Will interest rates continue their recent ascent?
If so, many investors will come to question the wisdom of holding dividend-paying stocks. After all, bonds and CDs are virtually riskless, and if they sport more attractive yields, why bother with riskier stocks?
Yet there is a whole different type of income-producing stocks that fail to meet that 4% yield threshold but should still hold great appeal. These are the stocks with fairly low yields right now but look poised for robust growth, which should set the stage for future yields well above 4%, using today's prices as a basis.
Notes From The Guru
Over the past six months, I've been eagerly awaiting the latest newsletter issues from my colleague Amy Calistri, author of StreetAuthority's Daily Paycheck. Amy has been spelling out a game plan for how to deal with the inevitable rise in interest rates that may now be underway, helping readers to separate winners from losers in a higher-rate environment.
In her most recent issue to subscribers, Amy focuses on an exchange-traded fund (ETF) that should fare quite well, even as rates rise higher. The current yield on this ETF is around 3.5%, which is below the 4% level I noted earlier.
Yet here's the rub: This ETF is chock-full of companies that are boosting their dividends at a fast pace, and a 3.5% yield today could easily morph into a 5% yield in a few years and a 7% or 8% yield in half a decade.
The combination of solid current and future dividend streams and potentially robust price appreciation makes me think Amy has delivered another winning pick to her subscribers.
There's another reason to focus on dividend growth: "Companies with a long history of dividend growth display high returns on equity (ROE)," according to WisdomTree's head of research, Jeremy Schwartz. The data bear that out: The companies in the widely followed NASDAQ US Dividend Achievers Index had a 22% annual ROE over the past 10 years, according to Schwartz, compared with 13% annual ROE for all companies in the S&P 500.
WisdomTree -- which has pursued the dividend angle for a number of years with funds such as WisdomTree Emerging Markets SmallCap Dividend ETF (NYSE: DGS) and the WisdomTree LargeCap Dividend ETF (NYSE: DLN) -- recently pursued the growth angle with a newly launched ETF, the WisdomTree U.S. Dividend Growth ETF (Nasdaq: DGRW).
This fund uses an index-based approach to select the top companies in a 1,330-stock universe in terms of dividend growth, sustainability of those dividends (in terms of a payout ratio above 1.0) and current yield. Tech stocks represent the largest weighting of any sector, at around 20%.
And that makes sense: The number of dividend-paying technology firms in the S&P 500 has shot up by one-third since 2010, according to S&P Capital IQ's Scott Kessler, who runs that firm's technology research department. "You need to think about the tech sector as being uniquely positioned for robust dividend growth in the years ahead," he adds. (Here's a hint: Amy Calistri's newsletter readers are well aware of that looming trend.) Along with tech, industrials, consumer discretionary stocks and consumer cyclical stocks are the primary focus.
My primary complaint with this fund is that it is focused only on large firms (each component has a market value of at least $2 billion). Smaller companies are often capable of even more robust dividend growth as they can tend to be earlier in their life cycle.
There is the WisdomTree SmallCap Dividend ETF (NYSE: DES), but this doesn't really have the dividend growth orientation that we're talking about. The fund's 0.28% expense ratio is respectable, but cheaper options are available. (Note that according to recent filings, Wisdom Tree indeed appears to be poised to launch a small-cap version of the dividend growth ETF.)
The Vanguard Option
For the ultra-low-cost approach, check out the Vanguard Dividend Appreciation ETF (NYSE: VIG), which owns companies with a history of 10 straight years of dividend growth. This approach brings two small drawbacks.
First, any companies that were forced to reduce or eliminate their dividend during the financial crisis of 2008 won't be here, even though a number of these companies are now back on track with solid divided boosts.
Second, it ignores the wide variety of tech stocks that only began paying dividends in recent years. For example, Apple (Nasdaq: AAPL) won't be in this fund for another decade.
Still, the Vanguard fund has real strengths. In giving the fund a five-star rating, Morningstar analysts noted: "Whereas many dividend-focused funds concentrate in smaller value companies, this fund shades slightly toward growth. VIG is a great choice for a core allocation."
Moreover, like many Vanguard funds, the 0.13% expense ratio is quite pleasing, so your long-term gains won't be diverted away to the fund company's coffers.
The PowerShares Dividend Achievers ETF (NYSE: PFM) and the First Trust Morningstar Dividend Leaders Index (NYSE: FDL) have a similar focus to the Vanguard fund, though they carry higher expense ratios of 0.60%, and 0.45%, respectively.
Risks to Consider: Dividend growers should relatively greater appeal than companies and funds that have limited growth prospects, but all equity-based income producers may sell off if fixed-income rates move sharply higher.
Action to Take --> Though rates are coming up off of generational lows, they are unlikely to rise much higher, killing the dividend party. Instead, assume a moderate move up in rates over time that still leaves plenty of room for robust dividend growers in your portfolio as well.