You might think that to generate inflation-beating dividend growth you’d have to invest in companies that can grow their dividends faster than inflation. And to some extent that’s true.
But there are other ways of generating high rates of dividend growth, and one of them is to focus on very high yield, but low growth companies. You know, the boring stuff that sends the average investor to sleep.
Climbing the dividend ladder
The process is surprisingly like vaulting up the property ladder.
With property you can buy a slightly run-down house at auction, spend some time and money doing it up so that it looks nice and attractive, and then sell it on to someone who wants a house with that is ‘ready to go’ with a nice new kitchen and bathroom.
If you do it right, you can make a tidy profit and buy something a bit bigger next time. Repeat often enough and you could become a property ladder millionaire.
The same thinking can be applied, more or less, to the stock market.
Take UK Mail. Some might say it’s a boring business that delivers letters and other things. It’s been around a long time and will likely still be around a long time from now. The yield when I added UK Mail to my investment newsletter’s model portfolio in October 2011 at 210p. The yield was 8.6%.
That’s a fantastic yield, assuming it was going to be sustainable. However, this company was unlikely to be of interest to a traditional dividend growth investor because the dividend showed no signs of growth at all. In fact the dividend had barely changed in a decade.
So if the company wasn’t growing its dividend, why did I add it to an income and growth portfolio? The answer is that by buying high and selling low (yield, not share price) I can climb the dividend ladder.
Stock market volatility is not a risk, it is an opportunity
Jeremy Grahtham of GMO has said that share prices are up to 19 times more volatile than the companies they represent.
This is not risk – it is opportunity.
It allows investors to find companies like UK Mail, with a strong and relatively reliable dividend, and buy them with a yield more than double the market average.
Okay, so there’s no chance of dividend growth by owning UK Mail, but there is a huge opportunity for dividend growth from buying and selling UK Mail.
I eventually sold the shares after a year. The share price had risen to 263p and the yield had dropped to 6.9%. That’s still high, but far lower than the original 8.6%.
The share price had risen some 25%, but it was obvious that UK Mail had in no way grown in value by 25%. On top of that a yield of 6.9% is far less attractive than a yield of 8.6%, especially in a company that has shown almost no ability to grow its dividend.
So what did selling give me?
Selling at 263p produced a capital gain of 25%. If my original investment had been for £10,000 in UK Mail then the 8.6% yield would have produced around £860 in a year. After selling, the capital amount would have been £12,500, which in turn would produce £1,075 if I found another share with a yield of 8.6%.
Going from a dividend of £860 to £1,075 is a dividend growth rate of 25%, even though the underlying company hadn’t grown its dividend at all.
This is dividend growth generated not by the company, but by the investor taking advantage of the wild and excessive swings of the stock market.
It turns out that if you know how to accurately measure a company’s value you can generate high rates of dividend growth. You can do this not just from the traditional high yield, steady growth blue-chips that dividend growth investors favor, but also from super-high yield, low growth companies that are only usually of interest to pure income investors.