced with the decision to cut or pause their dividend until profits can catch up. When this happens, it is a bad day for the dividend investor.
Rather than growing an already high dividend and risking it being cut, most high-yield companies tend to keep the dividend payout relatively flat or grow it at a very slow rate. On the contrary, companies that start out with a lower yield have a greater ability and room on the income statement to grow that dividend. In this case, the investor is not being paid out as much at first, but the dividend payments also grow faster year after year.
With the downfalls of investing in high yield dividends aside, the question becomes: which dividend behavior is more profitable for the investor?
To answer this question, it will be useful to look at two theoretical companies: ABC Corp and XYZ Inc. ABC Corp has a dividend policy that starts out with a yield of 2% but grows as 6% a year. XYZ Inc has a dividend policy that has a yield of 6% but grows at 0% a year. This essentially compares a company with a lower yield but high growth to one with a higher yield and no growth. Assuming there is an initial investment of $10,000, an investment horizon of 20 years, and the dividend yield doesn’t change at all, let’s examine these two investment choices.
Here, the below graph shows clearly that XYZ Inc has a much larger dividend than ABC Corp in year one (by a factor of 3). Additionally, it takes almost 20 years for ABC Corp’s dividend to grow larger than XYZ Inc’s. So far, this appears to be in favor of a high yield, no growth strategy.
But here is the kicker. By definition, the price of the stock is directly affected by the dividend yield. Since the dividend yields are assumed to remain constant over the 20-year investment horizon, and ABC Corp’s dividend is growing while XYZ Inc’s is not, price appreciation needs to be factored in to truly see the total return of each investment. Using a simple calculation of the dividend payment divided by the dividend yield, the result is an implied stock price. The below graph charts each investment’s total return by each year. That is, total return equal to dividend payments plus any implied stock price appreciation. When taking total return into account, it only takes 3 years for ABC Corp to overcome XYZ Inc on a total return basis. The interesting part is that as the years get further and further out, compounding begins to take effect, and the rate at which ABC Corp’s total return outpaces XYZ Inc’s gets faster (shown in the curvature of the line).
While this model is useful to understand the basics of these two different investments, the real world is usually not this simple. Assuming 6% dividend growth is a good target, but in actuality, it will most likely be an average of 6%, with 10% growth in some years and 1% growth in others. Assuming that dividend yields remain relatively constant is either appropriate or inappropriate depending on the maturity of the company and the overall market environment. Assuming that high dividend-yielding stocks won’t grow their dividend year over year is also not realistic. The purpose of this exercise is just to paint a picture.
So, what are some takeaways? First and foremost, if an investor is not looking to hold an investment long enough for dividend growth to start compounding, seeking a higher yield is probably an acceptable alternative. Second, seeking too high of a yield without researching whether a company can sustain it, is probably not a good idea. Third, and most importantly, in order to apply the dividend growth strategy, the investor needs to have high conviction and discipline. It takes years for the dividend to grow and begin to compound, thus, it takes years to realize a higher total return. In the end, if you have the patience, a growing dividend trumps a large one.
Supplemental figures below: