High Dividend or Dividend Growth Investing: Which is Better?
Posted at July 24, 2022, midnightAs a new investor or someone who wants to become a more savvy investor, it's important to know the differences between investment types and what they can do for your portfolio. You'll make more informed investment decisions if you understand the basics of investing and clear up any confusion you may encounter along the way.
Beginners and novice investors often struggle with figuring out the difference between dividend and growth investments and determining which to choose.
Let's have a look at that, starting from the basics.
What are Dividends?
A dividend is a payment authorized by a company's executive board to shareholders who are of record on a particular date. The dividends are a way for companies to return some of their profits to shareholders. Typically, dividends are paid as cash and calculated as a share price percentage. The directors' board can determine the interval at which dividends are paid.
There are two major subcategories of dividend stocks:
- Dividend growth stocks: These stocks have a higher potential of increasing dividend rates in the future.
- High dividend stocks: High dividend stocks, on the other hand, are those stocks that may or may not increase their dividend rate in the future since they pay out a high dividend rate.
Dividend growth stock investors focus on dividend growth. On the other hand, high dividend stocks investors focus on the distribution size.
Dividend Yield and Dividend Growth
Two main reasons typically drive dividend investors to dividend stocks.
Dividend Yield
The dividend yields are generated by dividing dividends paid annually by the current share price. When a stock pays an annualized dividend of $2 per share and is currently trading at $50, it has a dividend yield of 4%. The dividend yields would fall to roughly 3.6% if the stock price rose to $56 per share. While the dividend payout remains the same, the stock's price rise would decrease the dividend yield. So have in mind that dividend yields typically change daily according to stock price movements.
Both increased payouts and price declines can cause high dividend yields. For investors, it's crucial to look beyond dividend yields when choosing stocks with high yields to determine why the dividend is high and if it will be sustained. The higher the dividend yield, the higher the risk associated with the investment.
Because of the company's poor performance, the higher yield may indicate that the company wants to attract investors who otherwise would not buy the stock.
Dividend Growth
The other way to invest in dividends is to look for companies with a good track record of increasing dividend payouts. It generally indicates that the company is financially stable and well-run.
Maintaining and increasing dividend payouts each year indicates that the company is growing its bottom line and generating solid cash flow.
With dividend investing, you can generate a stream of passive income from your portfolio, regardless of whether you invest in high-yield companies or those with growing payouts.
Is Dividend Investing a Good Strategy?
Dividend investing can be a highly effective investment strategy for investors. This strategy allows investors to reinvest their cash dividends in additional shares or fractions of shares without incurring any commissions or fees when dividends are paid.
This strategy is beneficial for investors who are investing for the long term since shareholders will receive compounded returns over time. By increasing dividends, investors receive more income per share, which can be reinvested to buy more shares.
Dividend stocks are often attractive to investors who are seeking lower-risk investments, particularly those nearing retirement, because of their low volatility.
What is a Growth Strategy?
Growth investing involves investing in stocks that increase in value over time. Growth investors only invest in stocks if they believe they will increase in value significantly over time. This purchase may be influenced by several factors: a relatively low stock price, a company's financials, trends in the market, or a company's competitive advantage.
There are many different growth investing strategies, some of which hold a stock for a short period of time (1-2 years or less), while others hold a stock for 20+ years without ever selling it. Typically, these investors are only concerned with capital appreciation and are not concerned with dividends.
Why is Dividend Growth Important?
Income investors often overlook value metrics. With a well-designed dividend growth strategy, you can achieve dividend growth without sacrificing attractive yields.
Over the past decade, dividend strategies have spread throughout the market as investors sought attractive yields. Consequently, traditional high dividend payers have outperformed the market as a result of this attitude. Despite this, many of these large-cap companies still hold excessive debt due to the low-interest rate environment.
Investors have shifted their focus away from high-yield stocks to companies with a history of growing dividends. Some of the high dividend payers cannot compete with companies that have been paying out steady dividends for decades. All domestic large-cap and small-cap stocks benefit from this regardless of their size.
In a dividend growth strategy, you allocate a greater share of your portfolio to companies that
pay dividends with a steady growth over time. With such an allocation, investors are protected against volatility and interest rate rises, as well as a slowing economy. Dividend growth strategies don't allow sectors or company sizes to limit their asset selection. Rather, it emphasizes fundamentals tied to the value of a stock. Our screener and analyzer gives you the right toolbox to find such enterprises with just a click.
How to Implement a Dividend Growth Strategy
The key to a successful dividend growth strategy is to focus on quality, not quantity - that is, to look for value stocks with proven dividend payout tracks and strong fundamentals. In addition, they should be able to reinvest earnings at regular intervals thanks to a long-term investment horizon. In any market cycle, long-term sustainability and growth require this approach.
When putting a strategy into action, investors should consider the following factors:
- Consider the fundamentals of the sector.
In addition to being a key part of a successful investment strategy, sector diversification is also vital to dividend growth. Growth strategies tend to be more diversified across sectors instead of focusing purely on yield. By doing so, you will be able to manage your stock portfolio profitably when interest rates are rising, and volatility is high.
Dividend growth strategies look for companies with strong balance sheets and sector fundamentals rather than simply loading up on utilities, consumer staples, and financial companies.
- Pay attention to dividend growth pioneers.
The size of a dividend yield is a much better indicator of company performance than dividend activity since the dividend is generated from the company's underlying earnings. Therefore, earnings forecasts, free cash flow or even better operating cash flow, and buybacks play an important role in your dividend stock selection. In addition to this, these factors position the company for future dividend increases. A high yield does not provide that protection.
You can also add real value to your portfolio by investing in dividend growth leaders, which increase their payouts faster than inflation. Average inflation is expected to reach 2% annually, but recent data suggest prices are climbing faster than expected. Investing in stocks that increase payouts quickly is an excellent strategy.
What is more Important – High Yield or Dividend Growth?
One must is to control risk in many areas when investing in dividends over the long term. Choosing unsound companies, purchasing dividend-paying companies whose dividends are in jeopardy, creating an insufficiently diversified portfolio, and so on are all forms of risk.
So have in mind that the initial yield and expected growth rate of the dividend are two areas of risk for a long-term dividend strategy.
But let’s have look what result ends up with the better average return per annum over time.
First, we have a look at dividends with a lower yield at the beginning but with a higher rate of dividend growth.
| Example: lower Yield - higher Growth | |||||||||||
| 4.26% | 3.83% | 820.35 | 383.07 | 1,203.42 | |||||||
| year | Dividend Yield to total Return p.a. |
Dividend Growth |
Inflation | Real Dividend Yield |
Value of Investment (nominal) | Development Investment (adjusted by Inflation) |
Dividends | Total | |||
| 0 | 3.00% | 5.00% | 2.00% | 3.00% | 1,000.00 | 1,000.00 | 30.00 | 1,030.00 | |||
| 1 | 3.15% | 5.00% | 2.00% | 3.09% | 1,000.00 | 980.39 | 30.88 | 1,041.27 | |||
| 2 | 3.31% | 5.00% | 2.00% | 3.18% | 1,000.00 | 961.17 | 31.79 | 1,053.84 | |||
| 3 | 3.47% | 5.00% | 2.00% | 3.27% | 1,000.00 | 942.32 | 32.73 | 1,067.72 | |||
| 4 | 3.65% | 5.00% | 2.00% | 3.37% | 1,000.00 | 923.85 | 33.69 | 1,082.93 | |||
| 5 | 3.83% | 5.00% | 2.00% | 3.47% | 1,000.00 | 905.73 | 34.68 | 1,099.50 | |||
| 6 | 4.02% | 5.00% | 2.00% | 3.57% | 1,000.00 | 887.97 | 35.70 | 1,117.44 | |||
| 7 | 4.22% | 5.00% | 2.00% | 3.67% | 1,000.00 | 870.56 | 36.75 | 1,136.77 | |||
| 8 | 4.43% | 5.00% | 2.00% | 3.78% | 1,000.00 | 853.49 | 37.83 | 1,157.53 | |||
| 9 | 4.65% | 5.00% | 2.00% | 3.89% | 1,000.00 | 836.76 | 38.94 | 1,179.74 | |||
| 10 | 4.89% | 5.00% | 2.00% | 4.01% | 1,000.00 | 820.35 | 40.09 | 1,203.42 | |||
| Investment t-0 | 1,000.00 | ||||||||||
| Value incl. Dividends t-10 | 1,203.42 | ||||||||||
| Avg. Return (real) p.a. | 2.03% | ||||||||||
Alternatively, let’s have a look at dividend with higher yield and lower growth rate.
| Example: higher Yield - lower Growth | |||||||||||
| 6.40% | 5.78% | 820.35 | 577.77 | 1,398.12 | |||||||
| year | Dividend Yield to total Return p.a. |
Dividend Growth |
Inflation | Real Dividend Yield |
Value of Investment (nominal) | Development Investment (adjusted by Inflation) |
Dividends | Total | |||
| 0 | 5.00% | 3.00% | 2.00% | 5.00% | 1,000.00 | 1,000.00 | 50.00 | 1,050.00 | |||
| 1 | 5.15% | 3.00% | 2.00% | 5.05% | 1,000.00 | 980.39 | 50.49 | 1,080.88 | |||
| 2 | 5.30% | 3.00% | 2.00% | 5.10% | 1,000.00 | 961.17 | 50.99 | 1,112.64 | |||
| 3 | 5.46% | 3.00% | 2.00% | 5.15% | 1,000.00 | 942.32 | 51.49 | 1,145.28 | |||
| 4 | 5.63% | 3.00% | 2.00% | 5.20% | 1,000.00 | 923.85 | 51.99 | 1,178.80 | |||
| 5 | 5.80% | 3.00% | 2.00% | 5.25% | 1,000.00 | 905.73 | 52.50 | 1,213.18 | |||
| 6 | 5.97% | 3.00% | 2.00% | 5.30% | 1,000.00 | 887.97 | 53.01 | 1,248.44 | |||
| 7 | 6.15% | 3.00% | 2.00% | 5.35% | 1,000.00 | 870.56 | 53.53 | 1,284.56 | |||
| 8 | 6.33% | 3.00% | 2.00% | 5.41% | 1,000.00 | 853.49 | 54.06 | 1,321.55 | |||
| 9 | 6.52% | 3.00% | 2.00% | 5.46% | 1,000.00 | 836.76 | 54.59 | 1,359.40 | |||
| 10 | 6.72% | 3.00% | 2.00% | 5.51% | 1,000.00 | 820.35 | 55.12 | 1,398.12 | |||
| Investment t-0 | 1,000.00 | ||||||||||
| Value incl. Dividends t-10 | 1,398.12 | ||||||||||
| Avg. Return (real) p.a. | 3.98% | ||||||||||
As a first result, the higher dividend yield beats the higher dividend growth with a difference of 1.95% in average return per annum. An additional question is, what increasing rate is needed to achieve the same result?
| Example: What Growth is needed to get results like in first example?! | |||||||||||
| 6.52% | 5.78% | 820.35 | 577.77 | 1,398.12 | |||||||
| year | Dividend Yield to total Return p.a. |
Dividend Growth |
Inflation | Real Dividend Yield |
Value of Investment (nominal) | Development Investment (adjusted by Inflation) |
Dividends | Total | |||
| 0 | 3.00% | 12.93% | 2.00% | 3.00% | 1,000.00 | 1,000.00 | 30.00 | 1,030.00 | |||
| 1 | 3.39% | 12.93% | 2.00% | 3.32% | 1,000.00 | 980.39 | 33.21 | 1,043.61 | |||
| 2 | 3.83% | 12.93% | 2.00% | 3.68% | 1,000.00 | 961.17 | 36.77 | 1,061.15 | |||
| 3 | 4.32% | 12.93% | 2.00% | 4.07% | 1,000.00 | 942.32 | 40.71 | 1,083.02 | |||
| 4 | 4.88% | 12.93% | 2.00% | 4.51% | 1,000.00 | 923.85 | 45.07 | 1,109.61 | |||
| 5 | 5.51% | 12.93% | 2.00% | 4.99% | 1,000.00 | 905.73 | 49.90 | 1,141.40 | |||
| 6 | 6.22% | 12.93% | 2.00% | 5.52% | 1,000.00 | 887.97 | 55.25 | 1,178.89 | |||
| 7 | 7.03% | 12.93% | 2.00% | 6.12% | 1,000.00 | 870.56 | 61.16 | 1,222.64 | |||
| 8 | 7.93% | 12.93% | 2.00% | 6.77% | 1,000.00 | 853.49 | 67.72 | 1,273.29 | |||
| 9 | 8.96% | 12.93% | 2.00% | 7.50% | 1,000.00 | 836.76 | 74.97 | 1,331.52 | |||
| 10 | 10.12% | 12.93% | 2.00% | 8.30% | 1,000.00 | 820.35 | 83.00 | 1,398.12 | |||
| Investment t-0 | 1,000.00 | ||||||||||
| Value incl. Dividends t-10 | 1,398.12 | ||||||||||
| Avg. Return (real) p.a. | 3.98% | ||||||||||
The dividend growth has to be 12.93% yearly with a investment that has a dividend yield of 3% in t-0 to achieve the same investment result with parameters of 3% growth rate and 5% dividend yield at the beginning.
The Dividend Sweet Spot - Combining Higher Yield and Growing Dividend
For dividend investors, there's a third option that money managers prefer – the sweet spot of total dividend return.
It is best to mix higher yield and growing dividend if an investor is interested in both. Investing in dividend growth strategies has a high level of exposure to low volatility and quality factors. There is a high correlation between dividend-yielding stocks and low volatility factors.
As shown in the diagram, the left (vertical) axis indicates the dividend's likely growth rate. There is a wide range of growth rates, ranging from less than 3% per year to up to 20%. The dividend yield is shown at the bottom (horizontal axis), from low (lower than 3%) to high (greater than 10%).
There are four places in the red area you would normally avoid. The reason is as follows:
- The stock's yield is too low on the left edge of the chart, so it is unattractive because of alternative investments with higher return.
- In the right margin, there is a labeled "Yield Traps." High yields can be good, but only to a certain extent. Extremely high yields are often a sign of trouble. There is probably a reason for the high yield: the stock's price has plummeted. A long-term dividend strategy is unlikely to cut dividends on the best dividend stocks.
- Dividend growth rates above the top edge are called "Growth Traps." These are places where high dividend growth rates are probably not sustainable.
- Dividend growth rates less than 3% are unattractive because their should be an incentive to be better than the average inflation rate.
Conclusion
Growth investing and dividing investing are viable investment strategies for all ages, and they can also be combined. Considering the dividend sweet spot traps you can have a focus of around 9% (yield + growth as an easy application). However, depending on your financial situation, you should prioritize which investment strategy to pursue. Understanding the underlying financials of a company can help investors make informed investments, helping ensure that they are making a good choice.