Grow The Pie In 2016
If you had to feed your family in 2016 on a single apple pie (yes, it's a crazy premise, but bear with us), you would care a lot more about the size of the pie than the size of a single slice.
Unfortunately, too many cash-flow-hungry investors focus on the size of only one slice of the pie — the yield slice — and not enough on the other parts of the pie, such as dividend growth and capital appreciation.
It's a common belief. "If I need a cash-flow return of 4% from my portfolio to cover my expenses, I need a portfolio with a dividend yield of 4%." There are at least four problems with that logic:
1) If you limit your hunting ground to high-yield stocks, you greatly diminish the size of your opportunity set for finding stocks that can grow the pie. Among the roughly 5,000 stocks in our Quadrix universe, just 711 yield 4% or higher, less than 15% of the total. Viewed differently, investors who "need" a yield of 4% or higher eliminate 85% of their possible options. Hamstringing your investment process like that can lead to mediocre returns.
2) Since high-yielders tend to cluster in only few industry groups, you give up one of the true free lunches in the investment game — portfolio diversification. Among the stocks yielding 4% or higher, 63% are in the energy and financial sectors. Owning lots of stocks from only a couple sectors can lead to riskier-than-appropriate portfolios. In addition, high-yielding portfolios typically have a high degree of interest-rate sensitivity, an especially dangerous characteristic right now, given what appears to be a trend toward higher rates.
3) As a group, high-yield stocks don't provide the most attractive investment opportunities at the moment, according to Quadrix. Stocks with yields of 4% or higher average Overall scores of 51, while those yielding 1% to 4% average 64. High-yielders are somewhat cheaper, averaging Value scores of 65, versus 59 for those yielding 1% to 4%. However, stocks with modest yields have a big edge in growth, averaging Momentum scores of 53 and Quality scores of 62, versus 41 and 45, respectively, for the top-yielding stocks.
4) You are not likely to grow the pie if you focus solely on yield. The yield slice doesn't really grow. Sure, yields can rise or fall, but that's only because of the stock's performance or a change in the dividend. The yield itself, in terms of its overall impact on the size of the pie, is largely static. Dividend growth and capital appreciation have a much greater effect.
All investors, especially those who must generate cash flow from their portfolios, should aim to grow the entire pie. The U.S. government taxes qualified dividends and long-term capital gains at the same rates, encouraging investors to be agnostic as to how they generate cash flow from portfolios. In such an environment, it makes sense to increase portfolio value in multiple ways, including current dividends, dividend growth, and appreciation.
The Forecasts continues to see yields of 1% to 4% as the sweet spot for dividend and cash-flow investors. We also like to see annual dividend growth of at least 5% and market-beating appreciation potential, as evidenced by superior Quadrix scores. The table below lists 15 stocks that meet those criteria.