Peters: Look Beyond Dividend Growth

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. How should dividend investors weigh growth versus current yield? I'm joined today by Josh Peters, the editor of Morningstar DividendInvestor and also our director of equity income strategy, to take a look at this question.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: This balance between dividend growth and current yield, is this a real trade-off? Is this something investors need to be focused on when they're building a dividend portfolio?

Peters: Well, it always seems that I am pushing back against whatever the most popular theme of the day is, even within the universe of dividend-paying stocks. When people are really interested in those fat, juicy yields, then I'm the one that saying, "No, no, no. You always need to have at least some growth and you need good protection for the dividend." There's nothing better than a growing dividend to signal to you that the underlying dividend itself should be safe.

But at other points in the market, say when interest rates are going up and people are wanting to participate in a faster-growing economy, then it's dividend growth that is all the rage, and people tend to forget about current yield. When you start talking about, say, a 15%, 20%, 30% dividend increase from a company, that's great. But if the stock still only yields 1% or 2%, I think you need a little richer mix of income within that.

Glaser: You mentioned that dividend-growth investing is very much in fashion now. How is that generally defined? What does it mean if someone says they're pursuing a dividend-growth strategy?

Peters: I think in the consciousness of the market, the way I get a sense of what dividend-growth investing is in the collective mind of the market, it's got less emphasis on current yield. Very often you find dividend-growth investors looking for yields that are no better than the market average around 2%, or sometimes less than 2%. Instead, what you're looking for are either companies that have very high rates of dividend growth, 15% or 20% a year or more over some extended period of time. Obviously, there are some questions about how long any kind of growth rate like that can be sustained.

[Or the second thing you're looking for are] companies that have shown very consistent records of dividend increases in the past. Mergent maintains a very popular list called its Dividend Achievers list. A company has to have raised its dividend without interruption for 10 straight years or more to make it into the Dividend Achiever category. There's a very large, very popular exchange-traded fund that's based on that approach, called Vanguard Dividend Appreciation, ticker symbol is VIG.

Standard & Poor's also has a list called Dividend Aristocrats, which requires 20 or 25 years [of dividend increases] to make it onto that list. So certainly you are getting something different from these kinds of companies in terms of quality compared with just the run-of-the-mill dividend-paying stock.

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Glaser: What's wrong with those strategies, or is anything wrong with those strategies? It seems like having that long track record of dividend increases would be a positive for investors.

Peters: Well, it is. I don't want to knock it because over time it has worked relatively well. A company that makes a point of raising its dividend every year without fail is certainly emphasizing to investors that its dividend is important. They also have to run the business in such a fashion so that they have the financial strength to pay the dividends in the downturns without cutting them, and in fact continuing to raise them, as well as planning ahead and making those investments in future growth that are required to support dividend growth many years in the future.

The drawbacks, I think, are more just around the rigidity of this list-based approach. When you look at a company that's raised its dividend every year for 10 years or 20 or 30 or 50, that's no guarantee of what might happen next year. You need to have some more forward-looking analysis in order to pick the best dividend-paying stocks.

Within that, there are some companies that have come out of the gate either through spin-offs or in some cases through IPOs, and we were able to make it very clear that they were going to raise their dividends immediately right out of the gate. Do you really want, say, for Phillip Morris International, one of my favorite recommendations right now, to have to wait 10 years of getting dividend increases every year before that stock becomes eligible for your strategy.

When Philip Morris was spun out of Altria in 2008, it had zero for a record of consecutive dividend increases. But right off the bat, you knew that they had inherited that old Altria/Philip Morris DNA. Chances were they were going to raise the dividend every year, and they have. Thus far, they were spun out in 2008; you've had five years of dividend increases since then. It's going to be another five years before a company like that comes on to the list-based approach.

So, you don't necessarily want to hold yourself back from a company that meets all of your other criteria, including the likelihood of consistent annual dividend growth going forward, just because it doesn't meet some arbitrary list.

Glaser: [So you are saying that] thinking about the growth of the dividend is still important, but it's just you need to look forward and not backward and figure out where that dividend is going to go?

Peters: You always have to look forward; that's where your returns actually are going to be.

Glaser: How about those cases where dividends have the potential to grow very quickly for any number of reasons? Could this strategy of trying to find stocks that could rapidly grow the dividend be successful?

Peters: I think there's potentially some merit there, too, but it's very important again to go on a case-by-case basis and be that good old-fashioned shoe-leather stock-picker as opposed to just going off a list or a quantitative approach. If you look at the S&P 500 over the last five years, the fastest dividend growth rate is UnitedHealth, the big health insurance company. But how did they get a 90%-plus annualized rate of dividend growth? Well, the dividend that they started with was tiny. It was just $0.03 a share a year. Even now the stock still yields much less than the S&P 500 average, and I don't think that the growth of that dividend, impressive though it may be in percentage terms, has really had all that much to do with the total return that the stock has been able to generate.

Now if the dividend goes on to double from here and yield above the market average, those future dividend increases become more meaningful. But even beyond that, if a company is raising its dividend quickly, is it a function of, say, just buying back lots of shares, like IBM is doing? IBM could afford to pay a much, much more generous dividend, but they want to spend the money on share buybacks instead, and because of that choice IBM has a very run-of-the-mill type of yield in the 2% area. How much more attractive would that stock be for income investors if, let's say, it had half the dividend growth rate, so let's say, 8% instead of 16% or 17%, but yielded 4% or 5% instead of 2%. I think that that would actually be a very positive trade-off for a stock like IBM to be able to execute.

Then you've got some good old-fashioned growth stories. I cited a few in the November DividendInvestor cover story, like Fastenal. ITC Holdings is a very attractive business that's concentrated in electrical transmission infrastructure. These companies should be able to generate those double-digit dividend increases for a while longer. The questions are: "What's priced in, and what happens when the growth rate slows?"

When I've bought stocks with yields around 2% for the DividendInvestor portfolios, I have tended to get pretty poor results. I think in six or seven out of seven or eight cases, my returns lagged the market because the growth slowed. The dividend wasn't growing as fast, and earnings per share weren't growing as fast as I expected. And when the growth slowed, then the yield on the stock had to come up, which meant basically the stock price had to just stagnate or even drop in order to provide that higher yield.

So I think it's actually better to find a company that's got that mature mix of a sustainable long-term rate of earnings growth that can power the dividend increases going forward as well as an above-average yield that's there for downside protection.

Glaser: If the screens are too rigid then and some of these fast-growing dividend yields might be off a low base and still not provide that total return that you need, should investors look for that proverbial bird in the hand and just go for high yields? How do you balance those two then?

Peters: To me, I look at it as a very simple formula. Let's say, you want a 10% average total return, kind of a generic type of long-term return from stocks. If you get a 3% dividend yield, then what you're looking for is 7% dividend growth and hopefully capital appreciation, long-term capital gains, that correlate to those increases in the dividend. And a 3% yield being much above the market average helps that process along. It's not just forming a solid baseline for your total returns. It's also making sure that those dividend increases are meaningful in a real sense that they should, in fact, encourage the stock price to go up.

If you own a stock that, say, yields only 1%, the dividend might grow 20% a year, but nobody expects that kind of growth rate to be sustained. So that kind of math of the return you are expecting minus the dividend yield is the growth you need to get that kind of breaks down.

I like a 3% [yield] plus 7% [growth], I like 4% plus 6%, I like 5% plus 5%. I don't want necessarily yields of 8%, 9%, 10% because they're usually unsafe and unstable. But it's really in the middle of that spectrum where I'd find the best mix of yield and growth that provides safety, provides consistency, provides a lot of income, certainly a lot more than the market overall, or for that matter, what you could get from bonds, as well as a good level of growth. That sweet spot, I think, is where investors will get the most bang for their buck.

Glaser: Josh, thanks for talking with me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I’m Jeremy Glaser.

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