Should I have a minimum yield requirement?

In my entry criteria, dividend yield is the last factor used to select dividend stocks. After I screen the list of dividend champions or dividend achievers, I look at each company in detail.

First I look for growing earnings per share, and attractive entry P/E ratios. Then I check if the dividend is going up above the rate of inflation. Finally, I check if entry yield is above 2.50%.

Using my screen parameters, I sometimes end up missing companies which have low yields but high dividend growth. However, by doing so, I am somewhat protected in the case I purchase a low yield but high growth stock, which subsequently lowers distributions growth or stalls it. I want to avoid at all costs getting carried away chasing dividend growth. Chasing growth could result in overpaying for a low yielding asset that grows earnings and dividends, and my total return ends up being limited to the modest initial yield for several years. My investment philosophy is to avoid losing money, and as a result I am fine missing out on potential gains if that reduces dividend income risk. Winning dividend positions typically take care of themselves, while losing positions are typically the higher risk ones that could make you lose sleep at night.

For example, investors who purchased stock in some great blue-chip dividend payers such as Coca-Cola (KO) or Wal-Mart Stores (WMT) during the 1999 – 2000 period, saw their share prices go nowhere for over a decade. The only return they received was in the form of dividends, which were initially very low. At the same time, both companies managed to significantly increase revenues, earnings and dividends during that time period. The reason behind the lackluster performance was the fact that these stocks were very overvalued in the late 1990’s and early 2000’s. The lesson from this exercise is that even the best dividend paying stocks in the world are not worth overpaying for.

Furthermore, while I may miss out on some companies like Raven Industries (RAVN) or Franklin Resources (BEN), I am going to still be able to select stocks in the sweet spot, which generate best returns for the risk i am taking. A company like Phillip Morris International (PM) or Kinder Morgan (KMI) that provides a good starting yield of 4% which grows at 8%-10% per year, is a much better candidate that a company yielding 1 - 2%, that grows dividends at 12%. The higher initial yield provides a margin of safety for the time in the future when dividend growth stalls. This could be tomorrow, or it could be 20 years from now. The issue with high growth is that it cannot continue forever. At some point, the growth will come down to a more reasonable and sustainable level.

The negative of what I am doing is that I will surely miss out on the next McDonald's (MCD) or Johnson & Johnson (JNJ) dividend growth success story. This is because companies in the early stage of dividend growth typically have low current yields, but manage to grow distributions at a very high clip. Those are the types of companies which will generate outstanding total returns, and double-digit yields on cost for anyone fortunate enough to believe in the company, and put their money there. This is one of the reasons why I purchased Visa (V) in 2011 and recently in 2014, despite the low current yield. I also purchased Casey's (CASY) in 2011 and YUM! Brands (YUM) in 2010 and 2013, when their yields were less than 2.50%. I was betting that above average dividend growth will continue, and I also wanted to beef up my portfolio exposure to the low yield and high dividend growth investments.

In the grand scheme of things, I am starting to believe more and more that initial attractive valuation of less than 20 times earnings is helpful. If this valuation is even lower, that could be very helpful for total returns and future yields on cost as well. The other equally important thing to consider is growth of earnings per share. After all, a quality business that keeps growing over time will eventually bail out the investor who might have slightly overpaid in the beginning. However, if I overpaid for a business that pays a high yield today, but fails to grow earnings per share, chances are that the dividend will not increase above the rate of inflation, and I will end up downgrading my standard of living quite regularly. Therefore, a business which has the potential to earn more in 15 - 20 years, coupled with an attractive valuation, is the type that will deliver investment success to its shareholders. Whether this business pays a 2.50% yield or a 1.50% yield at the time of investment might not be as relevant. However, if I am wrong about my assessment of the business, I will end up losing more under the lower yield scenario, since earnings will not grow by much leading the the price to stagnate, In addition, the business will only pay a paltry yield, that does not grow by much either. Since I use my dividends from companies to buy shares in other companies, this could mean less money to be put to work in the next great dividend growth success story.

This is why evaluating each business one at a time is so important. The investor has to take into consideration valuation, growth prospects, changes in industry or competitive landscape and evaluate that against their unique set of investment opportunities and expectations. Unfortunately, investing is not as black and white as most would make you believe.

Full Disclosure: Long KMI, PM, KO, WMT, YUM, V, CASY

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- Types of dividend growth stocks
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