Can a huge dividend yield make up for lower dividend growth?

Ever been attracted by those stocks that have offered those huge dividend yields? The big, slow growers that give you 6%, 6.5%? It’s hard to resist the temptation to add them to your portfolio. Even if they don’t get their dividends cut at some point down the line, they may be doing your dividend income harm. Here’s why. 

 

I know that I have often been tempted by those dividend stocks that have these massive yields. 6%, 7% etc. I’ve occasionally jumped on them as well. My purchase of Telstra was done at an effective entry yield of almost 10.5%!

The big yielders may not be all that you think they are.

Sign of Dividend Cut

An excessively high yield (anything greater than 6% I’d argue), can often be a sign that the stock market has little confidence that the dividend can continue to be paid. It likely also means that the stock market expects the dividend to be cut.

For those of you who were in the markets during the 2008-2009 period, it wasn’t uncommon to see yields on bank stocks and REIT’s balloon above the 10% mark. In fact it was almost a daily occurence at one point picking whose dividend would be the next to get cut.

Many of the major banks including Citi, Bank of America etc had their dividend yields blow out to 8% plus during this period before they were all forced to cut their dividends.

But even beyond the prospects of a dividend cut, the high yielders also likely mean low dividend growth. It’s a rare mispricing where you can have a stock yielding 6% that can grow its dividend consistently at rates greater than 10%.

More likely, its probably only able to increase its dividend to a maximum of 5% a year. (But if any of you are aware of a 6% yielder that’s able to increase greater than 10% p.a, let me know, I’d love to have some of that action!).

So if you have the choice between a 6% yielder with 5% growth, and a 4% yielder with 10% growth, which way should you go.?

Part of the answer to this question may come down to your near term need for dividend income and how old you are. If you are approaching retirement and need to get that retirement nest egg in order really quick, then a high yielder may be a good place to look at putting your money.

You may also want to secure some quick dividend income if there is some uncertainty in your financial situation (ie potential loss of a job) and you are looking for some additional cash to hold you over.

Longer term Payoff

If however you aren’t in such a critical need of income and you have a slightly longer term horizon, I would almost always suggest looking toward the lower yielder that is growing faster.

Lets take a look at the difference in yearly dividend income between the 6% yielder growing at 5%, and the 4% yielder growing at 10%. We’ll assume $10000 is invested in each stock and no reinvestment of dividends.

Yr 1 Yr 5 Yr 10 Yr 20
6% Yield, 5% inc 600 729 931 1516
4% Yield, 10% inc 400 586 943 2446

As you can see in the table above, it doesn’t take long for our faster grower to start closing the dividend income gap.

Within 5 years, that gap has narrowed significantly from a $200 initial deficit to less than only $144.

You can see that the faster grower breaks even at the Year 10 mark (that’s when the dividend income from the 4% yield stock growing at 10% p.a actually exceeds the 6% stock growing at 5%p.a).

And by Year 20? The 4% yielding stock brings us an extra $900 in annual income!.

Dividend growth stocks that have a lower initial yield yet faster growth take a longer period of time to make up the difference, but if you have a long holding period (which hopefully you do as a dividend investor), you can really start to get a strong dividend payoff toward the back end of your holding period.

Personally, I feel I’m at the point where I can start to be a little more patient and wait for some of my lower yielding, yet faster growing dividend stocks to build up their dividend streams and return substantial income over the long term.

It does take discipline to look past that initial shortfall that you face with some of these faster growing, lower paying dividend stocks however.

So next time you have a choice between that high yielding, slow growing utility or bank stock and that faster growing smaller company, take some time to do some considered analysis, because the faster grower could deliver you a big windfall over the long term!

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