AMLP - High Yield Or Fast Dividend Growth? Have Your Cake And Eat It Too

2023-08-28 08:35:00 ET

Summary

• The conundrum for dividend investors is whether to invest in high-yield stocks or low-yielding stocks with fast dividend growth.
• Higher yields benefit accumulators by reinvesting dividends into more shares, but dividend growth typically generates higher total returns.
• For withdrawers, high yield has some obvious benefits but also some potential pitfalls, while some argue dividend growth is the best way to go even for retirees.
• Finding dividend unicorns that offer both high yields and rapid dividend growth is rare, but I highlight three stocks with strong potential to do just that.

The conundrum dividend investors often face is whether to invest in high yield stocks or low-yielding stocks with fast dividend growth.

This goes for both accumulators (workers) and withdrawers (retirees).

All else being equal, the core question is this:

Would you rather accumulate more shares over time or have fewer shares that increase in value faster?

For those in the accumulation phase of their journey, higher yields mean more dividends coming in to reinvest into more shares, which translates into more compounding of share count. All else being equal, more shares owned = more dividends.

On the other hand, companies with faster dividend growth tend to be higher quality, faster growing companies with safer dividends. These stocks typically enjoy faster share price appreciation, making capital gains a core piece of the returns profile. The dividend income stream will be smaller to start out, but since dividend growth is expected to be faster, your future dividend income should be much higher.

For those in the withdrawal phase, higher yields obviously mean more immediate dividend income to fund your lifestyle and everyday spending. But unless you are highly selective and smart about stock-picking, higher yields also open the possibility of dividend cuts and will likely result in lower stock price appreciation over time.

On the other hand, some argue that even retirees should focus on dividend growth rather than high income. If the increase in overall portfolio value, from both dividends and price appreciation, is greater than your spending needs, then a retiree can fund their lifestyle through a combination of dividend income and selling shares.

If you were to ask me whether I (as someone in the accumulation phase) prefer higher dividend yields or faster dividend growth, my answer would be a resounding:

Yes.

In an ideal world, I'd have both: a stock with a moderately high yield and fast dividend growth.

I know, I know. It sounds like a pipe dream. Why don't I just throw in a private jet and Ferrari while I'm at it?

Certainly, it is not possible to invest exclusively in these dividend unicorns -- stocks with high yields and fast dividend growth rates -- in the ETF world.

Let me demonstrate this.

Here are three fairly popular high yield dividend ETFs:

• Global X SuperDividend U.S. ETF ( DIV ) -- 7.5% Yield
• Invesco S&P 500 High Dividend Low Volatility ETF ( SPHD ) -- 4.7% Yield
• Alerian MLP ETF ( AMLP ) -- 8.2% Yield

These ETFs aren't cherry-picked other than being some of the more popular high yield dividend ETFs that have been around for at least 10 years. Total returns vary, but generally speaking, the higher the ETF's yield, the lower its price appreciation and total returns over time.

When it comes to dividend growth ETFs, here are three popular choices that have been around for at least a decade:

• Schwab U.S. Dividend Equity ETF ( SCHD ) -- 3.5% Yield
• Vanguard Dividend Appreciation Index Fund ETF ( VIG ) -- 2.0% Yield
• WisdomTree U.S. Quality Dividend Growth Fund ETF ( DGRW ) -- 1.9% Yield

As you can see, total returns are dramatically better for the dividend growth ETFs than for the high dividend yield ETFs.

Sometimes the market can be misguided or off-base, but generally speaking, a high yield is the market's way of saying that decent growth looks unlikely. Faster growing companies are more desirable to investors, and thus, their stock prices get bid up and their dividend yields pushed down.

But I would argue that it is possible to find a precious few true dividend unicorns offering both high yields and rapid dividend growth.

Take the example of Arbor Realty Trust ( ABR ), a mortgage REIT with a unique business model and investment philosophy. The mREIT focuses almost exclusively on residential and especially multifamily loans. The loans are less likely to default because of the defensiveness of the asset class as well as management's underwriting skill. And if they do default, they are asset-backed, thus limiting downside risk.

Despite consistently sporting a dividend yield of 8-10%, the dividend has also more than tripled over the last ten years:

Yes, it is true that ABR got crushed in the Great Recession and had to cut their dividend. But if you had bought sometime in the years after the Great Recession, you would today be sitting on a massive yield-on-cost.

Not to mention more than doubling the S&P 500's ( SPY ) total returns in the last decade.

Dividend unicorns like this are naturally quite rare. Very smart people are constantly on the hunt for incredible deals like this. Lots of people think they find them, but the high yield stocks they've found turn out to be fool's gold.

Sometimes a stock goes from having a low yield to a high yield because the market recognizes that the company's phase of rapid growth is over.

Sometimes company management teams simply promise more than they are capable of delivering.

Worse yet, sometimes the high yield portends on oncoming dividend cut.

Earlier this year, I made a small investment in Intel ( INTC ), thinking it could be one of these rare dividend unicorns. It's yield soared over 5%, compared to its historical average of around 2.5%. I was (and still am) bullish on its long-term prospects as a non-China, non-Taiwan semiconductor manufacturer.

Moreover, I thought the company's massive, $26 billion+ war chest of cash & short-term investments would be enough to sustain the dividend while investing heavily for the future. Unfortunately, capex requirements combined with a severe slump in PC sales changed the situation.

Then a pallid-faced Pat Gelsinger, CEO of INTC, appeared on CNBC to deliver the grim news of a 66% dividend reduction.

So, INTC turned out not to be a dividend unicorn.

I think a similar, slow train wreck could be playing out with the venerable 3M ( MMM ). As the stock has sold off, the dividend yield has crested 6%. But I don't see this one as a dividend unicorn. Not by a longshot.

"What?" I can sense your objection. "3M is a highly respected Dividend King with a 64-year dividend growth streak! How dare you insult his majesty, you insolent fool!"

But look at the facts. The company faces multiple huge legal liabilities for PFAS chemicals, defective earplugs, anti-bribery laws, and so on. The payouts for these liabilities are going to blow a huge hole in free cash flow, and we don't even know how much more damage future settlements will cause. Plus, 3M is about to spin off a huge chunk of its assets in the healthcare business, which could be the perfect time to, ahem, right-size the $3.3 billion annual dividend.

Management said nothing about the future of the dividend on the Q2 earnings conference call , which could indicate a lack of commitment to its current level.

I'm not saying the dividend will definitely be cut. But I am saying 3M is highly unlikely to be one of those dividend unicorns that offers both a high yield and fast dividend growth.

Three Potential Dividend Unicorns

I know what you're thinking.

"Alright, magic boy, do you actually have any tricks to show me, or are you all top hat and no rabbit?"

Keeping in mind that dividend unicorns are extremely rare and often, like the mythical creature, too good to be true, here are three high-yield stocks I'm buying that I believe will also be able to sustain above-average dividend growth.

Clearway Energy Inc. ( CWEN , CWEN.A )

• Dividend Yield: 6.5%

CWEN (and CWEN.A -- its sister share class with a higher yield, less trading volume, and more voting power) owns stabilized, operating renewable power production facilities (wind and solar) plus battery storage facilities and natural gas-fired power plants.

Its parent companies/sponsors are Global Infrastructure Partners and TotalEnergies ( TTE ), a powerful duo of equal owners that should ensure a continual pipeline of new assets to fill CWEN's portfolio.

Over the last three years, CWEN's dividend has grown at a high single-digit pace, and management asserts that the company remains on track to deliver 7-8% annual dividend growth through at least 2026.

The stock has sold off hard this year due to weak wind power production and higher interest rates. But I'd argue these are both bad reasons for the stock to sell off.

• A slow period of wind speeds does not necessarily indicate a permanent reduction in wind power production. It appears to have been an anomaly and that wind speeds will revert to the mean over time.
• No corporate-level, fixed-rate debt matures until 2028, which means CWEN has no refinancing risk until then.
• Most of CWEN's debt is in the form of non-recourse, project-level debt that fully amortizes over the loan term. In other words, the asset's cash flows fully repay the debt principal over time.
• Though these project-level loans feature floating rates, CWEN uses interest rate hedges to mitigate rising interest rates.
• CWEN still has $100s of millions in dry powder from the well-timed sale of its thermal energy assets a few years ago, eliminating any need for equity or corporate debt for growth investments over the next few years.

The primary risk I see to CWEN's ability to keep paying and growing its dividend is the potential for a severe weather event like a wildfire to cause one of its utility company customers to default on their power purchase agreement ("PPA"). This is exactly what happened with California's PG&E Corporation ( PCG ) about five years ago, forcing CWEN to reduce its dividend and pause its dividend growth.

Even this scenario, however, may not be as dire as it sounds, because in the PG&E case, the court eventually upheld the PPAs with CWEN, and CWEN was promptly able to restore its dividend and continue dividend growth.

NextEra Energy Partners ( NEP )

• Dividend Yield: 7.1%

NEP's story is similar to that of CWEN. Like CWEN, NEP owns stabilized renewable energy assets operating under long-term contracts, typically with investment grade customers like utilities, corporations, universities, and governments.

Largely because its parent company/sponsor in NextEra Energy Inc. ( NEE ) is one of the world's largest developers of wind, solar, and battery storage facilities, NEP has been able to handily deliver on its target of 12-15% annual dividend growth since its IPO in 2014.

NEP has also gotten dinged for weak wind power production, which I believe to be a temporary phenomenon, but the bigger issue is its use of convertible equity portfolio financing ("CEPF"). Rather than immediately issuing equity for growth investments, these deals basically allowed NEP to postpone equity issuance until years later while paying ultra-low or zero percent interest in the meantime.

In a zero interest rate world, CEPF worked swimmingly. Not so much in today's environment. But as a sign of management's alignment with shareholders and commitment to dividend growth, they are suspending incentive distribution rights ("IDRs") and seeking to sell NEP's few natural gas pipelines in order to eliminate all near-term CEPF liabilities. This rather than pause dividend growth.

Management asserts that NEP has no further equity needs for at least another year and that NEP will still be able to increase its dividend at 12% annually going forward.

Same risks as CWEN, plus execution risk pertaining to NEP's sale of gas pipelines and elimination of CEPFs. But I believe in management. They are literally incentivized to keep up the dividend growth!

VICI Properties ( VICI )

• Dividend Yield: 5.1%

Finally, the outlier in the group is VICI, the Landlord of Las Vegas. It's a REIT that owns trophy casino properties on the Las Vegas strip as well as regional gaming hotspots around North America. Since its creation as a REIT in 2017 coming out of the Caesars Entertainment ( CZR ) bankruptcy, VICI has delivered impressive dividend growth of about 8% per year.

After recently completing the $17 billion acquisition of MGM Growth Properties and its iconic casino resorts, VICI's growth rate will almost certainly slow from the high single-digits to the mid-single-digits.

But between more property acquisitions and ~2% annual rent escalations, VICI will continue to grow. I am assuming roughly 5% dividend growth going forward.

Combined with a 5%+ dividend yield, does this make for a "dividend unicorn"? That's up for individual interpretation, but I'm going to say yes.

Bottom Line

Can you have your cake (high dividend yield) and eat it too (fast dividend growth)?

You'd be wise to be skeptical. But dividend unicorns exist. The market is pretty efficient, but it isn't all-knowing.

As far as high-yielding dividend stocks go, I think the three above have a good chance of not only sustaining their dividends but also growing them at a rapid clip going forward.

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