Market turmoil, rising recession fears and increasing concerns for the global economic outlook have left many investors looking for ways to defend their portfolios while searching for potential pockets of upside. One investing strategy that is proving popular with factors like market volatility, inflation, and rising rates currently present is dividend investing, the process of investing in dividend-paying companies that have historically provided both reliability and growth over time.
Two common approaches to this strategy are targeting either dividend growth or a high dividend yield. Dividend growth investing focuses on identifying companies that have a track record of increasing their dividend payments annually, while high dividend yield seeks out companies that pay a high percentage of their earnings as dividends. Both approaches have their merits, but what makes these methods so attractive to investors? In this article, we will explore the pros and cons of targeting dividend growth versus high dividend yield.
Dividend growth investing focuses on companies that consistently increase their dividend payouts over time and can provide investors with a steady source of cash. These dividend-growing corporations are typically well-established, soundly managed companies with a solid financial foundation, a long track record of profitability and are typically viewed as less risky investments. These corporations tend to have stable earnings, consistent cash flows, a long-term growth plan and a commitment to returning value to shareholders. They also tend to experience durable competitive advantages, diversified revenue streams and strong balance sheets that allow for continued revenue growth throughout the complete market cycle.
Dividend aristocrats are a perfect example of these ‘dividend growers.’ These companies have a strong track record of steadily raising their dividend payments to shareholders, with requirements for a company needing to have raised its dividends for at least 25 years in a row and be included in the S&P 500 index to qualify for the title. Some examples of these companies include Coca-Cola, McDonald’s, and Exxon Mobil.
But what is the attractiveness of these dividend growers to investors? Companies that concentrate on consistently increasing dividends typically have higher-quality, cash-rich operations that perform well in both up and down markets. Dividend payments can also act as a buffer for investors, helping to offset losses in times of market declines while providing excess returns throughout the rest of the market cycle. For income-focused investors, these companies can also provide a long-term consistent flow of dividends, while providing the potential for consistent capital appreciation and can prove effective as essential defensive holdings within a portfolio.
High dividend yield investing, on the other hand, focuses on generating a steady stream of income from dividend payments, rather than solely relying on capital appreciation. The strategy targets businesses that offer attractive higher-than-average dividend yields. These corporations are typically highly established companies that have better-developed business models, steady and predictable cash flows and typically depend less on expansion to produce returns. High dividend payers have traditionally been found in the materials, utilities, and consumer staples sectors, as companies in these spaces generally provide goods and services with relatively inelastic demand.
However, investors should be wary of chasing high dividend stocks as all might not be as it seems. Most high dividend yields are also typically artificially high due to falling stock prices or other monetary problems, with these companies offering a lower prospect of capital growth for the portfolio. Investors also need to consider the repercussions of a business which distributes a large portion of cash generated to investors, with a lack of reinvestment into the business undermining its long-term prospects. This may result from a lack of attractive reinvestment opportunities, with excess cash therefore used to attract new investors, creating demand, and raising the price of their stock. As a result, analysis of the sustainability of the business model and the underlying financial performance is key for investors wanting to avoid businesses that carry the greatest risks, while considerations regarding the value of the underlying business and prevailing market conditions are key.
Let us take a look at a numerical example. An investor is considering the purchase of two different stocks, where Stock A is a high dividend-yielding business and Stock B is a dividend grower. If the investor wants to purchase two hundred shares of Stock A priced at £25 per share, they will incur a £5,000 initial investment. The stock in question pays an annual dividend of £1.13 per share (dividend yield of 4.5%), with the investor expecting a total return in dividend payments of £226 in the first year. If you were to disregard capital appreciation and assume that the dividend stream is continuous without growth, the payback period on the investment is 22 years. The payback period is the length of time it takes for the cash inflows generated by the investment to equal the initial investment which, when calculated, can help to establish a baseline performance or worst-case scenario.
However, if we were then to compare this to Stock B that is also priced at £25, with an initial annual dividend payment per share of £0.75 (dividend yield of 3%) the first-year total dividend returns would equal £150. Nevertheless, if this dividend growth stock managed to grow its dividend stream at just 5% annually, the investor would recoup the whole initial investment in just 20 years. In other words, the payback period for the dividend growth stock would be two years shorter. This dividend payback matrix model does make an assumption that the expected dividend growth is consistent throughout the period but can still be used to highlight the power of compounding dividend growth.
This numerical example can also be used to highlight some of the key strengths of high-yield dividend investing. The initial income generated by the investment in Stock A is significantly higher than Stock B. In fact, the total annual income generated is greater than Stock B for the first 11 years. High yield investing can provide investors with a significantly larger income stream annually which can, depending on the investor’s objectives, either be reinvested or taken out.
When taking a look back at the previous 45 years, companies that have consistently grown their dividends have been lead performers in the market, including when compared to other companies that simply maintain payments. Additionally, the outperformance has been achieved while also demonstrating lower volatility of returns, providing a more stable investing experience for investors. During periods of market uncertainty, the predictable nature of the businesses’ earnings and cash flows can make the stock less volatile, less exposed to sell offs and more recession resistant.
The defensive characteristics that are shown by these companies by being able to maintain and grow dividends throughout challenging periods can result in them being a critical allocation for investors. Companies with consistent cash flows and strong pricing power tend to be better positioned than competitors to maintain margins in the face of rising costs and interest rates. Due to their relative stability, absolute returns of defensive, dividend-paying companies have performed better than the S&P 500 Index during economic downturns, periods of high inflation as well as the previous six rate hike periods since the 1980s.
In conclusion, both dividend growth and high dividend yield investing have both their merits and shortcomings. Dividend growth investing can provide investors with a growing income stream over time, while high dividend yield investing can offer investors a significant income stream in the short term. Ultimately, the best approach will depend on the investor’s goals and risk tolerance. Investors seeking long-term growth and stability may prefer dividend growth investing, while those seeking a high-income stream may prefer high dividend yield investing.
This article was taken from the
Spring 2023 issue of
1875. To subscribe to our investment publications, please visit
www.redmayne.co.uk/publications.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.