Any investment that you would sell, upon encountering some adversity, is not worth holding no matter its long-term total return potential. There are plenty of stocks with great long-term characteristics—John Deere & Co. and its 12.5% annual compounding rate come to mind—but based on your individual profile, it could be a disastrous investment. It lost something like 75% of its stock market value during the last economic recession. Some people are not equipped to tolerate those kinds of losses. Other people save $5,000 per month, have fifty stocks in their portfolio, and could see John Deere’s $1 billion annual profits even during the worst of the recession, and power through the capital loss and maybe even add more if they were truly opportunistic.
Accurately knowing yourself as an investor is the foundation of everything—avoiding selling low is the critical ingredient to long-term stock market success, and you should only buy things that you know you would buy more, or at least hold, through 50% declines. If Berkshire Hathaway can decline 50% four times during Buffett’s stewardship, all fluctuations are possible. That’s why I rarely move the discussion on this site beyond Coca-Cola, Johnson & Johnson, Colgate-Palmolive, Chevron, Exxon, and Procter & Gamble—there are companies out there with better growth characteristics, but those firms listed are those that most long-term investors can readily buy more in response to price declines. Getting that part right will change your life because the stock market will actually serve you, and you won’t become one of those statistics mentioned in the Dalbar Study about how typical retail investors only achieved 3-4% returns when the stock market returned 9-10% annual returns.
With that in mind, I want to discuss those companies with low starting yields but very high dividend growth rates and long-term capital appreciation potential. Companies like Visa, Mastercard, T. Rowe Price, Franklin Resources, Becton Dickinson, even Disney, and a few others. For someone who is trying to maximize long-term wealth, these types of companies are wonderful considerations. For someone with an annual savings rate well into the tens of thousands of dollars and making investments in taxable accounts, they are great way to maximize returns because you are minimizing what you ship off to Washington D.C. and letting the company benefit from the tax efficient forms of compounding that are inherent when the company grows internally and repurchases its own stock.
It’s especially nice if you have no place to use the dividend income for a long while—after all, Frankin Resources doesn’t seem like a particularly enticing dividend stock because its dividend yield is typically around 1%. Most people who want income like to see at least 3% on their money coming back to them, as a bare minimum. But who is to say you are most people? If, twenty years ago, you saw Franklin Resources’ outstanding long-term compounding characteristics, and had no plan for the income, and decided to buy some shares, the yield on the amount you set aside would be quite nice. You’d be collecting $1,500 in dividend income on every $10,000 set aside twenty years ago, oh yeah, and there is the whole 17.4 capital appreciation thing. You’d have a 15% annual yield on your invested principal, plus that principal multiplied by 17.4 over the past twenty years (in other words, only $60,000 worth of Franklin Resources stock twenty years ago would make you a millionaire today). For people with very high savings rates that don’t need income and take tax strategy seriously, these selections are a godsend.
But…there is another side to consider as well. There are other people whose psychology is such that they can’t get beyond lukewarm about anything that only yields 1% or 2%. As soon as the capital appreciation slows down, stops, or reverses, the holding gets discarded. The heart wasn’t in the investment. If you can’t get past the lukewarm status with a low-yielding dividend investment, stay away altogether. It’s not worth it, because you won’t be attached to it over the long haul.
I swear, this site has a higher collection of BP investors than any other website on the internet. Most investment sites that discuss the company are upset by its lack of capital appreciation post-oil spill. They wanted a stronger recovery. A lot of people here respond by saying, “Are you kidding me? Five percent yields. Growing dividends. I love this.” They enjoy the opportunity to buy a high-yielding stock that is also on sale, with vast resources, that will be around for the rest of their lifetime. Buying a few hundred shares early in life grants great personal satisfaction, because you’re collecting $1,200 annually from your 500 shares. You could be bringing in 2-3% of the average American household’s salary from one oil stock dividend alone. You’re immune to the price fluctuations because the high income, and the growth of that income, is so strong that those shares won’t be pried out of your hands.
These are the questions that inform my analysis on the advisability of those low dividend yield/high dividend growth rate stocks. Who are you as an investor? Are you looking for tax strategy and income twenty years from now? Are you looking for very significant capital appreciation? Is your heart in it? If yes, then those companies make perfect sense. If you want current income, either to spend or reinvest, stay away. If you’re lukewarm about those companies, stay away because you will discard them easily. When you want/need money, and who you are as an individual investor, affects all investment decisions, including the appeal of those low-yielding dividend growth stocks. I prefer a balanced attack—why not own both BP and Visa?—but you’re not me, and you get to write your own story according to your own values, temperament, and goals.