In looking at two companies in the same sector, would you prefer to have a stock that pays a 2.7% dividend or one that pays a 3.1% dividend?

The answer might seem obvious at first; all else equal, who wouldn’t take the higher cash payout? But before you answer, take a look at Figure 1.

Figure 1

This chart shows the quarterly dividend of the two companies I mentioned above, both major U.S. retailers.  You will immediately notice that one company, “Company A,” has done a much better job than the other of raising its dividend over the past decade and particularly in the last few years.

Company A is the lower yielding of the two, with a current dividend yield of 2.7%.  But should it continue to raise its dividend in the years ahead, investors would realize a much higher cash payout over time despite the slightly lower yield today.

So, let me ask again, dear reader: Would you prefer to have a stock that pays a 2.7% dividend or one that pays a 3.1% dividend?

I’m sure you know what my answer is, and you probably agree.  You will probably agree even more when you find out what the two companies in question are: Company A is megaretailer Wal-Mart (NYSE:$WMT) and Company B is beleaguered electronics chain Best Buy (NYSE:$BBY).

In my last article, I warned investors not to “chase” high dividend yields.

You have chosen wisely.

And while I would hardly call buying a stock that yields 3.2% “chasing” a high yield, the core lesson is the same.  When building a solid, long-term income portfolio, you cannot make your investment decisions based on current yield alone.  Doing so puts you at multiple risks, all of which can be devastating to you long-term investment goals.

I’ll start with the obvious: business risk.  An exceptionally high current yield often means that investors have sold off the stock or bond due to real, fundamental problems with the business. It also often means that the market is discounting a cut to the dividend.

Does this mean that you should always avoid exceptionally high yielders?

Of course not.  Often times the market overreacts and gives us contrarian value investors fantastic opportunities to be greedy when others are fearful.  You have to look at each case individually and make a judgment call.  To give a recent example, I believe that the potential returns far outweigh the risks in Spanish telecom giant Telefonica (NYSE:$TEF), despite the risks implied by its 11% current yield.  There may be short-term turbulence in Europe, but the company’s long-term future is very bright.

I would be far less enthusiastic about, say, Teekay Tankers (NYSE:$TNK), which yields 9.8%.  The oil tanker business is extremely cyclical and subject to booms and busts.  And given the cut-throat competitiveness of the business, longer-term dividend growth (or even dividend maintenance) is by no means certain.

The second reason to focus on dividend growth is protection from the ravages of inflation.  I have no doubt in my mind that Wal-Mart will continue to prosper. Most of what it sells is merchandise that consumers are unlikely to buy online due to convenience and timing issues.  (On a personal note, most of my Wal-Mart purchases are spontaneous and based on immediate needs.  Where else do you buy a Rubbermaid trashcan, a can of paint, or a case of Dr. Pepper at 3:00 am?)

Wal-Mart’s dividend should easily beat inflation in the years ahead, which is critical for retirees that depend on dividends to meet their current living expenses.

I can’t say the same for Best Buy.  While the company is the last man standing among major big-box electronics chains, it is getting hit from two sides.  Shoppers tend to use the stores as a showroom to try out new electronics before whipping out their smartphones to order them online for far cheaper.  And for larger items no usually purchased online—such as home appliances—Best Buy will continue to see tepid growth for as long as the housing market remains depressed.

Best Buy would not appear to be at risk of failure in the immediate future, but investors searching for steady dividend growth should look elsewhere.

Disclosures: WMT and TEF are holdings in the Sizemore Capital Dividend Growth Portfolio.

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