This is a guest contribution written by Kay Ng who writes on Motley Fool Canada and also writes on Seeking Alpha under the alias Canadian Dividend Growth Investor. She also maintains a blog at Passive Income Earner with a focus on dividend investing as a Canadian investor in Canada and the U.S.
Many investors new to dividend investing would focus on companies with big dividends. There’s nothing wrong with buying companies such as AT&T Inc. (T, Financial) for safe, big dividends.
However, if you have decades for your investments to grow, low-yield, high-growth stocks can be your ticket to an early retirement. I’ll use real-life examples to explain.
First, let’s take a look at AT&T as an income and total returns investment.
High-yield example
Since 2000, AT&T has compounded its dividend per share (DPS) by 4.2% per year. However, due to its overvalued shares at the start of the millennium, its annualized rate of return has only been 1.5%. This underperformed S&P 500’s return of 3.3% in that period.
That said, $10,000 invested in AT&T over the index would have returned 1.8 times more in dividends.
Even if you had bought AT&T at a fair valuation, the total returns wouldn’t have been spectacular. After all, its earnings per share (EPS) grew less than 1.5% per year from 2000 to 2015.
If you were a retiree in this period, you might have only cared about the dividend checks. In this case, AT&T might have passed as a satisfactory income investment.
Since 2009, AT&T has only increased its DPS by 2% a year. If the company keeps this up, its shareholders should worry that their purchasing power won’t keep up with the long-term inflation rate of 3 to 4%.
Low-yield, high-growth example
If you have decades before you will tap into your portfolio, low-yield, high-growth stocks can double your money much faster than slower growing companies.
Starbucks Corp. (SBUX, Financial) started paying a dividend in 2010. Let’s say you confirmed a dividend hike before finally pulling the trigger and invested in it at $20 per share in 2011. Yes, it was the highest price in that year and it traded at a multiple of about 27!
Fast-forward to now, Starbucks has performed well by delivering annualized returns of 21.9%. This is backed by the restaurant’s high-growth EPS that compounded 20% per year from the fiscal years 2011 to 2016. In the same period, its DPS compounded 23.3% per year.
That is, a $10,000 investment in Starbucks would have become $28,218 (including capital appreciation and dividends). The same investment in AT&T during the same period would have become $16,097 for an annualized return of 9.5% only.
How low-yield companies can deliver great returns
Although analyst estimates aren’t accurate, they give good guidance on whether a company is worth its current multiple. In 2011, Starbucks traded at a multiple of 27 and ended up compounding its earnings at a rate of 20%.
At under $54 per share, Starbucks trades at a multiple of about 28 and its consensus analysts' EPS growth expectation is 18.7% per year for the next three to five years.
Although Starbucks trades at a premium compared to 2011, it is still not a bad valuation to buy some shares after a one-year consolidation period.
Periods of consolidation eventually lead to new highs as the company continues to grow its earnings
In the recent past (2012 and 2014), it has experienced periods of consolidation and moved to new highs. In the past year, it has experienced a similar period of consolidation and can very well rise to new highs in the future.
Although Starbucks only yields 1.5%, the company can continue growing its DPS by 18% per year if management decides to maintain its current payout ratio of below 43%. We will find out as soon as the company announces a dividend increase.
Conclusion
A company’s dividend growth rate is a good gauge for its growth. Since high growth leads to high returns and faster dividend growth, other than stocks with big dividends, investors should consider buying quality, high-growth stocks at the right valuations, including these 3 large caps.
AT&T’s earnings per share has grown at a snail pace of 1.5% per year since 2000. Subsequently, its dividend per share growth has been 4.2% per year, in that period, as its payout ratio expanded from 45% to 70%.
On the other hand, Starbucks’s earnings per share has increased by 20% per year since 2011. As a result, its dividend per share growth has been 23.3% per year, in that period, as its payout ratio expanded from 37% to 43%.
Disclosure: I am not long any of the stocks mentioned in this article.
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