Low yield is worth considering

Starting with stable, well established, consistent dividend growth payers should be part of the core of any investor’s portfolio. However there may be a case to look a little further afield to players that have lower yield.

 

Dividend payers that have moderate to high yield is a great way to construct a dividend portfolio. Having these dividend payers in one’s portfolio will help provide some income stability to the portfolio, as well as stock price stability. These companies have developed strong competitive advantages and have generally been able to construct wide moats for themselves over many years.

McDonald’s  and The Coca-Cola company  are two examples of companies that are anchor points of my portfolio.

A large, well known brand and operational efficiency give McDonald’s a sustainable competitive advantage and economic moat. With a current yield of 3.4%, McDonald’s has raised its dividend each and every year since first paying a dividend in 1976 and has had dividend growth of almost 19% annually over the last decade.

Similarly, intellectual property and distribution scale give the Coca-Cola Company a large economic moat. With a current yield of 3%, the Coca-Cola Company has had dividend growth of close to 8% annually over the last decade. The Coca-Cola Company has been paying a dividend since 1920 and has increased its dividend in each of the last 50 years.

However it has occurred to me recently that in spite of their bullet proof competitive advantages, McDonald’s and Coca Cola may be approaching a level of maturity in their core businesses. This doesn’t necessarily mean that they will be poor dividend payers, rather their rate of dividend growth may not be as pronounced as it has been in the past decade.

In McDonald’s case, there appears to be ongoing sluggishness in same store sales growth particularly in core North American and European markets. McDonald’s appears to be suffering a little from consumer trends towards healthier eating options and away from fast food.

One of the things that propelled McDonald’s spectacular growth over the past decade was an increase in operating margin from 18.6% in 2004 to over 30% in 2014. That level of improvement is unlikely to be seen over the next decade, which means McDonald’s will be reliant on top line revenue growth to sustain similar dividend income growth.

Coca Cola has been the subject of investor concern over the last couple of years. The reasons for this seem to be fairly obvious. US market growth has been pretty weak, with consumer preferences trending away from carbonated beverages to healthier options. Coca Cola has been investing in these healthier options, but it will take additional time to reposition the business to derive significant revenue from tea, juice and water segments.

The point is all businesses have a natural growth cycle where they go through a period of rapid growth and then approach a period of maturity in their business. Maturity generally leads to a period of growth slightly above inflation. While there is no suggestion that McDonald’s and Coca Cola have fallen to such low levels of growth yet, emerging operational issues in the business are indicative of things to watch out for.

So where does low yield fit into this picture? Both McDonald’s and Coca Cola are well established businesses who are no longer growing through a period of rapid rollout or expansion and thus have surplus capital which they can comfortably afford to pay out to shareholders rather than reinvest in the business.

This can be contrasted with Visa and MasterCard, both of which are experiencing rapid growth and consequently have significant opportunities to reinvest in their core business. Both Visa  and MasterCard  Inc. have paltry dividend yields but provide large dividend growth.

Visa is not traditionally thought of as a dividend growth stock due to its relatively small yield of 0.8%, but it has provided dividend growth of 33% annually since 2009. For those with a longer-term time horizon, Visa offers significant growth potential from its exposure to emerging markets as well as trends in mobile point of sale acceptance. Both should significantly accelerate revenues and drive future dividend growth.

Visa and MasterCard are still growing businesses. Unlike McDonald’s and Coca Cola, they are still riding growth trends in their core markets as the cash to credit cycle continues to accelerate and credit card acceptance starts to become established in international markets. Hence Visa provides a payout ratio of less than 20%, compared to McDonald’s at just less than 60%. Eventually, as Visa and MasterCard successfully harvest growth opportunities in their business, the cash flow that is currently being reinvested will be surplus to requirements, and likely paid out as dividends.

The point is a dividend portfolio that is balanced from a yield perspective will provide investors with dividend players who are able to ramp up dividend payments and increase dividend income, as more established dividend players mature and provide less dividend growth. To attain such a portfolio, investors need to cast an eye towards those dividend stocks that provide less in the way of dividend yield today, as it will be these stocks that provide significant dividend income as the core dividend portfolio ages.

While it may be counter intuitive for dividend investors to cast an eye toward low yield players, these same dividend stocks can offer significant dividend growth, which will lead to a meaningful dividend contribution in the medium term, and also act as a natural hedge as portfolio components transition from moderate dividend growth to low dividend growth as they move into a maturity phase of their business cycle.

Comments

  1. Completely on board with this plan. The core should be started around the KO, MCD, PEP, PG, JNJ, XOM but adding in the low yield/high growth counterparts is almost imperative in my opinion for someone with a 20+ year time horizon.

  2. Couldn’t agree more! A well balance portfolio isn’t just based on asset allocation between industries and sectors, but among high growth, low yielding stocks and low growth, high yield, and everything in between. Yield can provide an immediate boost to one’s numbers, but growth is what makes a dividend stream sustainable.

  3. I think it is important to consider diversity in any dividend portfolio. Not just chasing returns and yields. I will let you sleep at night.

  4. Integrator,

    Absolutely.

    I try to diversify between what I call the “3 stages” of dividend growth stocks. You have your stocks with lower yields, but higher growth rates, your stocks with higher yields and lower growth rates, and then your “sweet spot” stocks like KO where both the yield and growth are both moderate. I think there is room for all three in a dividend growth portfolio, but the mix will depend on one’s time horizon. If I were 60 I’d be weighted heavier toward Stage 1 stocks like T, VZ, O, etc. But at my age I have room for a company like V, which is why I’m a shareholder.

    Best regards!

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