Investors are often rightly drawn to dividend investing, especially following an historic run on equities of roughly 100% from the pivot bottom in 2009. While bracing for more reasonable, nuanced equity price increases moving forward, dividend investing is certainly a plausible approach to continue to return high returns in a low interest rate environment. However, there are two divergent approaches, each with their own risks and benefits:
Investing in High Yield Stocks
It can be tempting to target entry into high current yield stocks. Take Windstream Corporation (WIN) for instance, with its 7.5% yield. Even though investors have enjoyed a nice runup in shares over the prior year, let’s say moving forward, equities prices tread water. Wouldn’t it be nice to return 7.5% annually? That beats the heck out of 2% on a long-term CD and there’s the potential for capital appreciation.
The risk in targeting high yields is primarily that the issue will decrease the payout. In the case of Windstream, there’s a pretty strong history of 25 cent payouts each and every quarter going all the way back to 2006. This provides some assurance that moving forward (and especially as evidenced by an increasing stock price), one can reasonably expect to continue to realize that 7.5% yield from entry. However, when a stock yields double digits, that’s often a sign that the market has priced in a dividend cut. We saw this with numerous financials and industrials during the 2008-2009 financial crash. Many investors went after troubled companies chasing a 10-15% yield only to find those dividends cut to preserve capital within weeks of entry.
As a rule of thumb, there are some pretty steady sectors that have always provided historically high yields on a long-term basis high yield stock sectors, but yields over 10% are often a warning signal, and so is a declining stock price (which often artificially boosts the yield).
Investing in High Dividend Growth Stocks
Some investors shun high yield stocks for the risks mentioned above and instead focus on issues that are growing their dividend payouts rapidly. The thinking here is that it’s a long history of earnings growth that’s allowing the corporation to continually increase the dividend, and even though the current yield of say, 2.5% may seem low, it’s a formula for success when the dividend payout is continually increasing. Why? Because the dividend increases and underlying share price increases that ensue will take care of themselves.
If investors continue to imbue a stock with a steady yield range, but the company has been increasing the payout perennially, then obviously, the share price has to continue to increase to keep the yield steady. Additionally, rather than getting that same 25 cent payout every quarter for years and losing buying power in terms of present value, an increasing dividend keeps pace with inflation.
Personally, I have a mix of both types of stocks, you can check out my dividend portfolio here .
Which Approach Do You Favor?
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