Investors need to optimize total return with a good mix of dividend yield, growth, and quality, says Morningstar's Josh Peters.
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By Josh Peters, CFA | 01-24-14 | 06:00 AM | Email Article

A version of the following article first appeared in the November 2013 issue of Morningstar DividendInvestor. Download a complimentary copy of DividendInvestor here.

Josh Peters, CFA, is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks, and is author of The Ultimate Dividend Playbook (John Wiley & Sons, 2008). Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor. Click here for a free issue of DividendInvestor.

What is dividend growth investing?

That might seem like a strange question to ponder in the pages of DividendInvestor. Except for a few preferred stocks we bought on extremely favorable terms in 2009, we have always insisted on getting dividends that will grow over time. Since there is generally a trade-off between yield and growth, my conception of a dividend growth stock is any issue whose expected long-term dividend growth rate exceeds its current yield. On that basis, all 18 stocks in DividendInvestor's Builder Portfolio qualify as dividend growth stocks, as do eight of the 18 holdings of the Harvest.

 

However, I don't think our approach--even in the Builder--is the best reflection of what most investors think a dividend growth strategy is. Based on my reading of the market's collective consciousness, a dividend growth strategy seeks either 1) companies that have raised their dividends every year for at least 10 years in a row, or 2) double-digit rates of annual dividend growth over long time horizons.

All else being equal, it's very hard to argue against these attributes. I prefer a long history of dividend increases over a short one, and more dividend growth over less. Emphasizing dividend growth over current yield also seems to chime with the times. Investors are concerned about the impact of rising interest rates on high-yielding stocks, and it's plausible that more growth-oriented issues could outperform when the economy eventually moves out of first gear.

Yet all else is rarely equal. A clockworklike pattern of dividend hikes over the past 10 years can help us find and evaluate potentially worthwhile stocks, but far more important is what will happen over the next 10 years. Rapid dividend growth can be a meaningful driver of total returns' too, but the nature of rapid growth is that it eventually has to slow--and most fast-growing dividends provide below-average yields. As in so many other aspects of investing, we must deal with trade-offs. 

Though I require dividend growth to round out a good total return, I strongly prefer above-average yields even if it means giving up some growth. It's not just about current income: The total returns strike me as more attractive given the risks.

Dividend Achievers: Past or Future?
The concept of "Dividend Achievers," companies with at least 10 years of uninterrupted dividend growth, was popularized by a division of Moody's that is now known as Mergent. Mergent continues to publish quarterly guides in book form. No less an authority than Peter Lynch said, "Buy the stocks on Mergent's list and stick with them as long as they stay on the list." Standard & Poor's later came up with its own "Dividend Aristocrats" list, requiring 25 years for companies in the S&P 500 or 20 years for members of the S&P 1500 (an index that combines the large-cap S&P 500, the mid-cap 400, and the small-cap 600). Lists like these have been used to create several exchange-traded funds, the largest of which is  Vanguard Dividend Appreciation .

I like many of these "achievers" and "aristocrats" too; my intention here is anything but disrespect. Still, one essential element of their nature has never escaped my attention: All the stocks that make the list get there on the basis of past performance. Past may be prologue, but it's far short of a guarantee. Dozens of dividend growth streaks ended in ignominy in 2008 and 2009, including those for the vast majority of financial services firms. Moreover, it's not necessarily much of an achievement if all that matters to a company is staying on the list.  Consolidated Edison has a 39-year streak of dividend growth going, but in the past 20 years the average annual dividend increase has been just 1.2%--half the rate of inflation. 

Rummaging through the DividendInvestor portfolio archives, I discovered that only about half of our purchases qualified as dividend achievers when I first bought them. Of those that didn't have 10-year streaks in place, half of those hadn't yet been public companies for a full 10 years, which can't help but rule them out of an achiever approach. But as long as I am satisfied that earnings are going to grow and management will reward shareholders with rising dividends, I don't need to wait for a 10-year record to be established. Achiever status is helpful, but there's no reason it should be necessary. 

In fact, had I required 10-year or longer records of dividend growth before buying, I could not have acquired any of the eight stocks that have turned out to be our best performers. This group is led by  Magellan Midstream (purchased in 2008, at which point its growth streak was eight years long),  Compass Minerals (purchased in 2005, less than two years after it came public), and  Philip Morris International (spun off from  Altria in 2008, purchased in 2010). Why would I have wanted to wait until 2018 for Philip Morris to mark 10 years of uninterrupted dividend growth when that was a highly probable outcome right from the start? Yet had I been using a 10-year dividend growth threshold, I still could have bought five of our eight worst-performing stocks, including  Allstate , Developers Diversified Realty (now DDR ), and Associated Banc-Corp

Overall, stocks we bought that were not dividend achievers at the time have outperformed those that have--a conclusion that surprised even me. The achievers have provided an average total return of 18.5% while we've owned them, a result that fell 4.6% short of the S&P 500 over comparable holding periods. Meanwhile, the non-achievers (or achievers-to-be, in many cases) provided us with an average total return of 35.0%, beating the S&P by 10.1%. 

Maybe I'm just not that good at selecting stocks from the ranks of dividend achievers. Sometimes I've been late to the party, such as in the case of  McDonald's . I could and should have bought this dividend achiever many years before I finally did in October 2012, but since I climbed aboard, the company's profits have stagnated and the pace of dividend growth has dropped (temporarily, I think). But the Vanguard Dividend Appreciation ETF sets up an interesting test. Which is better, a pure-achiever strategy, or the more flexible DividendInvestor approach? 

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Josh Peters, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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