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Interest rates are only going one direction. And that’s up.
Bond yields have already jumped. The 10-year Treasury note yield is up 75% since early May. And the 5-year T-note is up 34%. When the Fed eventually increases interest rates to a more normal level, many investments – including long-duration bonds – will be crushed. Investors will have little choice but to hold them to maturity to avoid capital losses.
But one type of investment has outperformed time and again. That investment is a select group of dividend stocks. Dividend stocks that regularly increase their dividends deliver outstanding gains, even when interest rates are increasing.
In fact, data from Ned Davis research shows that in the three-year period following interest rate hikes, dividend growers outperform both high-yield stocks and non-dividend payers.
It’s likely that many companies will be increasing their dividends in the coming year. Last week I told you that the payout ratio for the S&P 500 averages just 36%. Compare this with a long-term average of 54% and it’s clear that there is ample room for dividends to grow at America’s largest companies. At smaller, higher growth companies, the story remains the same.
Income investors often overlook these dividend growers because they don’t offer the high yields. But the fact is that their total return – including dividends and capital gains – typically exceeds returns from high yield stocks.
In fact, investors should look straight past current yields for proven dividend growers, and instead consider what the yield will be three, five or even ten years in the future.
My reasoning is twofold.
First, current yield is a function of a stock’s price and the amount paid out in annual dividends. Since dividend growers are generally strong performers, the rising share price keeps a lid on the current dividend yield. It’s very difficult to buy a quality dividend grower with a really fat yield because these stocks also rise over time.
Second, in order to achieve the big yield from a dividend grower, you need to have owned the stock for some time. The wait for the juicy yield is worth it, because as you wait for the dividend to grow you’re likely to achieve a nice capital gain.
Let’s look at a very simple example. Coca-Cola (NYSE:KO) is one of the most reliable dividend growers in the history of the stock market. The company has increased its dividend in each of the last 50 years.
Today Coca-Cola trades for around $37.80 and pays $1.12 in annual dividends. That payout equals an annual yield of 2.9% ($37.80/$1.12 = 2.9%). That’s not bad, but it’s certainly not a high yield stock.
But thousands of investors are earning a much higher yield on their investment in Coca-Cola. How is this possible? They purchased shares years ago, and have held on as the company increased its dividend year after year.
Just three years ago, Coca-Cola was a $29 stock. Because it paid annual dividends of $0.85 (adjusted for the 2-for-1 stock split in 2012), the stock then yielded 2.9% ($29.00/$0.85 = 2.9%). That’s the same as today.
But shareholders that bought the stock in 2010 now earn a yield of 3.8%. ($29.00/$1.12 = 3.8%). That’s because Coca-Cola has grown its quarterly dividend by 32%, to $1.12, over the last three years. Over that time the stock has also risen by 30%.
The positive impact of Coca-Cola’s dividend growth becomes even more evident if we go back further in time, say ten years. In 2003, the stock traded for $22.00 and paid $0.42 annually in dividends. At the time, the stock yielded just 1.9%, but today those very same shares yield 5%. To top it off, the stock also rose by 72%.
Today, many of America’s biggest companies are swimming in cash. And many CEOs are sharing the profits with shareholders in the form of increased dividend payments.
The data clearly shows that there is more room for dividends to increase. Most importantly, history suggests that dividend growers will continue to offer superior total returns, even if interest rates rise.
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