This is part two in our new series of blog posts, in which we’ll create a fantasy portfolio, from scratch, and track it over time. In our first post we decided on a dividend portfolio, and when it comes to dividend portfolios, there are two main strategies: yield or growth. For this project we’ve decided on a dividend growth portfolio, but this article will go over the basics for both yield and growth stocks, in order to build a comprehensive understanding of dividend stocks.
Dividend Yield refers to the amount per share price paid in dividends, whereas dividend growth refers to how much those dividends increased over whatever time period you’re interested in (generally a year.) Usually, stocks are considered one or the other (a dividend yielder or a dividend grower), though, like anything, there are exceptions.
Whether or not a company is a dividend yielder or a dividend grower depends on a couple factors, one of which being how the company is situated in the market. A smaller company probably does not have the earnings yet to dole out a lot in dividends, but as it expands its business it has the potential to grow those dividends more quickly over time. On the flipside, a larger, more established company may not have a lot of room in the market to grow their earnings, so it may choose to reward stockholders with a hefty yield, but one that grows slowly.
In this blog post we’re going to discuss each type, using AT&T (T) and Comcast (CMCSA) to demonstrate the principles; T will be our yielder, and CMCSA will be our grower.
Dividend yield is calculated by dividing the dividends per share by the price per share. So, at the time of this writing, CMCSA was trading at $55.61 per share, and is paying out $0.90 per share in dividends (over the course of a year), making its yield $0.90 / $55.61 x 100 = 1.6%. T, on the other hand, was trading at $34.12, but is paying out $1.88 in dividends per share, making its yield 5.5%. Despite the fact that T has the lower price, it pays a higher dividend—this is why T is the yielder: you get more bang for your buck, so to speak.
As a general rule, a stock is considered a yielder if it’s dividend yield is 3% or above. But higher isn’t necessarily better—a dividend yield that’s too high, say north of 7%, can indicate that the company isn’t using earnings to invest in its business, which could lead to trouble down the road. It can also indicate that the market expects the company to cut its dividend in the future—if investors expect a dividend cut, they could sell their shares, causing the price to fall and so driving up the current yield. In order to assess whether or not the dividend yield is too high, investors often look at the Payout Ratio, which is the dividends per share as a percent of diluted earnings per share. These can vary quite a bit by sector, but as a general rule, anything north of 50% can stray into unsustainable territory (though, like many metrics, looking at how the payout ratio is changing overtime is useful as well.)
Because yield is calculated as dividends/price, a high yield doesn’t necessarily mean a high dividend—instead it could mean a depressed price. When this happens, the stock is called an “accidental yielder,” and while it’s not by itself a bad thing, it underscores the importance of knowing not only what the dividend yield is, but also why it is at that level. If you find a high yield stock, you’ll want to know if it consistently has that yield, or if it’s because the stock’s price is lower than normal. If it’s the latter, it’s important to know why the stock’s price is lower—was it a temporarily dip, or does it speak to a broader weakening in the business?
Dividend growth measures how much the dividends are growing year over year. Last year, T paid out $1.84 in dividends per share, and this year it promises to pay $1.88, meaning it’s only growing that dividend by 2.2%. CMCSA, on the other hand, didn’t pay out as much ($0.90), but it’s grew those dividends 15.4% over the previous year. With a growth rate like that, it will eventually catch up to T in the amount of dividends per share that it pays out. If we take a look at their Dividend per Share chart over the past the 10 years (the bottom chart in the image below), we can see this happening: the line for T (blue) is increasing very slightly, while the line for CMCSA (orange) is increasing more rapidly. With this trajectory, they’ll cross at some point in the future, and CMCSA will pay the same amount in dividends per share as T—potentially with a growth rate that continues to be higher than that of T. (Note that the bottom chart shows quarterly dividend payouts, not yearly.)
I should note that even if they were paying the same amount in dividends per share, their dividend yields wouldn’t be the same because they’ll (almost certainly) have different prices, which further illustrates the importance of using several metrics to gauge the quality and quantity of dividends you are getting.
Of course, if you’re investing in stocks, it’s not just the dividends that you’ll be looking at—you’ll also be paying attention to total return. In the chart above, notice that not only are CMCSA’s dividends increasing at a faster clip, but since the beginning of 2012 the stock itself has massively outperformed that of T. And while this is only just one example, we can use Stock Rover to look at a larger sample size of dividend yielders and dividend growers and see how they have performed in the past. First, let’s take a look at the criteria in each of these screeners (the Yield Screener is available in the Library, and the Dividend Growth screener has been slightly modified from the one available in the library.):
Below you can see a chart of our Yield Screener charted against our Dividend Growth screener. Note that these are not back tested, so this is showing how the stocks that currently pass our screeners have done in the past five years.
You can see that our current dividend grower stocks (orange) have outperformed the current yield stocks (blue) by quite a lot over the past five years, so we hope that this trend will continue for our dividend growth portfolio (even if it is just being financed by fantasy money.)
It’s also important to note the inflation rate when you are considering your investments. Currently, inflation is quite low (1.3%), so we haven’t included it on our discussion because it’s not high enough to be a real factor. But it’s important that even high-yielding, slow-growing stocks have a dividend growth that is above the inflation rate. If not, then you’d actually be losing on that dividend in real terms year after year.
In addition to thinking how the dividend would perform in inflation, it’s important to think about how the underlying business would do as well. If a company has pricing power, it will better be able to adjust to inflation than if it doesn’t have pricing power. For example, airlines and hotels can easily readjust their prices to reflect the current inflation rate, but companies with long-term leases like utilities and REITs would have less flexibility. We’ll keep this in mind when we actually pick our stocks for the portfolio.
Let’s return to our original examples of T and CMCSA. In order to demonstrate how you’d have done with each one, let’s construct two portfolios, each with just $10,000 of each one of the stocks bought on January 3rd, 2005. This comes out to about 456 shares of CMCSA (bought at $21.91) and 391 shares of T (bought at $25.59). Then, let’s go into the Portfolio Reporting facility in Stock Rover to see what the return of these two portfolios would have been since their inceptions.
Here you can see that even though T brought in over $6,300 in dividends to CMCSA’s roughly $1,700, CMCSA gained 174.4% in the time period, while T was up 65.6%. But this aligns with what we expected (and what we saw in the first image of this post)—T is an older more established company, whereas CMCSA has more room to grow its market share.
If we go to the Risk and Reward tab of Portfolio Reporting, we can see that this performance didn’t come risk-free. CMCSA was not only more correlated with the S&P than T was (0.96to 0.87), but also had a beta above 1, meaning that on average CMCSA moved more than the market did. Relatedly, CMCSA was more volatile than T. But, despite all that, its risk-adjusted return versus the S&P 500 was 13.7%, whereas T’s was 11.8%.
It’s our goal with this project to build a portfolio with stocks like CMCSA—stocks that are growing their dividends quickly, and that have the price appreciation to match. In our next post, we’ll take a closer look at dividend safety—or how likely it is that those dividends will be cut (or not.)