How Low Yield Dividend Stocks Can Fit Into A Dividend Growth Portfolio by Ben Reynolds, Sure Dividend

This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Rock. He is a passionate investor.

Not so long ago, Ben reached out to me to update this guest post where I wrote about low yielding dividend stocks.

More than ever, I think low dividend yield stocks should get more attention from dividend growth investors. This is why I accepted to rework this article and add more insight about the topic.

Since I started writing about dividend growth investing, many investors question my choice of adding low yielding dividend stocks to my portfolio.

“Your dividend yield is too low, why do you pick a 2% dividend yield stock when you can buy shares of companies offering over 5% in yield?”

They keep asking.  The answer is, it all depends on your investing strategy.

In this article I will share how low yielding stocks can bring growth to a dividend portfolio.

As with all serious investors, I have my own set of minimum requirements when filtering stocks to start my research for a new addition to my holdings. Here are the first metrics I look at:

  • Dividend yield over 2.50%
  • Dividend payout ratio under 80%
  • 3yr/5yr Dividend growth positive
  • 3yr/5yr EPS growth positive
  • 3yr/5yr Sales growth positive
  • P/E ratio under 20

These metrics are only setting the basics of my stock filter to find my next purchase. I manage my portfolio according to the following dividend growth investing principles:

Principle #1: High Dividend Yield Doesn’t Equal High Returns
Principle #2: Focus on Dividend Growth
Principle #3: Find Sustainable Dividend Growth Stocks
Principle #4: The Business Model Ensures Future Growth
Principle #5: Buy When You Have Money in Hand – At The Right Valuation
Principle #6: The Rationale Used to Buy is Also Used to Sell
Principle #7: Think Core, Think Growth

I also separate my portfolio into two segments: Dividend Stocks & Growth Additions.

The Dividend Stocks represent my core portfolio; this is where I will keep companies for years or decades. They meet all of my minimum requirements.

The Growth Addition part of my portfolio has companies that do not meet all of my metrics, but show great upside potential.These shares are meant to be part of my holdings for a shorter period ranging from six months to three years. The goal is to seize an opportunity and cash in the profit quickly. This is when low yield dividend stocks should not be ignored.

Why Pick Low Yielding Dividend Stocks?

I currently hold a few low yield dividend stocks in my portfolio:

  • The Walt Disney Company (DIS) pays a 1.46% yield
  • Apple (AAPL) pays 1.87% yield
  • Canadian National Railway (CNI) pays 1.82% yield

When I wrote on my blog that I was buying Disney about two years ago, many readers were wondering why I would even call Disney a dividend stock with such a low dividend yield. But I was looking at the forest, not the tree in front of me.

The point of picking a low dividend yield stock is to appreciate strong dividend growth companies with lower yield.

The main reason why I believe in dividend growth investing is because solid companies can afford to pay dividends. Then, incredible companies can afford to increase their dividend payments year after year.

Shaky companies can’t keep increasing their dividend on a consistent basis. No matter what the yield is, the fact that a company keeps increasing its dividend payment is a good sign of a solid enterprise. The focus on dividend growth instead of dividend yield is at the very center of my investing strategy.

Do you know what Disney, Apple, and Canadian National Railway have in common?

They all beat the S&P 500 over the last five years:

dividend stocks

The Key Point: Is There Growth?

In my opinion; growth is more important than the dividend yield. When I consider growth, I look at two types of growth: the stock value growth and the dividend payout growth.

Disney is showing a huge potential for the years to come due to its domination in sports broadcasting (ESPN) and its ability to produce blockbuster movies year after year. Their $4B acquisition in 2013 of Lucas Film, makers of Star Wars will probably be their best investment of the decade. We saw how the acquisition boosted their revenue recently with the first Star Wars movie. The company is also showing another growth factor through theme parks as they will celebrate the opening of their brand new Disney Shanghai this year.

But Disney is not only showing stock value growth, the dividend payout follows along the way. An investor who bought DIS in 2009, paid around $30 for a share and received a $0.35 dividend. Today, the share is just shy of $100 and pays a dividend of $1.42 per year. The 1% dividend yield of 2009 is now a 6.45% dividend yield based on that investor’s cost of purchase on January 2009. In another 5 years, it will probably pay around 10% dividend yield.

Apple is known more for its incredible growth since the early 2000s. This giant of innovation’s image pales over the past two years as financial analysts became more and more greedy. We all know the mobile industry (Apple gets 50% of its revenues from the iPhone) is highly volatile and the leader of today’s market can rapidly become a dinosaur in three years (Do you still remember Blackberry?).

But Apple is more than a phone company, its product ecosystem is probably the most perfect of all companies. There are many more innovations to come from this tech company and many more dividend payouts increases too. Apple started paying dividends in 2012 ($0.38/share) and now pays a $0.52 dividend. The company is generating over $50B per year from its operations. With a payout ratio of 22% and cash account showing billions, you can expect Apple to keep paying more to investors.

Canadian National Railway represents the first in class of railroad operators in North America. If there is only one reason to buy Canadian National Railway, it is probably the fact that there are no other railway operators in North America with such a low operating ratio.

We all know how costly it is to build, manage and maintain railways annually while truckers don’t have to pay a penny to construct highways. This is where Canadian National Railway has become the top of the line railway operator with an operating ratio of 54% last quarter. In comparison Canadian Pacific (CP) is at 59.8%, CSX (CSX) at 71.6% and Union Pacific (UNP) at 63.2%.
But if you need more reasons, here are plenty:

  • 5 year revenue growth of 11.22% CAGR,
  • 5 year EPS growth of 14.64% CAGR,
  • 5 years dividend growth of 15.40% CAGR,
  • Very low payout ratio of 27.39%

How Long do You Keep Low Yield Dividend Stocks?

The length of time to hold such companies is not really a concern in your portfolio.

As you can see, there is an important factor not to underestimate: the capacity of low yield dividend stocks to increase their dividend payout.

The three companies cited in this article will definitely pay a 5% yield based on your cost of purchase in five years from now if they keep increasing their dividends at this pace.

Therefore, if they keep posting strong results, they could very well become a part of my core portfolio instead of just figuring in the “Growth Addition” segment.

Only the future will tell, but I would rather pick stocks with strong metrics paying a low but constantly increasing dividend payout to relatively high yield dividend stocks with very limited upside potential in the upcoming five years.

I challenge you to find a high dividend yield stock showing similar growth in both stock value and dividend payout over the past 5 years. I bet it doesn’t exist.

The reason is simple: we are living in a very low interest environment, any stock paying over 5% yield definitely shows additional risks compared to lower yield stocks. Mature markets, limited growth possibilities, dying industries, volatile financial results, imminent threats to the business model… these are usually the reasons why stocks show a high dividend yield.

I’m not ready to take such risk in my portfolio.