There’s an old saying on Wall Street that says, “Profits are a matter of opinion, but dividends are a matter of fact.”
As U.S. and global economies accelerate and companies earn fatter profits, dividends are the proverbial “area of interest” for fact-minded long-term investors.
While various data differs, dividends have a powerful impact on investment portfolio returns. Over a five-year horizon, dividends account for 42 percent of total portfolio growth, according to Chuck Carnevale of F.A.S.T. Graphs, an investment firm in Florida. At 10 years, that figure rises to 48 percent, and at 20 years it rises to a whopping 60 percent of total returns.
But what’s the best, and fastest, path to great dividend returns? That comes down to two dividend investment strategies. There’s dividend growth, which is the annualized percentage rate of growth that a particular stock’s dividend experiences over time; and there’s dividend yield, which is a stock’s annual dividend payments to shareholders, provided as a percentage of the stock’s current price.
Unsurprisingly, there’s a difference of opinion on which strategy is best.
The case for dividend growth. “We believe that the practice of paying a sustainable and growing dividend imposes discipline on a company’s management team,” says Sean Lynch, co-head of Global Equity Strategy at Wells Fargo Investment Institute. “This discipline tends to make management teams diligent users of capital and can result in a conservative balance sheet, the efficient generation of free cash flows and a consistent focus on core operations relative to peers.”
Lynch believes “everything” must be working in concert from a fundamental standpoint to be able to continually grow the dividend. “You must have top-line growth, there must be great operators, strong free cash flow growth and the balance sheet can’t be stretched,” he says.
[See: 7 Dividend Growth Stocks to Buy Now.]
Lynch says dividend growers are typically higher quality companies that have relatively strong cash flow and relatively lower debt ratios. “We believe that dividend growers should have a better ability to ride out uncertain and volatile environments and ultimately gain share over more operationally or financially levered competitors.”
The lifestyle conditions in play for a given investor should also weigh heavily when choosing dividend investment strategies.
“In general, if the dividends are to provide for living expenses, I would go for dividend growth so that income had potential to keep up with cost-of-living increases,” says Ilene Davis, author of the book “Wealthy by Choice: Choosing Your Way to a Wealthier Future.”
“But for someone with only a short time to live, for example, or if you need higher income for a short period of time, then the current yield might be more important,” she says.
The case for dividend yield. “The best strategy is dividend yields, which have sustainable growth in payout over time,” says David Winters, CEO of Wintergreen Advisers in Mountain Lake, New Jersey. “This way an investor has an increasing yield over time. Plus, this scenario protects the investors’ purchasing power and protects against increases in interest rates.”
“Companies with a history of increasing their dividend fit this description,” Winters says.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
A fixed- or low-growth dividend yield puts the investor at greater risk for loss of purchasing power or increasing interest rates, Winter says. “If a dividend growth stock is unable to grow, an investor will not have greater purchasing power and with higher rates the potential for capital loss,” he says. “Usually companies that have been able to grow their dividends over time represent lower risk with more upside for the investor.”
Evan Tarver, investments analyst at Fit Small Business in New York, also prefers dividend yield over growth. “Your dividend yield will tell you exactly how much a stock will pay out in dividends each quarter or fiscal year,” he says.
For example, if you know that Coca-Cola Co. (NYSE: KO) gives a dividend yield of 3 percent, you can bank on the company paying out its profits equal to at least 3 percent of the current share price, Tarver says. “Each quarter you can count on this happening, helping you better forecast your investment earnings.”
Dividend growth, on the other hand, while good, doesn’t tell you much about the payout of a stock, Tarver says.
“For example, if you know a thinly traded company has a 100 percent dividend growth, but it only paid out a 0.5 percent dividend last year, then the result is only a 1 percent dividend yield after the dividend growth,” he says. “Then what? Can we expect dividends to grow another 100 percent the next year? We really can’t expect current growth to continue into the future, making dividend yield a more predictable earnings measure.”
The best of both worlds. Naturally, there’s a third option for dividend investors that’s favored by money managers — let’s call it the “King Solomon” approach.
“If an investor is interested in dividend growth or dividend yield, the best solution is a mix of both,” says Aaron Milledge, co-founder of Targeted Wealth Solutions, in Erie, Colorado. “According to recent Vanguard research, dividend growth-focused strategies tend to have significant exposures to low volatility and quality factors. High dividend-yielding stocks tend to have exposure to value and low volatility factors.”
[See: Dividend Stocks vs. REITs: 7 Crucial Differences.]
Aside from the benefits of adding different factor exposure to the overall portfolio, sector-level diversification is aided by a mix of strategies that focus on dividend growth and yield, Milledge says. “As an example, comparing the WisdomTree U.S. High Dividend Fund ETF ( DHS) and the ProShares S&P 500 Dividend Aristocrats ETF ( NOBL) shows that despite a common concentration in consumer staples and health care, the funds have noticeably different weightings in the other sectors.”
Ask your financial advisor which dividend strategy works best for you, and start kicking some tires on one of the most impactful, reliable and profitable investment tools available.
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Dividend Stocks: Is Yield Better Than Growth? originally appeared on usnews.com
