High Income vs. Dividend Growth
A quick look at the Dividend Strategy section of Seeking Alpha will reveal several authors who review their portfolios on a monthly basis. A lot of these focus heavily on a dividend growth strategy, picking equities which may not blow away the S&P 500 in terms of yield but have the potential for annual dividend raises and capital appreciation. A few others emphasize high yield, professing to not even care about what happens to the price of the stock or fund as long as the income stream remains intact. Both strategies have their ups and downs. Dividend growth offers a higher potential for capital appreciation but at the cost of lower current income. It also places more emphasis on estimating future performance and cash flows, which are inherently less certain. A high income strategy often accepts lower future growth in exchange for higher current income. Successful security analysis in this strategy depends more on understanding the balance sheet and the ability to cover dividends at the current rate.
The best income portfolios are therefore a blend of both strategies, with the mix depending on the income needs of the individual. A younger person of working age who has income from their job can focus more on dividend growth, while a retired person may be counting on their portfolio for a significant portion of their income. I would argue, though, against going 100% to either side of the spectrum. 2020 has been a challenging year for many high income investments, including energy stocks and MLPs, hotel REITs, and some bond funds as interest rates collapsed. Dividend growth has undoubtedly been the winner this year, but after having been in favor so long, many of these securities are approaching nosebleed valuations. Those who can remember back to the early-2000’s dotcom collapse recall that even high quality tech names lost years worth of capital gains while value stocks held up much better.
How To Read Articles Like This One
I suggest readers keep the following questions in mind whenever reviewing an author’s portfolio performance, including mine which I present below.
- How does this portfolio balance growth and income? What is the author’s age and income need and how does it compare to mine?
There is one young millennial author on this site who publishes a portfolio summary monthly. It definitely skews toward the dividend growth strategy, although even he has a few REITs, pipelines, and high-yield, low growth stocks. He’s had a stellar year, beating the S&P 500 by over 10 percentage points as of the end of August. Still, his portfolio yield is only a bit over 2%. The outperformance clearly comes from what I like to call the “F MAGA” stocks, Facebook (FB), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOG) (GOOGL), and Apple (AAPL), which made up nearly 30% of his portfolio. To be clear, I’m not criticizing this approach or calling it lucky. I appreciate the analysis that went into picking these names and the courage it took to continue riding them up as valuations got higher and higher. This is exactly the right approach for a younger investor. Personally, though, as someone older who wants more income, I’m willing to forgo high growth in 2020 for higher yield as long as there is some expectation that some out-of-favor names and sectors can play catch-up in terms of valuation.
- Does the author provide clear performance data?
I see a lot of articles where the author promotes achieving a certain dollar amount of income each month, or even a percentage growth of income vs. last year. This isn’t very meaningful without knowing how much of the change was driven by security selection and how much was from new contributions to the portfolio. Some authors provide an average yield but neglect to disclose total return. While total return in the short term may depend on which stocks are in or out of favor, it is obviously an important consideration in the long term and should be disclosed.
- Is the author providing the full picture or just the equity portion?
It’s not always clear if the portfolio that the author discloses is a comprehensive list of all their investments. There may also be an allocation to cash, individual bonds, speculative stocks, or alternatives not covered in the article. Despite the low return of most bonds, a 100% dividend-paying equity portfolio may not be the best choice for everyone. Consider for yourself whether a more diverse asset allocation is needed.
With the caveats noted above, this is my portfolio which I rely on for a significant portion of my income. I have followed the example of another author and grouped the 38 securities into six categories: Core Dividend Growth (36%), High Yield (28%), High Dividend Growth (14%), Non-Dividend (11%), Special Circumstance (<1%), and Cash and Low-Risk Fixed Income (10%).
My usual activity on Seeking Alpha involves analyzing these securities individually, usually around an earnings report or significant news item. Please see my author page for links.
Core Dividend Growth – These are reliable annual dividend raisers with strong underlying business to support the dividends. I trade these very infrequently as you can see from the low cost basis on many of them, indicating a multi-bagger capital return. Average yield is 2.39%, which is superior to the S&P.
High Yield – These include some lower growth stocks that nonetheless have either the cash flow or balance sheet to support at least a continuation of the dividend. They also include preferred stocks, REITs, MLPs, and unconstrained bond funds. Some names in the last three categories mentioned were subject to distribution cuts in 2020. The MLPs and hotel REIT were also hit hard by the pandemic in terms of capital gains. I believe this to be temporary and expect prices to recover as pandemic impacts recede next year. Diversification kept the overall impact on portfolio capital gains and yields low. The resulting forward yield for this group remains an attractive 7%.
High Dividend Growth – These are stocks which have either enjoyed large capital gains (Thermo Fisher (TMO), Visa (V)) or are newly issued (Carrier Global (CARR)) and so have a low current dividend yield of around 1% or below. As I have written elsewhere, I like the business models of all three and believe the potential exists to raise dividends considerably if management prioritizes doing so over paying down debt or buying back stock.
Non-Dividend – This currently includes only Berkshire Hathaway (NYSE:BRK.A) (BRK.B). While the company itself does not pay a dividend, it is famously known for investing in companies that do, or for negotiating preferred stock deals with companies on far better terms than the average investor can get in the market. Berkshire has been a drag on the portfolio, but can turn into a tailwind if value investing comes back in style.
Special Circumstance – This small bucket includes the warrants left over from the Bristol-Myers (BMY)-Celgene merger as well as a speculative investment in the SPAC DiamondPeak Holdings (NASDAQ:DPHCU), soon to merge with electric truck producer Lordstown Motors (RIDE). You can read more about DPHCU and Lordstown here.
Cash and Low Risk Fixed Income – This includes a muni bond fund (Nuveen Ohio Quality Income Municipal Fund (NUO)) which recently raised its dividend even faster than I anticipated, as well as a couple of individual muni bonds. There is also a ladder of investment or near-investment grade corporate bonds with 1 to 4 years maturity. These could all be sold to finance a more attractive investment if one comes along with low risk of having to take a capital loss. The 3.65% yield on this bucket beats the 0.03% yield I can get in my broker’s money market fund.
I normally write a comprehensive review of my performance at year-end and mid-year. YTD through 10/5/2020, my portfolio has a total return of 0.95%, including 2.32% of income (non-annualized). As you can see from the table above, the forward annualized income yield is 3.29%. The total return compares unfavorably to the 6.84% YTD total return of the S&P 500 index fund (SPY), mainly due to the absence of the F MAGA stocks in my portfolio. Nevertheless, it compares favorably to most popular high dividend and dividend growth ETFs. Performance of the high dividend and dividend growth ETFs from State Street, iShares, and Vanguard are shown below.
|ETF||Goal||Capital Gain||Income||Total Return||Current Yield|
Year to date, my portfolio is beating the three dividend growth ETFs on income and all but the Vanguard Dividend Appreciation ETF (VIG) on total return. It is soundly beating all the high dividend ETFs on total return. Even with some high yield securities that had sizeable price declines and/or distribution cuts, and even with a short-term underperformer like Berkshire Hathaway, I was able to generate more income and stay competitive on total return compared to a passive dividend growth strategy. I am satisfied with this result and believe I can start outperforming the SPY if market sentiment turns toward value investing and away from F MAGA.
As you can see from the above table, the main advantage of my blended allocation is that it produces much higher income without the need to select and sell any holdings. Compared to both the benchmark SPY and dividend growth VIG, my portfolio generates nearly twice the income (3.3 / 1.7 = 1.94x). There is no denying that a current disadvantage is a lower total return compared to these two funds, but this has not been a permanent disadvantage and need not remain one in the future.
As shown in the chart below, my portfolio was a steady outperformer vs. the S&P in the first decade of the century, beating it in all years except one. During the 2010s, results shifted to a slight underperformance but not missing much except during the big up years of 2013 and 2019.
Looking at in terms of relative cumulative performance, we see that the outperformance in the 2000s leaves me ahead of the SPY even with the lower performance in the 2010s.
Cumulative performance, starting 12/31/2000
Going forward, there is no guarantee that my strategy will resume outperformance, but it is hard to argue that the “F MAGA” stocks which have been a big driver for the S&P vs. my portfolio are not very richly valued. I expect a market sentiment to swing toward value and income, and one may already be taking place. Here is another value index vs. NASDAQ 100 chart like I included at the beginning of this article; this time since the last market peak in early September. In a little over one month, the value index has outperformed by over 5%.
iShares S&P 500 Value ETF (IVE) vs Invesco QQQ ETF Sep.-Oct. 2020
I believe my portfolio is in good shape to benefit from this swing. Investors who have benefitted by having a large allocation in the high growth stocks may wish to trim a portion and reallocate to a mix of my core dividend growers and high yielders. My favorite ones at this time would include financial common stocks, financial preferreds (if below or not far above par), and any of the core dividend growers that have not run up strongly because of the “stay-at-home” COVID trade. Younger investors who don’t need the portfolio income may want to start a position in Berkshire Hathaway to gain an indirect stake in the dividend growers among that company’s investments. Most of Berkshire’s fully-owned companies are also strong cash generators whose cash flow is retained for now but may be paid out at some time in the future.
A pure dividend growth strategy sacrifices some current income to achieve higher capital gains over the long term. It can be a good strategy for younger investors who do not require the current income. A high dividend strategy can be risky as the high yield could be a sign of an upcoming dividend cut, or it could simply mean the security is out of favor and it may take some time for the market to recognize the value. Some combination of both strategies can be optimal depending on the age and income needs of the investor. Higher yielding securities can be a healthy income booster for any portfolio provided they have the balance sheet and cash flow to continue the dividend. Those are the fundamentals on which investors should focus when selecting high yield securities. If the research suggests these are in good shape, then you just need the patience and fortitude to hang on through then inevitable market volatility. The reward will be a continued high level of income along with the potential for capital appreciation when the cycle eventually swings and growth stocks lose their momentum.
This is a different type of article than the individual security analysis articles I most often write. I hope it was a useful higher-level topic to cover before earnings season ramps up. I’d appreciate any feedback on the content, level of detail, or requests for related topics readers would like to see. Likes and Comments are welcome.
Disclosure: I am/we are long BRK.B, CARR, DPHCU, NUO, TMO, V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long all securities listed in the first table.