Canadian Finance Blog

Posted: 09 Aug 2011 02:00 AM PDT

When I first started learning about stocks I was drawn towards investing in companies that pay dividends. As I researched more about dividend stocks I wondered why anyone would invest in a stock that paid a lower dividend yield than their competitor. I clearly did not understand dividend yield vs. dividend growth.

High Dividend Yield

I began identifying high dividend yield stocks and even gravitated towards the Dogs of the TSX approach to investing. This is where you purchase the 10 stocks in the S&P/TSX 60 with the highest dividend yield, hold them for a year, and then replace them with the new list of 10 high yielding stocks.

This strategy was a variation of the Dogs of the Dow approach that was invented by the U.S. stockbroker Michael O'Higgins, and it has performed quite well over the last few decades. The problem I had with the strategy is that I didn't want the constant turnover in my investment portfolio; I wanted something I could hold for the long term.

The other issue with investing in companies with a high dividend yield is trying to determine if the dividend is at risk of being cut or eliminated. High dividend yielding stocks have often been beat-up due to poor earnings or a change in their business, hence the name "dogs of the TSX". A company like Yellow Media has an extremely high dividend yield, but it will be nearly impossible for them to sustain their dividend while earnings continue to fall.

High Dividend Growth

So if high yield alone is not a good enough measure to determine which dividend stocks to own, what else can investors look at? Dividend growth investors are looking for stocks that can consistently raise their dividends over time. There are a few ways that investors can use to determine the best dividend growth stock.

Dividend Aristocrats – Stocks that have increased their cash dividends every year for the past 5 years are considered to be dividend aristocrats. The Claymore Dividend ETF (TSX: CDZ) tracks this index, so a good starting point to find dividend growth would be to research their individual holdings.
Average Dividend Growth Rate – Some stocks don't raise their dividends every year but can still be considered dividend growth stocks due to a high dividend growth rate over a longer period of time. For example, the Canadian banks did not raise their dividends for a few years during the global economic crisis, but their 5 year average dividend growth rates were still respectable.
Low Yield, High Growth – The stocks that often get ignored by dividend growth investors are the low yield, high dividend growth stocks. Stocks like Shoppers Drug Mart (TSX: SC) have a low initial yield of 2.4%, but their average dividend growth rate is over 17% per year over the last 5 years. Similarly, CN Rail (TSX: CNR) has a current dividend yield of 1.6%, but boasts an impressive 16% average dividend growth rate over the last 5 years and has increased their dividend for 14 consecutive years.

Chasing Yield

It's important for dividend investors to remember that the search for yield does not simply mean chasing the highest yield in the market. Often times there are warning signs that accompany stocks with high yields and unsustainable dividend payout ratios.

Broaden your scope of research to include stocks with a high dividend growth rate. Even though their initial yield may be lower, they tend to be above average companies that deliver above average returns over time. This keeps the stock price high and the current dividend yield low; meanwhile you collect the growing dividends while increasing the return on your initial investment.

Dividend Yield vs. Dividend Growth originally appeared on Canadian Finance Blog on August 9, 2011.