Investing For Income: Yield vs. Growth

If income is an important part of your investment goal, you will need to focus on the tradeoff between high current yield and high rates of dividend growth. Ideally, you would like to maximize both, but realistically, you will find that the stocks with the highest yield tend to have less attractive prospects for dividend growth. Even so, you will still want to come as close as you can to the best-case ideal. In other words...

• If you want to maximize yield, you are probably focusing on Utility (Electric, Natural Gas, or Water) or Real Estate stocks. Recognize that dividend growth in these sectors is typically less buoyant than is the case elsewhere. But in choosing among Utility/Real Estate stocks of comparable yield and risk, you would still want to select those that offer the best growth prospects relative to these categories. Analyze this issue by comparing Company yield to the Average Yield for the Industry and Sector. Do likewise for 5-year Average Yield and 5-Year Growth Rate.
  
  
• Income investors outside the Utility and Real Estate areas are typically willing to sacrifice some current yield in exchange for the greater potential dividend growth. Assuming yields on stocks you consider will typically be lower than what you would expect within the utility sector, it would still be reasonable for you to seek stocks whose yields are higher than their respective Industry and Sector averages. An income seeker should not accept a yield lower than that of the S&P 500 unless the stock's dividend growth prospects rate is dramatically higher.

Whether you stress yield or growth, you should be sensitive to the level of the company's Payout Ratio (the percent of Net Income that is paid to shareholders as Dividends). All else being equal, lower Payout Ratios are better. That's because such companies have greater income cushions that would allow them to avoid cutting dividends in bad times. Different businesses have different cash needs and different levels of normal earnings volatility. Hence it's best to evaluate Payout Ratios by comparing a company to the average for its Industry.

Net Income is prone to temporary developments such as gains or losses from the sale of assets or writeoffs of various kinds that could cause the payout ratio to fluctuate widely from one year to the next. If a company payout ratio differs from the industry average in a dramatic way, that might be serve as a hint that the level of earnings is unusually high or low. Confirm this by comparing the stock's yield to the industry average. A noteworthy difference in payout ratio, accompanied by a modest difference in yield, suggests that the payout ratio is being computed based on an atypical level of net income. There are two reasons why you can use this assumption. First, because companies in the same industry share a generally common set of cash flow and capitol needs characteristics, it's reasonable to assume that payout ratios will be generally similar. Second, as we'll discuss below, yield provides an important window into Wall Street sentiment. Hence a generally normal yield relative to the industry usually suggests that Wall Street sentiment toward the stock more or less matches sentiment toward the industry.

All Investment Goals: Yield As A Barometer of Sentiment

Example: The shares of ABC Company normally yield about 1.0% and the average yield for the other stocks in the same industry typically runs near 1.1%. One day, you look at ABC and find that it yields 2.5%, while the average yield for the industry is 1.2%.

True or False? ABC is a very attractive investment right now because it presents an unusual opportunity to earn a greater level of income than you could normally expect from this stock.

It's very tempting to say "True." Isn't it? And indeed, it might really be true for a particular stock. But until you've carefully investigated the facts, you should start by assuming that ABC's soaring yield is a negative signal. In the real world, all things are possible, so perhaps ABC is a true needle in a haystack. But more likely than not, the yield has jumped — relative to the industry — because of a drop in the stock price without a comparable drop in the dividend. Investors probably know about the high yield (this sort of information is extremely easy to uncover in a wide variety of sources), but choose to ignore it because they perceive company developments that could cause the Directors to cut the payout.

All investors, even those who seek capital growth, can benefit from using relative (to the industry) yield as a barometer of investor sentiment.