MarsBars
There are two important components to dividend investing: current dividend yield and dividend growth. Current yield is important because that is the core of what dividend investing is all about: generating cold, hard cash flow from your investments. It is the substance that differentiates dividend investing from virtually every other investing style out there.
While cryptocurrency and high-growth disruptive tech “investors” speculate on what price Bitcoin (BTC-USD), and while Palantir stock (PLTR) might get bid up next week in a manner viewed as totally divorced from fundamentals, dividend investors are a different breed. Instead of making investment decisions based on the latest hype, FOMO, and what they think others will do, dividend investors take a cool, calm, and collected assessment of the actual underlying business fundamentals and determine what the intrinsic value of the business is before deciding to buy its stock.
Ultimately, what it all boils down to is this question: how much cash will this investment give me in the coming years? The dividend yield is what it will deliver to them today relative to the amount of money that they invest in it.
The dividend growth rate then is also important because it links the current dividend yield to the ultimate intrinsic value of the investment because it enables the investor to determine how much cash the investment will be giving them in the future. For example, a stock or fund may offer a juicy 10% yield right now, but if it is expected to slash that dividend by 90% next year, it suddenly becomes a much less attractive investment proposition. In contrast, if a stock offers a 5% dividend yield but is likely to grow that dividend at a 9% average clip for the foreseeable future, then it becomes a much more appealing bargain.
In this article, we will look at a sample portfolio of five funds with a weighted average dividend yield of ~5% and a weighted average dividend growth rate of ~9%. Combined, we expect that this portfolio will provide investors with a very attractive combination of current dividend yield and future dividend growth.
The 5% Dividend Yield And 9% Dividend Growth Portfolio
The reasons why we targeted these metrics for this portfolio are:
With the Federal Funds rate at a little bit over 5% right now, many cash savings accounts are offering yields of ~5%, thereby driving a lot of money away from yield-focused investments in favor of the safety and superior yield that cash offers. However, if an investor can get a similar yield from an investment that also offers annual growth, it still remains a more compelling investment proposition, especially if they have a longer-term time horizon for that investment. Many income investors live off of all of the passive income generated by their portfolio, particularly if their yield is not terribly high. With the 4% or 5% Rule often advocated by financial planners for retirees, we felt it made sense to target a higher dividend growth rate on top of our 5% yield since it would then enable the portfolio’s income stream to comfortably outpace inflation and hopefully also drive meaningful long-term principal appreciation, thereby leading to wealth compounding in addition to simply meeting the retiree’s income needs.
With that being said, let’s dive into the portfolio:
Tickers Allocation Dividend Yield 3-Yr Dividend Growth CAGR SCHD 25.00% 3.5% 9.4% VIG 35.00% 1.8% 11.8% AMLP 10.00% 8.1% 6.1% XLE 10.00% 3.6% 11.8% PFFA 20.00% 9.7% 2.3% Click to enlarge
As the table shows above, the top two holdings in our portfolio are popular well-diversified dividend growth ETFs: the Schwab U.S. Dividend Equity ETF (SCHD) and Vanguard Dividend Appreciation Index Fund ETF (VIG). While SCHD has a dividend yield that is nearly twice that of VIG, VIG’s 3-year dividend CAGR has been 240 basis points higher than SCHD’s has been. Combining the two gives us a better-balanced combination between dividend yield and over 10% average annual dividend growth. While both are well-liked due to their strong long-term track records of growing dividends year after year at a brisk pace, generating attractive total returns, and charging very low expense ratios of just 0.06% each, they differ in terms of portfolio makeup. SCHD prioritizes a more balanced approach to allocating across sectors, with more focus on defensive sectors like health care, whereas VIG goes after faster-growing sectors like technology more aggressively. Moreover, VIG holds more stocks, with 318 total holdings, whereas SCHD is more concentrated with 104 holdings.
Their differences in capital allocation are also noted in their top 10 holdings:
SCHD’s:
Broadcom Inc (AVGO) – 5.00% AbbVie Inc (ABBV) – 4.70% Merck & Co Inc (MRK) – 4.66% The Home Depot Inc (HD) – 4.32% Amgen Inc (AMGN) – 4.10% Verizon Communications Inc (VZ) – 3.99% Chevron Corp (CVX) – 3.93% Cisco Systems Inc (CSCO) – 3.88% Texas Instruments Inc (TXN) – 3.85% Coca-Cola Co (KO) – 3.83%
VIG’s:
Microsoft Corp (MSFT) – 5.31% Apple Inc (AAPL) – 4.44% JPMorgan Chase & Co (JPM) – 3.25% UnitedHealth Group Inc (UNH) – 3.22% Broadcom Inc (AVGO) – 3.14% Exxon Mobil Corp (XOM) – 2.65% Visa Inc Class A (V) – 2.63% Johnson & Johnson (JNJ) – 2.49% Mastercard Inc Class A (MA) – 2.35% The Home Depot Inc (HD) – 2.30%
As you can see from the lists above, both companies hold substantial positions in AVGO and HD, but otherwise, their top 10 lists are different, with VIG clearly putting more emphasis on lower-yielding mega-cap tech stocks like MSFT and AAPL.
The next largest holding in the portfolio is the Virtus InfraCap U.S. Preferred Stock ETF (PFFA). While this ETF generates very slow dividend growth (due to the fixed-income nature of its underlying holdings, thereby limiting dividend growth mostly to opportunistic capital recycling from fully valued, lower-yielding preferreds to new undervalued, higher-yielding opportunities through the fund’s active management), its yield is quite high and fairly dependable given that it is fully backed by cash flow from preferred dividends. It also helps to diversify our portfolio somewhat from what is otherwise exclusively common stocks.
We then round out the portfolio with two energy funds, one that is focused on energy midstream infrastructure (AMLP) with blue chips like MPLX (MPLX), Energy Transfer (ET), and Enterprise Products Partners (EPD) among its top holdings and another that is focused on the leading energy E&P companies (XLE) like Exxon Mobil (XOM) and Chevron (CVX). These funds combine attractive current yield with solid dividend growth as their fundamentals have gotten quite strong in recent years with energy businesses generally boasting very strong balance sheets and generating a lot of free cash flow.
Moreover, with VIG in particular having very little exposure to energy, these funds help to better balance our portfolio while also serving as a bit of a hedge against inflation since energy tends to perform very well in inflationary scenarios.
Investor Takeaway
Dividend investing differs from other forms of more speculative investing by focusing the investor’s attention on the cash that their underlying holdings actually give them, rather than hoping that some other investor will be willing to pay them more for what they own in the future. This focus ultimately then comes down to analyzing stocks based on two factors:
Their current dividend yield Their projected dividend growth rate
By focusing on a powerful combination of current dividend yield and dividend growth, we were able to put together a reasonably well-diversified portfolio of five funds that provide investors with a 5% current yield and a 9% dividend CAGR.
