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Dividend Growth and Inflation
Dividend investors are, generally speaking, looking for their stock investments to generate income. Many use that income to live off of in retirement. That said, there are two very different approaches to dividend investing. On one side of the ledger, investors simply look for large dividend yields. On the other, the yield is less important than the growth of the dividend payment over time.
An investor only interested in a high yield may be sacrificing future buying power. Indeed, a large, but static, dividend payment will be eaten away by inflation, rising living costs, over time. This is the same problem that bond investors face.
True, the value of a stock has a better chance of increasing over time than a bond that simply guarantees the repayment of principal. However, even if the stock’s value keeps up with inflation, a stagnant dividend disbursement will likely lead to principal being used at some point to pay for living expenses. Clearly, this is not the ideal situation for someone who intends to be alive for an extended period of time.
Thus, the other broad group of dividend-focused investors prefers to look at dividend growth instead of dividend yield. If a stock’s dividend growth outpaces inflation, then not only is the shareholder’s payment going to maintain its buying power—that buying power is actually going to increase over time. That sounds like an ideal situation.
The problem is that dividend growth tends to be fastest for companies with relatively low yields. This makes complete sense, since sustainable dividend growth is dependent on a company’s continued success and growth. So, many companies with impressive dividend growth rates are also the same companies putting up solid earnings growth. These companies typically catch the eye of Wall Street and are bid up.
This leaves something of a dilemma for investors looking to live off of the dividend income from their portfolio. Luckily there is a clear middle ground, where one seeks reasonable yields and more modest dividend growth rates. The percentages of each will vary with the market, but there are few rules of thumb that are worth using.
First, inflation has historically averaged around three to four percent a year. So, if an investor wants a dividend disbursement to keep up with inflation, a historical growth rate of 3%, or higher, should be the minimum acceptable. Moreover, there should be a high likelihood that dividends will grow at that clip or better in the future. Any companies that fall below that dividend growth threshold for a prolonged period should be replaced.
Value Line subscribers should examine the Annual Growth Rates box on each Value Line stock report to get a handle on dividend growth. Annualized growth rates for the past five and 10 years are presented, as well as the rate projected out over the next three to five years. It’s worth taking a quick look at the revenue and earnings figures in this section of the report, as well. Since a growing dividend stream needs the underpinning of a strong and growing business, seeing solid historical and projected growth on these two measures is important. Ideally, dividend growth rates will be below earnings growth rates, but that isn’t always the case and isn’t always concerning since dividends are technically paid out of cash flow—not earnings.
Second, investors have to be realistic about the dividend yield. A 10% dividend yield may be an opportunistic purchase or a red flag. The truth is that high yields are more often than not red flags. So treading carefully is important when examining yield. That said, there are some industries that tend to have higher yields, including utilities, real estate investment trusts, and limited partnerships (these securities have material tax consequences, so consult a tax advisor before delving too deeply here). The reasons for the higher yields vary from the fundamentals of the industry to the corporate structure of the businesses. Regardless, a focus on these groups can often result in a collection of stocks with generally higher yields and reasonable dividend growth prospects.
In addition to these select industries, many mature companies pay higher dividends than their smaller or more aggressive counterparts. However, some of these mature companies still have respectable dividend and earnings growth rates. So investors may not get a 10% yield, but 4% to 5% isn’t out of the question. This is particularly true if patience is part of the buying process (easier said than done, unfortunately).
Value Line subscribers might consider starting their research with the Safety Rank. The Safety rank is computed by averaging two other proprietary indexes, the Price Stability Index and the Financial Strength rating. Both of these measures are found at the bottom right of a Value Line report in the Ratings box. Safety ranks range from 1 (Highest) to 5 (Lowest). Dividend minded investors would be well served if they limited their purchases to equities ranked 1 (Highest) or 2 (Above Average) for Safety.
Companies with such high Safety Ranks are generally large, stable companies with the wherewithal to stand the tests of time. Having cut the universe of potential investments down to a manageable size, investors can then start looking at the best businesses that also pay dividends, collecting a wish list. While companies with high Safety Ranks tend to be more stable, price wise, the market fluctuates and often will put things on “sale” if investors can wait long enough.
What does sale mean? The rule of thumb used by many in the finance industry is that 4% of a portfolio can be withdrawn on a yearly basis without undue risk of depleting the portfolio. Well, if an investor can get 4% or better dividend yields backed by a dividend that has a history of growing over time, then he or she is in even better position since no money needs to be withdrawn at all to support that 4%.
Using the Dow Jones Industrial Average as a starting point, some companies that dividend investors may wish to review include: AT&T (T - Free AT&T Stock Report), Verizon (VZ - Free Verizon Stock Report), and Merck (MRK - Free Merck Stock Report) all have dividend yields above 4%. (Note that all three are members of the so-called Dogs of the Dow club.) The two telecom giants have historical and projected dividend growth rates that are generally around the inflation rate, and earnings and revenue growth that has historically been supportive of that dividend growth. Projections for earnings and revenues appear healthy, too. That said, AT&T looks most promising. All three companies have top-notch Safety Ranks (1, Highest).
This is, however, a list of just 30 companies. There are hundreds of stocks that earn Safety Ranks of 1 or 2. Value Line subscribers can start their search using the online screening tools available in the subscriber sections of valueline.com or examine the screens in the back of the printed Summary & Index each week—one screen specifically lists the companies with Safety Ranks of 1 and 2.
In the end, investors seeking dividend income would be well served by looking for a middle ground between dividend growth and current income. It may take a while to create an appropriately balanced portfolio, but that extra time will likely be worth it in the end.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.