Dividend Yield or Growth: Which Should You Prefer?

I’ve long divided dividend stocks into three baskets.

The first basket I’ll call growth stocks that happen to pay dividends. These are companies that are primarily interested in growing, but also throw their owners a bone by including a small dividend. Examples of this in Canada include Brookfield Corporation and Dollarama.

The other end of the spectrum are high-yield dividend stocks. These are companies whose high growth days are firmly in the rearview mirror, but they compensate for their lack of growth by spitting out gobs and gobs of predictable cash flow. Some of these stocks offer risky payouts with too-high payout ratios, but for the most part these companies can deliver decent returns, mostly from dividends. Just don’t expect much growth.

Finally, we have the Goldilocks of the three categories, dividend growth stocks. These are companies that pay a decent yield today (something in the neighborhood of 2-5%), with a combination of steady — albeit unspectacular — growth, say in the neighbourhood of 5-10% per year.

As I said in a tweet a couple of weeks ago, I love these stocks. Especially when they fall and you can pay a very reasonable valuation for them.

Although I firmly believe that a diverse dividend portfolio should have all three types of dividend stocks, here’s why the dividend growth category is where I spend a lot of time — and where I think you should spend your time, too.

The unsung portfolio heroes

It’s funny how much attention the other two categories of dividend stocks attract. On the one hand, I get it. But, on the other, there are some pretty big weaknesses to focusing on these types of stocks.

Growth stocks that happen to pay dividends can be your best friend in a bull market. They’ll march higher, and usually at a faster pace than the rest of your portfolio, too. But these stocks are hardly ever available to buy for a reasonable valuation, and then tend to slump badly during bear markets. That can be fine, depending on your risk tolerance, but I’ve found saying you’ll be calm during a bear market is much easier than being calm when it seems like the world is ending.

Take it from me; I’m old enough to have weathered dozens of corrections, and they suck. Especially in today’s social media-driven world.

Many rookie dividend investors go to the other extreme. They are attracted to high-yield dividend stocks, following the simple logic of dividends good, so more dividends better. They scour the top yielding stock lists, make picks that’ll maximize their dividend income, and usually end up disappointed.

As I said off the top, I believe there’s a place in every dividend portfolio for high-yield stocks. Adding just a few to a well-rounded portfolio can really boost the overall yield. Don’t listen to folks who say all high-yield dividend stocks are trash that are thisclose to cutting their payouts. There are stocks out there that offer high yields — and even some that offer high yields and dividend growth.

In fact, I wrote about one just a couple months ago, a nearly 7% yielder with an enviable history of dividend growth (plus many special dividends!).

Ultimately, I like dividend growth stocks because they offer a little bit of growth and usually a pretty decent yield. Over time that’s a powerful combination — even if it doesn’t seem like it.

An example

Royal Bank of Canada (TSX:RY) is the absolute perfect example of how a good dividend growth stock can really supercharge your portfolio — all while posting solid, unspectacular results.

In 2006, Royal Bank earned $3.59 per share. In 2023, it earned $11.39 per share. That looks pretty impressive, but on a compounded basis it translates into Canada’s largest bank growing its bottom line by about 7% per year.

That’s pretty good, but hardly spectacular.

The company paid a $1.82 per share dividend in 2007, which means shares yielded anywhere between 3-4% that year.

These days, Royal Bank pays a $5.68 per share dividend, which puts shares at right around a 3.4% yield. It also means that the dividend has gone up about 7% per year since 2007, tracking earnings growth almost exactly.

It’s funny how these things work out, huh?

I picked 2007 as a starting point because the 2008-09 financial crisis ravaged bank stocks. It was a terrible time to put money to work in the sector, the very epitome of buying at the top.

Royal Bank not only survived, but it thrived.

A good rule of thumb for estimating total returns is:

Dividend yield + earnings growth + changes in valuation = total return

Dividend growers like Royal Bank — or dozens of others on the TSX, and hundreds more in the U.S. markets — which offer decent starting yields and steady potential growth can combine to deliver surprisingly solid returns. Especially if you reinvest your dividends.

These types of stocks work really well for creating your own pension, too.

One argument I always hear about Royal Bank is it’s too big, and its days of earnings growth are behind it. After all, it is the largest stock on the Toronto Stock Exchange. Well, guess what? It was the largest stock on the Toronto Stock Exchange back then too, although it was surpassed by Research in Motion in 2007, a temporary phenomenon that eventually ended in tears for RIM shareholders.

Royal Bank is an obvious pick. I’m the first to admit that. But obvious can be good. Remember, there are no bonus point for complex ideas in investing.

One more example

Let’s look at one more example of a stock that has a demonstrated history of paying a decent dividend and delivering a reasonable amount of growth.

IA Financial Group (TSX:IAG) is one of Canada’s oldest life insurers. The Quebec-based insurer has been in business since the 1890s and debuted on the TSX in 2000.

It has since expanded into all sorts of different financial services areas, including specialty insurance, dealer financing, and wealth management. Since its 2000 IPO it has grown book value per share — an important metric for insurance companies — by about 9% per year. Earnings have increased at about the same rate.

Management has also targeted a 10% annual growth in core earnings per share, a measure that strips out volatile swings in the investment portfolio value. It has achieved that target from 2015 through 2023 through a series of smart acquisitions and via organic growth. Making deals is in the company’s DNA; it has made 70+ acquisitions since 2000.

Management isn’t finding many interesting acquisitions these days, so the company is doing the next best thing and retiring what it views as undervalued shares. It has repurchased some 5.6% of total shares outstanding thus far in fiscal 2024, with plans to buyback about 8% of the equity by the end of the fiscal year.

This means that even if earnings stay flat from year-to-year, earnings on a per share basis will increase by 8%. That’s the power of a consistent share buyback.

As it stands today, IA Financial pays out a $3.28 per share annual dividend. That’s good enough for a yield of just over 3%. Add in projected earnings growth of 7-10%, and I see a stock that could very easily return 10%+ on an annual basis for the next 20 years.

Just like it did over the previous 20 years.

The bottom line

Both Royal Bank and IA Financial are both in that Goldilocks dividend growth zone.

Both stocks have a decent beginning yield (3%+) with solid historic earnings growth that should continue in the future.

I like to spend much of my research time on these types of stocks. Once I have a solid foundation of these types of stocks then I go shopping for some growth and some high yield.

By combining the three categories into one portfolio, I get a little bit of everything. I have enough yield to ensure my early retirement withdrawal strategy is safe, while having enough growth to keep ahead of inflation.

It’s a nice combination, even if you’re not quite yet an early retiree.

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