Dividend Growth Investing: A Comprehensive Analysis

 

Dividend Growth Investing: A Comprehensive Analysis

1. Core Concept

Dividend Growth Investing (DGI) is a long-term equity strategy focused on buying shares of companies that consistently increase their dividend payouts over time. The goal is not merely high current yield, but sustainable dividend growth that outpaces inflation and compounds returns. It combines income generation with capital appreciation potential.

2. Key Principles & Strategy

• Quality Over Yield: Targets financially robust companies with strong competitive advantages ("moats"), low debt, and stable cash flows.

• Dividend Aristocrats/Kings: Many practitioners focus on companies with long track records of annual dividend increases (S&P 500 Dividend Aristocrats: 25+ years; Dividend Kings: 50+ years).

• Reinvestment: Dividends are typically reinvested (DRIP) to harness compounding.

• Valuation Matters: Emphasizes buying at reasonable valuations (e.g., using metrics like P/E, dividend yield relative to history).

• Screening Criteria: Often looks for dividend growth rates >5-7% annually, payout ratios <60-75% (industry-dependent), and consistent earnings growth.

3. Theoretical Underpinnings & Rationale

• Compounding Machine: Growing dividends accelerate return compounding, especially when reinvested.

• Quality Signal: Sustainable dividend growth signals management confidence, financial discipline, and earnings durability.

• Downside Resilience: Dividend payers, especially growers, historically show lower volatility and better bear market performance.

• Inflation Hedge: Growing income protects purchasing power, unlike fixed-income instruments.

• Total Return Focus: Dividends have historically contributed ~40% of S&P 500 total returns.

4. Advantages

• Predictable Income Stream: Growing dividends provide a tangible, rising cash flow.

• Lower Volatility: Mature dividend growers are often less speculative.

• Discipline: Forces focus on business fundamentals, not market noise.

• Tax Efficiency (in some jurisdictions): Qualified dividends often taxed at lower rates.

• Behavioral Benefits: Income focus may encourage long-term holding during downturns.

5. Criticisms & Risks

• Sector Concentration: Dividend growers cluster in sectors like consumer staples, healthcare, and utilities, leading to portfolio concentration.

• Opportunity Cost: May miss high-growth sectors (tech) that reinvest profits rather than pay dividends.

• Dividend Cuts: Even "safe" dividends can be cut during crises (e.g., 2020 COVID-19 cuts).

• Interest Rate Sensitivity: Rising rates can make bonds relatively more attractive.

• Overvaluation Risk: Popular dividend stocks sometimes trade at premium valuations.

• Tax Inefficiency (in taxable accounts): Creates annual tax liability even when reinvesting.

6. Performance & Evidence

• Historically, dividend growers have outperformed high-yield and non-dividend payers with lower risk (Ned Davis Research, Hartford Funds studies).

• However, during strong bull markets (e.g., tech-led rallies), DGI may lag the broad market.

• Critical nuance: Not all high-yield stocks outperform; dividend growth has been the key factor.

7. Practical Implementation

• Portfolio Construction: Typically 15-30 stocks across sectors; some use ETFs (e.g., NOBL, DGRO).

• Monitoring: Track payout ratios, earnings growth, and debt levels, not just yield.

• Rebalancing: Sell if dividend safety deteriorates or growth stalls.

• International Diversification: Some incorporate global dividend growers.

8. Comparison with Other Strategies

• vs. Value Investing: Overlap exists, but DGI specifically targets payout policies.

• vs. Growth Investing: Opposite philosophy—cash returned vs. reinvested.

• vs. High-Yield Investing: DGI prioritizes growth over initial yield.

9. Modern Context & Adaptations

• Low-Interest Rate Era: DGI gained popularity as bonds offered meager yields.

• Tech Sector Evolution: Some tech giants now pay growing dividends (Apple, Microsoft), expanding the opportunity set.

• ESG Integration: Many dividend growers align with ESG criteria due to their stability and governance standards.

10. Key Thinkers & Resources

• Theoreists: Ben Graham (margin of safety), John Bogle (total return).

• Practitioners: David Fish (U.S. Dividend Champions list), Tom & David Gardner (Motley Fool), Charles Carlson.

• Books: The Ultimate Dividend Playbook (Josh Peters), The Single Best Investment (Lowell Miller).

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Summary & Final Commentary

Dividend Growth Investing is a disciplined, income-oriented strategy that harnesses the power of compounding through ownership of high-quality businesses with shareholder-friendly capital allocation policies. It appeals particularly to investors seeking:

• Reliable and growing passive income (e.g., retirees).

• Lower portfolio volatility and downside protection.

• A fundamentally grounded approach that avoids speculation.

However, it is not a universal solution. The strategy requires patience, sector diversification awareness, and careful valuation analysis to avoid "value traps." In a low-yield world, its popularity has sometimes led to crowded trades and inflated valuations.

The core insight: Dividend growth is a powerful indicator of business quality and a mechanism for compounding. When executed with selectivity and patience, DGI can be a robust pillar of a long-term portfolio, particularly for those who prioritize tangible cash flow over purely theoretical gains.

Future Outlook: As demographic shifts increase demand for income-generating assets and as more companies adopt disciplined capital return policies, DGI principles are likely to remain relevant—though they must adapt to changing tax policies, interest rate environments, and sector dynamics (e.g., the rise of tech as dividend payers). Ultimately, DGI is less about chasing yield and more about investing in durable economic moats that generate ever-growing cash distributions.

Conventional Valuation Yardsticks: Dividend Yield

Dividend Yield

Why is my discussion of dividend yield so short?

• Although at one time a measure of a business's prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. 

Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. 

• Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. 
• Investors buying such stocks for their ostensibly high yields may not be receiving good value.  On the contrary, they may be the victims of a pathetic manipulation. 
• The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. 
• This manipulation was widely used by money-center banks through most of the 1980s and had the (desired) effect of propping up their share prices.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield
Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

Dividend Yield Investing

As deposit accounts pay very low interests or next to nothing, dividends on shares seem attractive. But you'll need to choose carefully.

Many large companies pay decent dividends once, twice or even four times a year. The yield – the dividend expressed as a percentage of the share price – is often attractive by comparison with interest rates on savings. There are now a wide range of blue chip companies yielding 4pc.



Warnings for those seeking Dividend Yield in their investing

When comparing a dividend yield with the interest rate on a savings account, however, certain warnings should be borne in mind.

1. The first point is that your capital is not guaranteed; share prices can and do fall.

2. Secondly, dividends can be cut drastically or axed altogether with little or no notice – and this can lead to a fall in the share price as well.


So just buying the shares with the highest dividend, without researching how safe that dividend is, can be a mistake.

There are now a huge range of high yielding blue chips but it is best to look for a dividend that is less likely to be cut even if that company's profits fall.

A high yield alone is not synonymous with a decent dividend.

If you carry out thorough research and pick the right shares, you will get better value for your cash than by leaving it in a savings account.



Measure of a dividend's reliability is Dividend Cover

The long-established measure of a dividend's reliability is dividend cover: the ratio of net profits to the size of the dividend payout.

Generally, a cover ratio of at least two – meaning that the company has twice as much net earnings as the amount earmarked for dividend payments – is considered a strong indicator.

Once again, for those who invest for yield or income - either Dividend Yield Investing or Dividend Growth Investing - STOCK SELECTION is still the key.

Search out for those companies that have a good chance of sustaining or even increasing their dividends.

If you are knowledgeable, you can even anticipate and avoid those companies that may skip or reduce their dividends in the future.




Stock selection is the key to dividend yield investing.

Some investors look at historic yields; some at forecast (or "prospective") yields.

But either way, those yields can be unexploded mines, lurking for the unwary.

Looking at yield on its own, in short, can quickly introduce you -- painfully -- to the meaning of the term "yield trap".



Yield Trap

The yield trap is simply explained.

You buy a share, attracted by the high yield. But the dividend is then cut, or cancelled -- leaving you without the anticipated income. Worse, unsupported by the payout, the share price usually falls as well, leaving you also nursing a capital loss.


Let's see it in action.

Company A pays out 9 pence a share, with shares changing hands for 100 pence per share. So the dividend yield -- which is the dividend per share, divided by the share price, and multiplied by a hundred to turn it into a percentage -- is 9%.

But that 9 pence is unsustainable. Company A then halves its dividend, slashing investors' income. What happens to the yield? If the share drops to -- say -- 80 pence, the historic yield the becomes 5.6%. The "yield on cost" figure, of course, is 4.5%.



How, then, should investors spot potential yield traps?  Answer:  Dividend cover

The most obvious reason for slashing the dividend is that the business simply hasn't got the money to pay it.

The business's earnings, in short, aren't large enough to support a distribution to shareholders at historic levels.

Put another way, actual earnings per share aren't sufficiently large when compared to the anticipated dividend per share.

Which is where the notion of 'dividend cover' comes in: earnings per share divided by dividend per share.



Interpret Dividend Cover with care

Now, dividend cover shouldn't be followed blindly.

Some businesses -- such as utilities, for instance -- can quite happily operate with lower levels of dividend cover than more cyclical businesses.

Other businesses -- such as REITs -- must pay out a fixed proportion of earnings as dividends, so again a low level of dividend cover is the norm.

Still other businesses have very high levels of dividend cover, because they are growing -- and therefore retaining earnings for future investment -- rather than paying them out as dividends.

But as a broad brush generalisation,

- A ratio of close to one is definitely the danger zone.
- A ratio much bigger than two indicates a certain parsimony.
- A ratio of 1.5-2.5 is usually what I'm looking for.



Stock Performance Guide on Dividends (by Neoh Soon Kean)

He considers dividend per share (DPS) as the most important factor when evaluating the worth of a share.

The ideal situation is for the DPS of a company to grow smoothly and rapidly over the years. (This is the Dividend Growth Investing I mentioned).

The DPS track record should be unbroken for many years.

One important caveat: you must compare the amount of dividend paid with the amount of earnings per share (EPS). (This is the dividend payout ratio).

- The growth of DPS must be proportionate to the growth of EPS.

- A company cannot sustain year after year of higher DPS thanEPS.

- On the other hand, the DPS should not be too small compared with the EPS unless the EPS is growing rapidly.

He advises, under normal circumstances, the DPS should be between 30% to 70% of the EPS.



Happy Investing

Dividends, Dividend Yield and Bond Yield

The Danger of Low Dividends

By Morgan House
April 25, 2013 

Earnings among S&P 500 companies are at an all-time high. By quite a bit, too: Operating earnings per share last year were more than 10% above the previous peak set in 2006, when the economy topped out before the recession.

Dividend payouts are also at an all-time high, but there is much less to be excited about here. Companies have been paying out a lower share of their earnings as dividends for decades, and the trend shows little sign of slowing. The dividend payout ratio is pitiful:

Source: Yale, author's calculations.

A lot of this decline over time is explained by companies using more of their free cash flow to repurchase shares. Benjamin Graham's classic 1949 book contains deep analysis and commentary on dividends, but scarcely a mention of share buybacks. That changed dramatically after the 1980s. Legg Masson has shown that from 1985 to 2011, S&P 500 dividends increased fourfold, but share buybacks increased 21-fold.  

The impact this shift has on how investors are compensated is deep. As Shawn Tully of CNNMoney pointed out earlier this year, the dividend yield on ExxonMobil (NYSE: XOM  ) is a little more than 2%, but the total yield including buybacks is north of 7%. Pfizer's (NYSE:PFE  ) dividend yields more than 3%, but with buybacks the company returns 7.6% to shareholders. Wal-Mart's (NYSE: WMT  ) total yield is about double its dividend yield.

There are mountains of evidence showing that, on average, investors are better off with dividends than share buybacks, as CEOs have a terrible history of buying back their shares at nosebleed prices.

But I think the damage of the shift toward buybacks may even be underrated. With interest rates at zero, investors have been clamoring for yield wherever they can find it. For years, that's been stocks with high dividends, whose prices have been pushed to record levels and yields down to near record lows. Shares of Verizon (NYSE: VZ  ) now yield less than 4% and Altria Group (NYSE: MO  ) , less than 5%.

These are still healthy yields, particularly compared with fixed-income alternatives -- and both companies have high dividend payout ratios. But I can't help but wonder whether companies favoring buybacks over dividends will ultimately be a disservice to companies with high dividends. The lack of yield among most stocks drives up valuations at companies that still do provide reasonable payouts, and high current valuations will eat into future returns.

Managers typically cite the desire to "enhance shareholder value" when announcing share buybacks. But never underestimate the power of unintended consequences. 

http://www.fool.com/investing/general/2013/04/25/the-danger-of-low-dividends.aspx

Don't Fall For False Security Of 'Defensive' Stocks

In times of uncertainty, and in preparation for market declines,Wall Street’s advice to investors is always the same. The market cannot be timed, and cash does not pay enough interest to even keep up with inflation. So investors need to remain fully invested and continue to buy stocks, but can protect themselves by shifting to ‘defensive’ stocks and sectors.

No matter what happens to the economy people will still have to eat, drink, and take their medicines. So food, beverage, and drug companies will continue to do well in an economic or market downturn, and the stocks of utilities and other solid companies that pay high dividends will also do well since the dividends will help offset a decline in the stock prices.

Although consumers will still have to eat, drink, and take their medicines, investors will not have to continue to value the earnings of those companies as highly as they did in a rising market. Stocks that sell at 20 times earnings in the excitement of a rising market may only sell for 12 times earnings by the time a correction has made investors more fearful. So even though a company’s earnings continue to rise, its stock will still be dragged down by the falling market.

The same holds true for the high dividend payers. They also do not escape the problem of investors not being willing to value their earnings as highly as they did in a rising market.

In fact, since defensive stocks and sectors are touted so heavily by Wall Street near market tops, driving their prices to more over-valued levels than other stocks, their subsequent declines often exceed the decline of the rest of the market.

It doesn’t take much research to check it out, but unfortunately most investors aren’t inclined to bother. However, that is my job, and here are the facts.

Utilities are traditionally among the highest dividend paying stocks, yet the DJ Utilities Average plunged 60% in the 2000-2002 bear market, considerably more than the 50% decline of the S&P 500. And it plunged 48% in the 2007-2009 bear market, not much different than the 50% decline of the S&P 500.

In lesser corrections the degree of safety promised for high dividend paying stocks has been equally disappointing for those who accepted the theory. In the summer correction of 2010 the S&P 500 declined 15%. The DJ Utilities Average declined 13%. So far in the current correction, the S&P 500 is down 7.8%. But the DJ Utilities Average is down 11.6%.  A similar relationship exists between the SPY and XLU ETFs.

Likewise, the ten highest dividend-paying solid companies in the 30-stock Dow are down an average of 18.9% in the current correction, compared to the S&P 500 being down 7.8%.  Look at the DVY ETF and how it has now held up well during the past month.

High-dividend payers have an added incentive for selling in the current correction since one of the risks of the ‘fiscal cliff’ is that taxes on dividends might jump significantly. And that’s true. But those same ten stocks plunged an average of 65.3% in the 2000-2002 bear market, and an average of 55.4% in the 2007-2009 bear, much worse than the Dow and S&P 500.

Meanwhile, we’re seeing the same historical pattern for the ‘still gotta eat, drink, and take their meds’ stocks.

So far in the current pullback, while the S&P 500 is down 7.8%, the still gotta eat and drink category is holding up fairly well, although Coca Cola (KO) is down 10.2% and PepsiCo (PEP) is down 7.3%.

In the ‘still gotta take their meds’ category, while the S&P 500 is down 7.8%, most major drug-makers are down more. Abbott Laboratories (ABT) is down 12.4%, Bristol Myers (BMY) is down 14.8%, Eli Lilly (LLY) is down 14.6%, and Merck (MRK) is down 10.7%.

You can blame it on concerns about drug company profits under Obamacare. But just as the high-dividend paying stocks plunged right along with the rest of the market in the 2000-2002 and 2007-2009 bear markets, so too did the drug-makers. Abbott Labs, Bristol Myers, Eli Lilly, and Merck, plunged an average of 54.5% in the 2000-2002 bear market, and an average of 49.1% in the 2007-2009 bear.

Several conclusions could be drawn from that history. The first is that there seems to be nothing to gain by repositioning into the so-called defensive stocks or sectors. In fact, by doing so one may come out the other side even more damaged than by holding onto current holdings.

Taking profits and moving to cash when risk is high would be a much better strategy, even though the cash would earn nothing, since one keeps the previous profits and can re-enter when the correction ends, rather than having huge losses and needing the next bull market just to get back to even. If the expected correction doesn’t materialize, the cost is only some lost opportunity for more gains, not the actual painful losses incurred by remaining fully invested and moving into so-called defensive stocks.

Another approach, which I prefer, is that the best defense is often a good offense. For instance, an ‘inverse’ etf or mutual fund designed to move opposite to the S&P 500, like the Rydex Inverse S&P 500 fund (RYURX), or the ProShares Short S&P 500 ETF (SH) will gain roughly 20% if the S&P declines 20%, more in larger corrections.

Regardless of what decision is made, let’s be street smart and realize that so-called ‘defensive stocks’ usually are not close to being so.

Sy Harding is president of Asset Management Research Corp.

http://www.forbes.com/sites/greatspeculations/2012/11/20/dont-fall-for-false-security-of-defensive-stocks/?partner=yahootix

Getting Rich with Dividends: 3 Tips to Improve Returns With Dividend Stocks

http://finance.yahoo.com/blogs/breakout/3-tips-improve-returns-dividend-stocks-172506087.html

Beware the "yield trap".

Understandably, income investors study dividend yields quite closely. After all, a share on a dividend yield of 5% will pay out twice as much as a share rated on a more miserly yield of 2.5%.

Some investors look at historic yields; some at forecast (or "prospective") yields. It's not a deal-breaker either way, although personally I prefer forecast yields.

But here's the kicker: either way, those yields can be unexploded mines, lurking for the unwary. Looking at yield on its own, in short, can quickly introduce you -- painfully -- to the meaning of the term "yield trap".

Siren call

The yield trap is simply explained. You buy a share, attracted by the high yield. But the dividend is then cut, or cancelled -- leaving you without the anticipated income. Worse, unsupported by the payout, the share price usually falls as well, leaving you also nursing a capital loss.

Let's see it in action.

Company A pays out 9 pence a share, with shares changing hands for 100 pence per share. So the dividend yield -- which is the dividend per share, divided by the share price, and multiplied by a hundred to turn it into a percentage -- is 9%.

But that 9 pence is unsustainable. Company A then halves its dividend, slashing investors' income. What happens to the yield? If the share drops to -- say -- 80 pence, the historic yield the becomes 5.6%. The "yield on cost" figure, of course, is 4.5%.

Dividend cover

How, then, should investors spot potential yield traps? The most obvious reason for slashing the dividend is that the business simply hasn't got the money to pay it.

The business's earnings, in short, aren't large enough to support a distribution to shareholders at historic levels.

Put another way, actual earnings per share aren't sufficiently when large compared to the anticipated dividend per share.

Which is where the notion of 'dividend cover' comes in: earnings per share divided by dividend per share.

Interpret with care

Now, dividend cover shouldn't be followed blindly. 

• Some businesses -- such as utilities, for instance -- can quite happily operate with lower levels of dividend cover than more cyclical businesses. 
• Other businesses -- such as REITs -- must pay out a fixed proportion of earnings as dividends, so again a low level of dividend cover is the norm.
• Still other businesses have very high levels of dividend cover, because they are growing -- and therefore retaining earnings for future investment -- rather than paying them out as dividends.

But as a broad brush generalisation, 

• a ratio of close to one is definitely the danger zone. 
• A ratio much bigger than two indicates a certain parsimony. 
• Personally speaking, a ratio of 1.5-2.5 is usually what I'm looking for.

5 Shares At Risk Of A Dividend Cut

Danger signs

The table below highlights five shares with dividend cover well into the danger zone that I've mentioned. They're all big names, and -- given their yields -- are popular with income investors. And in each case, I've shown the last full year's earnings per share and dividend, yield and dividend cover.

There are shares with lower levels of dividend cover, to be sure -- but they tend to be REITs, or other special cases. The five highlighted have fewer extenuating circumstances, and seem to me to be more in danger of reducing their payout.

Company	Forecast yield %	Full-year earnings per share	Dividend	Dividend cover
Standard Life (LSE: SL)	6.6%	13p	13.8p	0.9
United Utilities (LSE: UU)	5.3%	35.3p	32.1p	1.1
Hargreaves Lansdown (LSE: HL)	4.7%	20.3p	18.9p	1.1
Admiral (LSE: ADM)	7.7%	81.9p	75.6p	1.1
Aviva (LSE: AV)	10.1%	5.8p	26p	0.2

So should holders of these shares be worried? There isn't sadly, a clear-cut answer -- a fact that highlights the importance of looking at the underlying data quite carefully, and considering the full set of circumstances.

Reading the runes

Standard Life, for instance, seems clear-cut, on both a historic and forecast basis: by my reckoning, the dividend is genuinely sailing close to the wind.

But Hargreaves Lansdown and Admiral, though, complicate matters by distinguishing between an ordinary dividend and a more discretionary extra 'special' dividend. But either way, a cut is a cut, and both firms have a level of dividend cover just above one, implying that there's very little margin of safety.

United Utilities may surprise you, depending on which stock screener you use. I've gone back to the annual accounts, and used the underlying earnings per share of 35.3p, described by the company as "providing a more representative view of business performance" -- implying the level of dividend cover that I've shown. Plug the statutory basic earnings per share of 45.7p into the calculation, though, and the dividend cover is a healthier 1.4.

And finally, there's Aviva, where the opposite problem applies. On a statutory basis, the earnings per share of 5.8p delivers a disturbing level of dividend cover of 0.2. Throw in the company's own preferred definition of earnings per share, and a healthier level of earnings of 53.8p emerges, giving a dividend cover of almost 2.

Signs at the Bottom

The bottom - or near enough the bottom - of a market cycle theoretically should be easier to call than the top or near top.

The evidence is found in the corporate balance sheets, income statements, P/E ratios, dividend yields, and other quantitative measures.  It is likewise reflected in low ratios for the market as a whole.  The quantitative factors speak for themselves.

The dividend yield on the Dow Jones Industrial Average, for example, usually cycles between a high yield of 6 percent at the market's bottom and a low yield of 3 percent at the top.   The Dow's average dividend yield sometimes stretches beyond these boundaries, but historically this is a trustworthy parameter of undervalue and overvalue.

Comparing equity yields with term deposits is lazy

Marcus Padley
December 3, 2011

I have been getting a little bit irritated by the constant comparisons between the yield on equities and the yield on a bond or term deposit.

The argument goes that equity yields are now higher than bond yields and also higher than term deposits, so you should switch.

But the truth is that a comparison of the returns on term deposits or bonds with equity yields is simply lazy and ridiculous and reckless, because it misses the point about why people are in term deposits in the first place.

Let me explain by taking a well-known income stock - the National Australia Bank, one of the highest-yielding and safest blue-chip stocks in the market. The yield on the NAB is 7.5 per cent - 10.7 per cent including franking. That, everyone will tell you, is cheap and the argument is that all you mugs holding term deposits earning just 5.5 per cent are idiots because you get a whole extra 2.2 per cent in the NAB or 5.2 per cent including franking.

Fair enough, until you consider this exercise.



Get a chart up of the NAB over the last year (one year will do). Now mark off the peaks and troughs since January and calculate how many and how big the variations have been. You will find that the NAB has had 10 fluctuations. Five rallies and five falls.

The size of the rallies has been +12.8 per cent, +17.8 per cent, +8.3 per cent, +23.2 per cent and +26.9 per cent. The falls have been -9.8 per cent, -15.3 per cent, -23.9 per cent, -13.5 per cent and -18.7 per cent and if we picked a smaller-income stock or took NAB out over a longer period, it would be even more dramatic.



Now tell me after 10 moves of more than 7.5 per cent in just a year that I should be worrying about the 7.5 per cent yield on the NAB. Now tell me, amid that volatility and instability, that I should mention the yield on the NAB and the yield on a risk-free term deposit or bond in the same breath. Now tell me the prudence behind selling my term deposit and buying the NAB.


The NAB and almost all other income stocks in the current market, are not stable low-risk investments; they are volatile trading stocks and the message is clear and let's make it clearer, once and for all. You cannot compare the yield on an equity to the yield on a bond because one includes no risk of a capital loss (no risk of a gain either) and the other contains a currently huge perceived risk of a capital loss (or gain).

Promoting income stocks because they yield more than a bond is ignoring that extra risk and misunderstanding why people are now in bonds and term deposits. They are there because they don't want to lose any more money. Because they don't want volatility.

The only way to compare equities to bonds or equities to term deposits is if the equities came with a price guarantee, which they don't, or if you compare risk-free yields with the expected total return from equities, which includes the extra volatility and risk and not just the dividends.

In the current market, equities are nothing like a bond or term deposit because share-price risk is dominating the investment decision not the yield. Do you really think people are in term deposits to make 5.5 per cent? No, they are in term deposits to avoid losing money. The focus is on the risk not the return. Risk rules.

But it's not all gloom. The good news is that this is not a normal state of affairs. The sharemarket is supposed to be about opportunity not risk and the fact that risk is so in focus means the opportunity side of the equation is being ignored.

Also, risk can change very quickly. Ahead of the last European Union summit the market jumped 11 per cent in four days on lower perceived equity risk. The banks jumped 19.2 per cent. If the GFC doesn't reignite, the focus is going to very rapidly swing back to yields and price-to-earnings (PE) ratios. If the GFC is behind us, how long do you think the NAB is going to trade on a 10.7 per cent yield and the market on a PE of 10.7 times against a long-term average of 14 times?

Not long. In which case the game now is not debating the marginal merits of term deposits versus equities but waiting for a chink of light in the outlook for risk, because that is all that matters and because when it appears, the herd is going to smash down the door to get to those yields and PEs.

At the moment they don't believe in them. Your job is to be on the ball on the day they do.

Marcus Padley is a stockbroker with Patersons Securities and the author of sharemarket newsletter Marcus Today. His views do not necessarily reflect those of Patersons.



Read more: http://www.smh.com.au/money/investing/comparing-equity-yields-with-term-deposits-is-lazy-20111202-1oakh.html#ixzz1jkzaigzd