The following is a guest blog post:
There are two types of dividend investors out there: yield grabbers and growth groupies. But the most successful dividend income investors capture both.
Income-focused investors are not happy receiving a paltry 2% dividend yield.
Who can blame them! Earning 2% a year doesn’t begin to cover life’s many expenses. That’s why many investors gravitate toward high-yield dividend stocks. For the sake of this argument, I’ll define high-yield stocks as those with yields greater than 4%.
Let’s call these investors “yield grabbers.” They’re looking for a big dividend check in the short-term.
Telecommunication and utility companies, master limited partnerships, and real estate investment trusts often have high yields. They also have slower dividend growth.
These companies and the products or services they provide are often natural monopolies. Some examples of natural monopolies are oil and gas pipelines, telephone lines, and internet connectivity. But often, government regulation or other factors limit profit and dividend growth.
But not all high-yield stocks make good investments. Actually, some of them are downright dangerous.
We call these stocks “yield traps” because the companies are in trouble. They have high debt loads and declining sales, and they cannot afford to keep paying their lofty dividends for long.
Yield trap dividends are unsustainable and are terrible investments. If you invest in these stocks, you’re likely to lose money in two ways. The first is an income hit when the company cuts, or eliminates its dividend to preserve cash. The second is a principal hit as the price of the stock continues to fall with the company’s declining business performance.
Yield grabbers must be experts at identifying and avoiding yield traps if they want to build a lasting dividend income stream.
But avoiding yield traps doesn’t guarantee that yield grabbers will have enough to get by in the future.
While higher income today is great, it’s also important to have much higher income tomorrow. Unfortunately, most high-yielding stocks don’t fit that bill.
Typically, high-yielding stocks have slower distribution growth. They raise their dividends just a few percentage points each year. Some high-yield stocks haven’t raised their dividends in years (if ever).
Yield grabbers usually dismiss low-yielding stocks. They often won’t invest in a dividend stock with a yield below 2.5% or 3%.
It’s understandable in some cases.
Low-yielding stocks don’t generate enough income right now for yield grabbers. If you’re in or near retirement and are depending on dividends to pay your everyday bills, a measly 1% to 2% yield doesn’t cut it.
But here’s the good thing about some lower-yielding stocks…
They typically grow their dividends at a much faster pace than their high-yield counterparts. Some lower-yielding stocks even double their dividends every single year! This is especially true of new dividend payers.
That’s why growth groupies love them.
You can blame it on the law of small numbers. If the dividend is small to begin with, even a tiny increase will be a big percentage gain.
Let me show you how it works…
A $0.05 raise on a $0.05 dividend means that the company increased its payout by 100%. That doubles your yield on your cost basis if the number of shares you own stays the same.
(As a refresher, yield on cost is calculated by dividing the current annual dividend by the price you paid for the stock.)
Higher-yielding stocks, on the other hand, often have larger dividends in terms of dollar amounts.
That same $0.05 bump on a $1 dividend means that the company increased its payout by just 5%. In this case, you get a lot less bang for your invested bucks and may actually lose spendable dividend income as inflation rises.
So, investors should benefit from high initial yields and dividend growth. How?
Through the 12-11-10 rule. Generate 12% annual returns with an 11% yield over a 10-year period.
With returns like that, you’ll triple your money in 10 years.
That should be more than enough to make yield grabbers and growth groupies happy.
When it comes to dividend investing, you don’t have to choose between the two most profitable strategies. You can have both!
Check out some of the top dividend achievers listed here.