Last time DividendWatch discussed how investors might weigh up the competing claims of immediate yield versus future growth in dividends. We asked, what would you rather…
Company A: yielding 6%, growing its dividend at 2% or
Company B: yielding 2% but growing its dividend at 6%?
We demonstrated that it would take 30 years for Company B’s dividend to catch up with Company A’s, so concluded that perhaps the bird in the hand is worth two in the bush. But we observed that this analysis ignored how the share prices of these two companies might perform over time.
So, what will the shares in companies A & B be worth in 5 years’ time? And does this change their merits?
Assuming the valuation that the stock market applies to these companies stays the same, Company A will still be yielding 6% on a dividend that has grown at 2% per annum from 6p to 6.6p so the shares will be 110p. Company B will still be on a 2% yield on dividend that has grown at 6% from 2p to 2.7p, so the shares will be 134p, significantly more. We have a new winner!
This demonstrates the importance of dividend growth because it is the growth in dividends that powers up the share price.
Adding back the cumulative dividends collected over the 5 years, the higher share price appreciation at the faster growing company nearly perfectly offsets the lower starting yield. Company A shares have gone from 100p to 110p and paid 38p of dividends, so a 48% total return. Company B shares have gone from 100p to 134p and paid 14p of cumulative dividends so a 48% total return. Oh my! It’s a dead heat!
This parity makes perfect sense. Over short time periods, the total return is simply the yield plus the growth rate. So for both Company A and Company B, it is 8% in both cases and so in this concocted example, investors can be ambivalent, unless they have a preference for income over capital gain.
But what this story really demonstrates is that if you wish to maximise your total return, then investors should look to maximise both the yield and the dividend growth rate. And this is precisely the approach of the Slater Income Fund.
“What would you rather?” We want it all.
Important: Slater Investments Limited does not offer investment advice or make any recommendations regarding the suitability of its products. No information contained within this article should be construed as advice. Should you feel you need advice, please contact a financial adviser. Past performance is not necessarily a guide to future performance. The value of investments and the income from them may fall as well as rise and be affected by changes in exchange rates, and you may not get back the amount of your original investment.