Look Beyond Yield to Win with Dividends

Erik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yield seekers are driving up the prices of dividend stocks, thus suppressing yields. If you are one of those seeking better yields, you have to think differently to beat the crowd. This is especially true for those of you on fixed income, or expecting to be when you retire.

The Secret Ingredient

The secret ingredient most dividend investors are blind to is the potential for excellent dividend growth that's sustainable over many years, if not decades. Dividend investors tend to have much longer time horizons than the average investor, but that dividend growth can make a huge difference sooner than you realize. It can also radically improve your retirement, as it has done for my parents and for my grandparents before them.

A Stark Comparison

To illustrate what dividend growth can do for you, let's consider the five companies in the table below. It shows the stock price (as of June 15, 2013), dividend yield, and average annual dividend growth over the past 6.5 years. That takes us back to November 2006, well before the financial crisis.

<img alt="" src="http://g.fool.com/editorial/images/51039/table-1_1_large.png" />

StoneMor Partners (NYSE: STON) is a master limited partnership (MLP), a type of business known for its high yields. France Telecom (NYSE: ORAN) has an unusually high yield for such a large company, for reasons I'll elaborate on in a moment. Chevron (NYSE: CVX), Intel (NASDAQ: INTC), and Microsoft (NASDAQ: MSFT) are all big stalwart companies with typically lower yields.

Without any due diligence beyond looking at a company's yield, you might trot right over to your broker and buy shares of StoneMor and France Telecom. But here's the rub: StoneMor's dividend has barely kept pace with inflation, while France Telecom's dividend has actually fallen. Worse, France Telecom's dividend is high because it's share price has been wasting away for years. Some may call that a buying opportunity, but the price is down because of fears the dividend will fall further. Buyer beware!

Assess the Dividend Growth

Let me now expand my table to include the future yield on your basis for the four companies whose yields have a future. This is the future dividend as a percent of your original cost basis. Let's look at the yields 5, 10, 15, and 20 years out. I'll also assume 2% inflation to keep the results in today's dollars. Over time, the fast growing dividends (Chevron, Intel, Microsoft), even those originally with lower yields, leave the placid growers (StoneMor) in the dust. Time is the friend of the smart dividend investor. Make time your friend.

<img alt="" src="http://g.fool.com/editorial/images/51039/table-2_large.png" />

Realize that you don't have to hold exactly the same stocks over these time periods, just like-minded stocks. In this case, we're comparing high-yield low-yield-growth companies to low-yield high-yield-growth companies. The latter must also have a special sauce that I'll reveal below.

Here's a bonus for this strategy: the actual yield stays about the same over the years, which means your share price is climbing at the same rate as the dividend. That's a 5-times share price increase for Intel over 20 years. It's actually done even better over the past 20 years. Pretty sweet.

The Special Sauce

What makes the difference between these companies? MLPs, REITs (real estate investment trusts), and most other high yielding companies pour nearly all of their profits into their shareholder dividend payments leaving very little for investment into future growth. Their dividends grow modestly, usually just a little above infaltion. They give you high yields today; but over the long-haul, they offer essentially a fixed income, much like bonds.

France Telecom, in contrast, is a company trying desperately to evolve out of the beleaguered land-line telecom industry that is being disrupted by mobile technology. Do not invest for dividends in a disrupted industry no matter how high the yield. Dividends are not guaranteed! Not ever.

Chevron, Intel, and Microsoft, in contrast, are all in enduring industries that have and will continue to power and shape civilization for decades to come. Look at your relative yield after time has passed. These companies will trounce fixed-income assets over the long-haul, which liberates us from the trap of post-retirement fixed income. Instead, we can watch our wealth actually grow during our retirement, improving our lot with each and every year.

I might add that this strategy will also work absolute wonders if you are in your 20s or 30s as you are looking at six decades of yield growth. Choose wisely using the Secret Ingredient and the Special Sauce, then remember me with a smile when you retire.

I know this works because I've watched it work first-hand over the past 50 years with my parents and grandparents. Each year only got better for them. I intend to obtain the same beneficial outcome, and encourage you to do so as well.

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Erik Eason has no position in any stocks mentioned. The Motley Fool recommends Chevron, France Telecom (ADR), Intel, and StoneMor Partners. The Motley Fool owns shares of France Telecom (ADR), Intel, Microsoft, and StoneMor Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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