Dividend investing has become popular. Interest rates have been falling for decades. Where can you go to generate income when the US 10-year Treasury bond pays 1.362%?1
That has led thousands of investors to dividends for income. Unfortunately, dividend investing for income is a terrible strategy.
I know, I know; the guy that wrote a dividend investing book is now calling it a terrible strategy. Let me explain.
When most people think about dividend investing, they think only about current dividends. This is a mistake. Over the years, I’ve looked at hundreds of investment portfolios. The most common issue I see is investors focusing way too much on dividend yield.
This past weekend, I was looking at a portfolio with an average yield of 7.5%. The highest yield was 15.5%. Now, I don’t know the person that owned this portfolio; I don’t know their situation.
What I do know is that focusing only on high dividend yields and nothing else can be disastrous. A high yield strategy can result in cut dividends, falling stock prices, and even bankruptcy.
A dividend strategy should not focus on maximizing today’s dividends; it should focus on maximizing dividends over the entire lifetime of the investor. The key question is not what today’s dividend is, but what it will be 10, 20, 30 years from now.
How a 2% yield can be higher than 6%
Consider two stocks – both trading at $100 per share. Stock A pays a $2 dividend. Stock B pays a $6 dividend. The investor focused on dividend yield alone would go for Stock B. A 6% yield is better than a 2% yield.
So, a dividend investor would clearly prefer the higher yield, right? That might be the case, but we need more information than that.
Let’s say both companies earn $6 per share. The only difference is how much of that they distribute. Stock B pays 100% of that $6 earnings as a dividend. Stock A only pays out 33% of its earnings to the dividend.
Now, which would you prefer? Again, the dividend investor prefers the higher dividend payout, right? It may seem like a higher dividend payout is better, but that’s not always the case. (More on that in a minute.)
We still don’t know enough information. Let’s say both stocks can earn the same 15% return on their capital. (Here's why ROIC is so important.)
Stock A pays out $2 as a dividend, which you can reinvest yourself. They reinvest $4 on your behalf back into the business. This $4 reinvested earns a return of 15%, which works out to an extra $0.60 per share in profits. If they payout the same rate, the dividend will go up by $0.20 from $2 to $2.20. Repeat year after year for a long-term dividend growth of 10%.2
Most dividend investors ignore the importance of retained earnings. You have to reinvest back into your business to grow. Home Depot can’t open new Home Depot stores without money to do it. Without money to reinvest, the business will stagnate.
Stock B is in that situation. They are paying out 100% of their earnings, so they can’t add new stores, build new factories, or whatever else they are doing. The only way to do it would be to add new capital; since they don’t generate extra capital, they must find it elsewhere. And that’s going to be costly.
Two Bad Alternatives: More Debt or Dilution
The only way for Stock B to reinvest in the business is to get more money from external sources. They can either (1) borrow the money or (2) issue new stock to other investors.
The problem with borrowing money is that lenders won’t like that they pay out 100% of profits as a dividend. Where exactly are they going to come up with the money to pay the interest? Hmm…
So that leaves issuing new equity – a common practice amongst large dividend yielding stocks. (Cough, cough pipelines cough, cough.)
If you pay a 6% dividend and then dilute shareholders by 6%, what’s the point? That's like giving you a $20 bill and requiring that they give you a $20 Amazon gift card in return. It makes no sense.
Future Dividend Growth
Let’s assume Stock B can somehow grow without any of these financial shenanigans.
If they could manage 2% per year, the dividend would grow from $6 to $8.07 per share after 16 years. If you had paid $100 per share today, your ‘yield on cost’ would be 8.07%. (That's $8.07 dividend in 16 years / $100)
Stock A is reinvesting 66% of its earnings at 15% per year, which means they can grow earnings at 10% per year. If they continue to payout 33% in dividends, Stock A’s dividend per share would grow from $2 per share to $8.35 after 16 years. A $100 investment today would have a ‘yield on cost’ of 8.35% in 16 years.
OK, so what? Why would you want to wait 16 years to get a higher dividend yield on cost when you could get it all now?
The Real Benefit of Dividend Investing
The income you get from a dividend stock is only one part of the equation; it’s actually the least important. The real benefit of dividend growth investing has to do much more with the relationship between the dividend and the stock price.
Let’s assume both Stock A and Stock B trade at a constant dividend yield. If that were the case, here’s what would happen to their stock price after 16 years:
- Stock A: $8.35 dividend / 2% = $417
- Stock B: $8.07 dividend / 6% = $139
The growing dividend stream pulls the price upwards over time. If there is a strong link between dividend growth and price growth, then we can assume that growing dividends will lead to growing prices. In this example, Stock A increases its price over 8 times more than Stock B.3
What about dividend reinvestment?
The flip side is that a higher dividend results in more money to reinvest in the stock, which we need to consider.
In the above scenario4, your Stock A investment would have 1.32 shares for every 1 you started with. Assuming a $8.35 dividend at a constant 2% yield, the stock would be worth $417 per share. Multiplying that by your 1.32 shares gets you to a total ending market value of $551.
Stock B had the higher dividend yield, so you were able to repurchase more shares. (This equation would change in later years.) You would have 1.96 shares for every 1 share you started with.5 A $8.08 dividend divided by a 6% yield equals $134 per share. Multiply that by your 1.96 shares and you get an ending market value of $264.
So Stock A growing a 2% yield at 10% would likely result in roughly 2x higher return than Stock B at the 6% yield growing at 2%.
What if future yields are not constant?
I can already hear some objections. What if Stock A doesn’t trade at a 2% yield anymore? A fair point.
Let’s say Stock A’s price drops 50% relative to their dividend the day after you bought it and never recovers.
Stock A's price in 16 years would be $8.35 dividend divided by 4% (or .04) equals $209.
At a 4% yield, you would accumulate 1.64 shares for every 1 you started with. The stock price is cut in half, but you accumulated twice the shares. So your ending market value would still be $342.
That’s still better than Stock B at $264, which we’ve assumed has no decline in stock price. (Not to mention they were able to magically grow 2% without any more capital.)
Focus on Dividend Growth, not Dividend Yield
If you have been focusing more on dividend yield than dividend growth, stop. Now. Dividend yield is a component of dividend investing, but it is not the only component. It’s not even the most important component.
Think about how the dividend will likely grow over the long-term, instead. (And I mean ‘long-term’ as in 10+ years.) If you get that right, you should be successful with the underlying stock price as well. If you can combine dividend growth, price growth, and dividend reinvestment, you have a well-oiled dividend growth machine.
Have you been focusing too much on dividend yield? Reply to this email and let me know what you think. I’d love to hear from you!
DISCLAIMER: This is not financial advice. This is not an offer to buy or sell any security. Past performance does not guarantee future results. Double check my calculations. (I can’t guarantee they are accurate.)
- Source: CNBC.
- 66% retained earnings * 15%
- $317 increase vs. $39.
- Assuming 10% dividend growth and a constant 2% yield
- Assuming 2% growth and a constant 6% yield.
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