Thursday, July 14, 2005
A recent question from a reader asked what a rising dividend stock might mean in retirement, and if non-growth high yield stocks ever work. This is the way I think of it. A rising dividend stock has two buckets of return, a cash bucket and a price appreciation bucket. Let's use Wells Fargo as an example. WFC's dividend yield is currently 3.5%. That means on $1,000,000 the actual cash income is about $35,000 per year. So the first bucket produces a predictable and growing cash of that amount. The second bucket comes from the dividend growth of WFC. It is not guarantee or consistent, but the odds of its coming are very high. We currently estimate that WFC will increase its dividend by 10% per year. This is about 3 to 4 times what we estimate inflation will trend over the next decade. If WFC does in fact hit our target, we would expect its price would also grow about 7-10% per year. That means the second bucket would produce an annual return of between $70-$100,000. It will be spotty and come and go, but over the next decade, we would expect this sort of annual gain. Obviously, the total of the two buckets is between $105,000 and $135,000, or 10.5-13.5% annual returns. These kinds of rates of return seem out of reach, judging from recent experience, but if WFC's price does not go up the dividend yield will continue to rise, and the first bucket will continue to increase. Under this circumstance, the total return will not be as much as if the price rises along with dividend growth, but the buckets will continue to increase in value. Companies with stagnant dividends only have the income bucket. The only reason they would rise in price is if interest rates fall, which we do not believe will happen. Thus, pure high dividend yield is not the same as rising dividend investing. As the commentor said, we would choose a bond over a stagnant dividend stock. *PS. Someone just mentioned that there are really three buckets, and I have to admit that, strictly speaking, there are, indeed, three buckets. 1. Current dividend income bucket. 2. Dividend increase income bucket. 3. Price appreciation bucket. I'll have to think about the second bucket. It might really be a part of the first bucket. I do believe the power of the whole bucket approach, however, is that the dividend growth (2nd bucket), not only increases cash flow but also pushes price higher. I'll let it brew a while. I might come back and rename this Three Buckets.