Personally, JP states that high yield stocks (above 10% or so) are risky.  So, in order to get an expected return above that, he adds the current dividend yield to the expected dividend growth rate.  I, personally, consider that a riskier strategy.

For example, a stock I own (Frontline Tankers FRO) has a current yield of 11%.  Josh would not include it in his portfolio for a few reasons.  First, it has too high a yield.  Secondly, it's dividend growth rate is sporadic (depends on tanker oil transport spot rates).  Third, it's a relatively small company that hasn't been around long.  Fourth, it has no moat.  Fifth, it's ROE is quite high and might not be sustainable (55%).  And so forth.

He would choose instead a stock with a 6% yield and a 5% dividend growth rate.

I would consider FRO to have an expected return of 11% (ignoring any dividend and share price growth).  Josh would consider his company to have an 11% expected return also, and would include it in either of his portfolios.

The difference between FRO and Josh's company is that he's betting on the come (5% dividend growth rate, going forward), while I'm betting on the excess 5% of current yield FRO is generating to be sustained, going forward.  FRO's growth will come from compounding the excess 5% yield it's generating.

ElLobo, your explanation of JP's approach of combined decent-to-high yields with dividend growth vs straight-forward investing in high-yield products is classic. I just have one question about your last statement, though...

FRO's growth will come from compounding the excess 5% yield it's generating.

I assume when you say this that you really mean that the growth of your FRO assets is the direct result of your compounding your shares by reinvesting FRO's dividend. Am I correct? If I am wrong, please set me straight. Thanks!

Regards,

Susan

Susan,

"Am I correct? If I am wrong, please set me straight. Thanks!"

My answer was with respect to the original posting as to why I (er, Stats!) would not choose individual stocks that JP recommends.

Nevertheless, in answer to your question, yes, the situation would be directly comparable if I were to reinvest the excess 5% dividend yield from FRO back into purchasing more shares of FRO.

In the comparison, the value of my holdings, in FRO, would almost match that of JP's stock.  However, I believe my holdings would be worth more, over time (given constant 11% yield for FRO and constant 6% yield plus 5% yield growth.  The reason is compounding.

JPs stock would see it's per share distribution rise over time (by 5%), I would see FROs distribution stay constant, but I would own 5% more shares each year.  And each new share generates the 11% yield.

(Stats, mathamatically, I know what I wrote above might only hold if the per share distribution rose by a given dollar amount, rather then by a constant percentage amount)

(Also, I fully realize that a stock that has a constant dividend distribution would NOT be expected to see any increase in share price, while another stock, with a 5% growth in its dividend would be expected to see an increase of 5% in it's share price [constant P/E and D/E assumed].  Both JP and I ignore share price behavior.)

But there's another advantage for my strategy.  I don't have to put that excess 5% yield back into FRO.  I could put it in another company.  Or a fund.  JPs income growth is a captive to his company.  For what that is worth.

Next, I assumed that FRO had a zero growth rate for it's dividend.  That hasn't been the case, obviously.  If you apply JPs dividend growth model to FRO, you find that it hasn't been zero.  Nevertheless, any growth I get is frosting on my particular cake.  My risk is a cut in dividend, while JPs risk is zero growth OR a cut!

Also, the whole point is that JPs model for dividend focused investing relies on a positive growth rate for the yield income of the asset.  However, this locks out all assets that have a high yield, but no expected growth of that yield.  Specifically, long term and/or lower quality bonds.  Such debt has a place in my portfolio, but not in JPs.

As do mutual funds (both open and closed ended.)  All equity funds have a yield  (readily available on M*).  However, the financial data needed, by JP, to calculate the yield growth term isn't available for fund.  So, JPs portfolios contain only individual stocks.  Funds have a place in my portfolio.

The prime example is ADVDX.

Next, JPs model for calculating that expected dividend growth rate is a bit complicated, while still logical.  Even still, you have to make some qualitative judgements as to the sustainability of the data going into that model to end up with realistic, believable growth rate estimates.

In the case of FRO, it's ROE has been 55%, so I would have to estimate how much to shave/cut from that number.  Since my model is oblivious to that growth component (I ignore espected dividend growth), I need only do a reasonabless check on it (to see if the growth rate could be negative).

Finally, BOTH of our models are woefully lacking in any way to estimate the quality of the size of the dividend yield itself.  That is, JP simply states that a 10% yield is risky, so he doesn't consider such stocks for his portfolios (maybe he does, but throws them out for other reasons).  I assume 10% is safe, unless something tells me that it isn't.  FRO is a fine example of why we each have our own views.

So, FROs dividend yield is 11% today.  It's share price is just south of $60.  If it happens to continue on it's recent trend, and goes to $120 by the end of the year, it's yield would be cut in half (to 5.5%), assuming it maintains it's per share payout.  It was never clear to me why FRO, at 11% dividend yield, would be more risky then at a 5.5% yield!  I don't think it is.

But that's just me.

Did I answer your real question?

I do believe that the risk increases when companies adopt a high  payout strategy. The high div reduces the financial flexibility of the company to grow organically. That in turn forces the high payer company to grow  by issuing stock. And that is usually an unpleasant surprise for shareholders.

David 

David,

"I do believe that the risk increases when companies adopt a high  payout strategy. The high div reduces the financial flexibility of the company to grow organically. That in turn forces the high payer company to grow  by issuing stock. And that is usually an unpleasant surprise for shareholders."

You are talking about a high dividend payout ratio, not a high dividend.  The payout ratio is the ratio of the dividend to earnings.  That is, if the payout ratio is high (above, say, 50%), then what you say is true.  However, if the ratio is below that same 50%, it's considered safer.

Say earnings were $2/share, and the company paid a $1.50 dividend.  The ratio would be 75%, and the dividend would be at risk.

Now, if the share price of that stock was $15, then it's yield would be 10%, and I would agree that this is a risky dividend.  If the share price were, OTOH, $30, the yield would be only 5%, but the risk of the dividend is still as high.  Actually, it's higher!

You, and Josh, would say that the risk was there, at a 10% yield, but not at a 5% yield, although the amount of the dividend, the earnings, and the payout ratio were the same.

OK, ElLobo, I've got a question for you.  It's not a hypothetical.

I invested in a spankin' brand new company in the last days of 2005 at just under $14.00 a share.  It was promising to pay $0.50 a quarter - $2.00 per year.

And it has done just that.  Of the two bucks, $1.20 is qualified because that is just about what they earned - so $0.80 is a return of my investment.

Over two years, I've received about $2.40 in dividends that were taxable at 15% and  about $1.60 that is a return of some part of my investment.  My investment is now $12.40, right?

I haven't sold any of this investment so I don't have any positive or negative return (other than the dividend) but IF I had sold some shares last Friday, they would have fetched about $32 each.

Is my investment riskier now than it was the day I made it?

Regards.

Cliff 

Cliff,

"Over two years, I've received about $2.40 in dividends that were taxable at 15% and  about $1.60 that is a return of some part of my investment.  My investment is now $12.40, right?"

Correct.  That is your cost basis, as I understand it.

"I haven't sold any of this investment so I don't have any positive or negative return"

No true.  So far, you have $4/share positive return.  $2.40 of that was yield, $1.60 was unrealized capital gains.

"Is my investment riskier now than it was the day I made it?"

Are you asking if you purchased more shares last Friday, at $32, would that investment (in those shares) be riskier then your investment in the original shares (at $14/shares?)

If so, my answer is yes.  Specifically, it's more probable that share prices, going forward, will decline (back down to $14, or $12.40) rather then continue to increase, up to $50/share.

In fact, this holds whether or not you purchased new shares on Friday.  That is, most measures of risk involve declining share prices (at least bad risks!), and something is considered riskier if the chances of such decline are greater then the chances of an increase.  This is mean reversion type stuff.

Put another way, if the payout out of a stock is constant, while the share price is volatile, then the stock is riskier at higher share prices, which means lower PERCENTAGE yields.  And the higher the percentage yield, the lower the risk.

Did I answer your question?

Put another way, any investment in a stock is riskier if the stock is currently overvalued.

Is my investment riskier now than it was the day I made it?

I understand your discussion as it relates to overall investing precepts.  And I would agree, in general.

However, the question was "Is MY investment riskier now than it was the day I made it?"

And I guess my answer is no, not even close.

When I plunked down $14 bucks a share this company barely existed - the cash from its IPO had just hit their account and the stock was already down over $3 from that $17 IPO price.  They said they wanted to distribute $2.00 a share but no one was going to jail if they didn't.  They had a plan and some management experience but they didn't have any track record with this company.  Oh, yeah, I think I recall reading that they didn't expect to make $2.00 a share for quite some time and they'd probably need more money along the way and they might borrow a whole boatload of it if they wanted to.

MY investment at that time, even I would admit, was quite risky.

Today that company has over two years of operating experience, is profitable and is somewhat of a leader in their business.  Yes, they pay out more than their earnings but that is in accordance with their stated plan.

As for me, MY investment is only $12.40.  I'm getting about a 10% yield (the $1.20 dividend) on that $12.40 AND, in addition, they're returning about $.80 a year of my investment.

So, on a fundamental basis - a couple of years of profitable operations is better than a rank start-up - I think my investment (my $12.40) is less risky now.

As far as the price of the company's stock last Friday or tomorrow?  I don't know if others consider it overvalued or undervalued or fairly priced.  The current pricing of the company's stock isn't really related to MY return because I'm not selling.  And as far as the stock price and MY risk, I guess I look at a situation like this and say 'I'd rather the price be $32 and have a very great chance of dropping than have the stock price be priced considerably lower today.'

On both counts - a fundamental look at what's happened with the company and the price of the company's stock today - I'd say MY $12.40 is less at risk today than was my $14 a couple of years ago.

Regards.

Cliff

p.s.  Those Greek guys do know how to start up a shipping business, don't they?  :) 

Cliff... risk is ultimately a very important consideration but unfortunately the risk each investor sees and feels is often very different.  I know this discussion is about the risk difference between high yield versus low yeild but fundamentally it is about risk... so I will pick on a company we own.

We own some shares of GE that we were fortunate enough to buy at $27.  So how do we see the risk of GE?  When I bought them I did not pay attention to price as much as I do now... and I over paid, M* had them rated as a 2-stars.   So by my standards today there was lots of risk.

Does someone who bought recently at $31 have more or less risk than I?... They bought a 5-star stock; they got an excellent deal and probably consider GE not very risky.

Pity the poor fellow who bought at $38 recently... he saw the 14% drop this month and sees lots of risk.

Then there is the fellow considering buying GE now because its price is back down near its 12-month low.  What is his risk? 

We all see different risk... because we all have a different price. 

Your purchase was risky when you bought it.  It has worked out well and the risk has decreased somewhat.  It is still likely very risky... risk is important, but it is ultimately an individual assessment.

Stats

PS... I am one of those Greek guys who does not know how to start up a shipping buisiness.  :-)