Regular readers will know that I have been a big fan of Shire as of late. The company has fantastic growth, a pipeline that is envied by other biotech’s and a management team that is astute and rational. The best part about Shire is the valuation with shares trading hands at a P/E of less than 13. When a company looks attractive, I always ask myself ‘is there something I am missing? Is there something that I am not seeing that is making investors trade the stock at such a cheap valuation relative to its peers.’ With Shire, I think the answer is that investors are overlooking this stock due to its low dividend yield of 0.4%. In a world of low interest rates, investors are chasing yield and thus are pushing stocks with high pay-out ratio to oblivion and are leaving those that have a low payout for dead.
As a dividend focussed investor it can be easy to get caught up in the trap of chasing yield. I could easily buy the highest yielding stocks in order to get my dividend income up by the most. But by doing so, I risk burning myself as many companies in todays market are paying what looks like unsustainable dividends as the payouts are greater than cash-flows. One of the key tenants of dividend growth investing is to only invest in companies with sustainable pay-out ratios. The whole point is for my dividend income to grow year on year and not be cut.
Chasing yield also has the detrimental effect of slowing your dividend ‘growth’. Research has shown that stocks with high dividend yields tend to increase their dividends year on year at a slower rate than those with low dividend yields. This is particular of significance to me as I am still young having only turned 25 recently. As I have a long time horizon in-front of me, the dividend growth really does add up over time.
Let’s take Shire for instance. The shares are trading at approx £44 and the company pays out a dividend of £0.23 giving a dividend yield of 0.52%. Over the past 10 years Shire has increased its dividend at a rate of 15% a year. With the extremely low current payout ratio and the fantastic growth ahead for Shire, I think it is fair to extrapolate that Shire will continue at this dividend increase rate for the foreseeable future. So if I buy one share of Shire today and hold it all the way to retirement age, what do you think my dividend yield on cost would be considering it s only 0.55% today. Any guesses?? My yield on cost would be 159%. I would be getting £720in dividend a year for just holding on to a fast growing dividend share.
On the other hand let’s say another stock is also trading at £44 and has a starting dividend of £3.08 (yield of 7%) and has a growth rate of 5%. If we were to take the same time horizon as above the dividend of this second company will only have grown to £22.76 a share for a yield on cost of 51%. It does pay to be patient and collect a smaller dividend today for in order to get a greater payout tomorrow. (However if you were to re-invest the dividends of a high paying stock from the get go, I am sure you can get a return close to the fast growth example above. Perhaps this is an experiment for a different day).
Now I am not saying low yield stocks are better than high yield stocks. I am saying that they both should be included in a well balanced portfolio. High yield stocks, provided they are well covered by cash-flow, should from the basis of a portfolio. Looking at my first two dividend stocks, BP and Shell, they were both yielding close to 10% at the time of purchase. Bagging these two dividend stalwarts gave my portfolio a solid base and allowed me the momentum to pursue other opportunities. Furthermore seeing big dividends from these two companies hitting my accounts allowed me to be more rational in downturns – I did not panic and sell stock in the past couple of corrections as I knew the large divided cheques will keep flowing in.
Once you have a solid enough foundation, you can add low yield but faster growing companies to your portfolio. But again this all depends on individual circumstances. Higher yield stocks have historically been shown to be less volatile so if you are person that panics or a person that will sell in the next downturn, high yield is a better option in my opinion – but truth be told you shouldn’t really be in the stock market if you don’t expect a downturn as downturns always happen. Additionally if you are much older than I am and are counting on dividend income today as opposed to some time in the future, sticking to high yield stocks is probably a good idea. If on the other hand you are like me and are relatively young, you can’t afford not to have exposure to companies which are fast growing but have a low starting dividend yield.
I think the problem most people have when starting out is not appreciating fast dividend growth companies due to their lack of capital. Looking at Shire, a person who only has £440 and buys 10 shares is put off when shares only send them £2.3. Even if the dividend grows 15%, the dividend payment only grows to £2.64. That’s the deterrent. But once you reach a point where you are collecting £8,000 per year in dividends, that singular 15% dividend raise adds $1200 to your income automatically, giving you an extra three and a bit more pounds per day just for staying alive. Dividend growth investing with the best companies in the world becomes its own self-sustaining machine once you grind it out through the beginning days.
Shire Stock Purchase
This past week has seen market volatility return for the first time in a while. This volatility has allowed me a chance to snap up shares in share at prices I see as being really attractive. I bought 18 shares in Shire at £44 each. Having previously bought shares in the company using my monthly stock purchase programme, I now own a total of 28 shares in the company.
With the current dividend of 30 US cents – Shire sets its dividend in US dollars – I am expected to receive a total dividend of $8.4 or £6.4 a year from the company. This may not sound like a lot but as I mentioned earlier, dividend growth will really make this amount rocket upwards.