Growth Stocks

High Yield and Low Growth or Low Yield and High Growth Stocks?

I think all investors know someone who bought a stock that has grown 20% a year for the last decade or so. A common example I hear about in Australia is CSL, which has delivered truly incredible performance. Given the performance of the stock, investors who had the foresight to buy in early are likely to be sitting on both massive capital gains and also a huge yield on initial cost.

For those of us looking to invest now, it is imperative to consider the tradeoffs between dividend growth expectations and initial yields. In this article, I touch on the importance of dividend growth to stock prices, the effects of dividend growth on the yield of an investment, and where I find the “sweet spot” to be in the tradeoff between growth and yield.

Dividend Growth Drives Stock Prices.

As we are all aware, most companies in Australia pay dividends, typically twice a year. The good companies are able to raise their dividend every year. For those who don’t focus on dividends, this is a nice surprise, but for those of thus that focus on dividends, we understand that this dividend growth is what enables our compounding machine to work.

If you take nothing else from this post, I want you to understand this: dividend growth drives the compounding principle. The reason this is the case is because a stock that is producing dividends is worth more if it is producing higher dividends.

Growth %

Simple, right?

I’m going to say it again just so it sinks in. A stock that produces a rising dividend will become increasingly more valuable.

In order to further reinforce this point, I have created a simple table below. We start with a stock that is worth $20; the dividend is $1 per share. Then, we assume that the dividend grows at 5% per year. Check it out:

Year

Dividend

Yield on Cost

1

1

5.0%

2

1.05

5.3%

3

1.10

5.5%

4

1.16

5.8%

5

1.22

6.1%

6

1.28

6.4%

7

1.34

6.7%

8

1.41

7.0%

9

1.48

7.4%

10

1.55

7.8%

In year 10, the growth of the dividend means that the yield on cost has increased to 7.8%. This means that if our stock price was still $20, it would be trading on a 7.8% yield. If we assume, however, that the stock remains trading on a 5% yield (as was the case initially), then the stock price must have increased to $31.03. Although not the focus of this article, you should also be aware that reinvesting your dividends would mean that your principle has compounded far in excess of this 50ish percent increase.

Of course, this increase in prices is not guaranteed, and certainly won’t be a straight line, in any case. In fact, given the manias and panics in the market, a stock like this would almost certainly trade at one point on a 3% yield, and almost certainly at some point at a 7% yield. However, assuming everything else is equal, a stock price will rise as much as the dividend rises.

High Dividend Growth versus Low Dividend Growth

Unfortunately, stocks which have high dividend yields also very rarely exhibit strong growth characteristics. More often, potential investments fall into two categories: High Yield and Low Expected Growth or Low Yield and High Expected Growth. So which of these investments is more likely to deliver satisfactory returns?

There are a lot of companies currently listed on the ASX that I would expect to deliver strong dividend growth over the next ten years. These stocks have yields of 1.5% approximately. There are a number of other stocks which I would expect to generate moderate (mid single digit) dividend growth over the next ten years – these stocks as a generalisation trade on yield of 4.5%. Assuming the first group delivers dividend growth of 15% and the second grow at 5%, what do the potential yields look like after 10 and 20 years?

Year

Low Growth/High Yield

Yield on Cost

High Growth/Low Yield

Yield on Cost

1

4.5

4.5%

1.5

1.5%

2

4.73

4.7%

1.7

1.7%

3

4.96

5.0%

2.0

2.0%

4

5.21

5.2%

2.3

2.3%

5

5.47

5.5%

2.6

2.6%

6

5.74

5.7%

3.0

3.0%

7

6.03

6.0%

3.5

3.5%

8

6.33

6.3%

4.0

4.0%

9

6.65

6.6%

4.6

4.6%

10

6.98

7.0%

5.3

5.3%

11

7.33

7.3%

6.1

6.1%

12

7.70

7.7%

7.0

7.0%

13

8.08

8.1%

8.0

8.0%

14

8.49

8.5%

9.2

9.2%

15

8.91

8.9%

10.6

10.6%

16

9.36

9.4%

12.2

12.2%

17

9.82

9.8%

14.0

14.0%

18

10.31

10.3%

16.1

16.1%

19

10.83

10.8%

18.6

18.6%

20

11.37

11.4%

21.3

21.3%

We can see from the above that the hare will eventually catch the tortoise. In fact, in year 14, I’d imagine you would have an acute case of “I should’ve’s”. But consider the number of companies that currently exist that have grown their dividend at 15% for 14 years and have been paying dividends all the while – I’m certainly not aware of any (although I’d love to be corrected!).

Given the difficulty in growing at 15% a year for a sustained period of time, I believe that investors are best served by aiming for higher initial yields and lower, and more achievable, levels of growth.

My Rule of Thumb

My guideline has always been to attempt to achieve a 10% yield on cost as soon as possible. This means I typically aim for stocks that yield 4-5% and are growing at 5-8% or better. These stocks are certainly out there, and importantly, are often high quality companies. In addition, these companies often have a history of paying dividends, and are relatively mature, allowing you to both study recent dividend trends (stable or increasing growth rates?) and project future dividend growth trends with some certainty.

There are some catches here. Some cyclical companies may appear to be paying large and growing dividends during supportive periods in the cycle – this may be unsustainable if business conditions deteriorate. Make an effort to understand whether the business is affected by cycles or not. Commodity linked companies are great examples of this.

You should also be aware of companies with high levels of debt. Nothing can destroy a promising investment as quickly as too much debt – and given debt is more senior than equity, dividends will be cut to maintain required interest payments. Be particularly cautious of companies that take on debt to pay dividends.

Cyclical companies and companies with debt issues or other concerns may appear at first look to be very attractive yield stocks. You should be cautious with stocks with very high yields (9%+). These stocks typically do not fit the description of long term compounders.

Conclusion:

Its  my belief that higher yielding but lower growth stocks will help you achieve a better investment result than low yield but higher growing stocks. These companies are generally more mature, are more committed to their dividend, and have a consistency that allows an investor greater confidence in the future prospects of the company.

The growth of the yield should be greater than inflation, ideally much higher. It is the growth of the dividend yield that allows your compounding machine to get to work – so don’t look for stocks that are high yielding but with no growth prospects. This dividend growth also drives stock price growth – so the time spent identifying the future prospects of the business may be the most important part of the investment research that you perform.

(Disclaimer: The information in this piece is personal opinion and should not be interpreted as professional investment advice.  The author makes no representations as to the accuracy, completeness, suitability, or validity of any of the information presented. As always, seek professional advice.)

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