Equity investors that focus on immediate income often favor high yields over the quality and growth of the stock. However, in the long run, this approach is shortsighted and can often bring in less than paying attention to steadily increasing and sustainable dividends.
Sustainability over Immediate Yield
Many analysts and advisors have been pointing out for years that in the long run, the growth and sustainability of a fund’s dividend can matter just as much if not more than current yield.
The credit crises of 2007 to 2009, when the majority of companies cut their dividends due to recession, caused a fall in payouts from many funds, while some large companies such as banks eliminated dividends completely. This affected all investors but the make-up of the fund dictated how quickly it would recover once the situation stabilized.
A good example is to compare two equities funds before the crash. Cullen High Dividend Equity which displayed a good 3.4% 12-month yield seemed like a better option than Vanguard Dividend Growth with a yield of just 1.8%. However Cullen’s dividend took a major dive after peaking at $0.53 per share in 2007, and did not recover for seven years when it finally reached $0.66.
In comparison, Vanguard Dividend Growth Funds much lower dividend at the time reached $0.292 per share in 2009. It fell for a fraction in 2010 but it quickly rebounded in 2011 to an ever better $0.313 payout. Finally, from 2008 to 2014 its payout increased 6.7% annually while Cullen’s went up by only 3.4%.
Prioritize Quality over Yield
While funds composed of low risk, high quality stocks may seem a bit boring, but in the end it is the amount generated over time is what really matters. The funds with dividends that recovered fastest after the crisis were primarily those with holdings of high quality, lower risk stocks which highlight dividend growth over current yield.
These funds are made up of companies that focus on profitability, competitive advantage, return on capital, and dividend and balance sheet metrics. If all other factors are equal, companies with a low return on capital tend to have lower dividend growth potential than companies with higher returns so it pays to look at the make-up of any fund before investing.