I love dividends, but only partly because of the income they generate in my portfolio. In fact, if all you look at is the size of a company's dividend yield, you'll miss out on some very important information.
Here are two high-yield dividend investing tips that can help you earn thousands of dollars. They help explain why Hormel Foods Corp.'s (NYSE:HRL) 2.1% yield is more exciting than it looks, and why Magellan Midstream Partners' (NYSE:MMP) 5% yield could be more desirable than those of midstream peers with much higher yields.
1. Valuation matters
Hormel is a food manufacturer focused on the protein space. Its best known product is probably Spam, but it has a range of offerings from Wholly Guacamole to bacon. Right now, being a food company is something of a problem, because consumer tastes are shifting from prepackaged foods usually located in the center of the grocery store to items perceived to be fresher and located on the periphery.
Hormel isn't resting on its laurels, and has been shifting its business along with customer tastes. In fact, it has products throughout the store, most with leading industry positions. And it continues to shift and adjust, using product innovation, ground-up construction, and acquisitions to expand its portfolio, geographic reach, and diversification within the food industry.
But the good news at Hormel hasn't stopped investors from focusing on the negatives in the broader industry... and pushing shares lower. Which is where tip No. 1 comes in: Hormel's yield, though only 2.1%, is at the high end of its historical range. Yield relative to history is only a rough guide to value, but it can provide a key signal that it's time to do a deep dive. Hormel's yield suggests that now is a good time to step in and buy the food company.
Of course, you'll want to look at other factors as well. For one thing, Hormel has increased its dividend annually for over 50 years. For another, the company's long-term debt only makes up around 5% of its capital structure. Sure, Hormel is facing some issues today, but it's proven it knows how to survive (while continuing to reward investors with dividend hikes) and has the balance sheet to deal with just about any storm that comes its way.
Meanwhile, if you step back and compare Hormel's yield to historical trends, you'll see that investors are likely mispricing this food industry stalwart today. If you are willing to go against the crowd you could make a profit from the relatively high yield alone, and be in line for capital appreciation when investors get a little more rational.
2. Growth can change things
There's another key fact that investors frequently miss when they focus only on high yields: the importance of dividend growth. The first big reason for this is inflation, which slowly eats away at the buying power of a dividend that doesn't grow by at least 3% a year. The second is the profound effect that compounding has on numbers.
A great example of this shows up in the midstream oil and natural gas space. Industry giant Enterprise Products Partners L.P. (NYSE:EPD) is generally considered one of the best run partnerships around, and offers investors a sizable 6.4% yield. Over the past decade, its distribution has grown at a respectable 6% (or so) on an annualized basis. That beats inflation, but it's a full five percentage points behind the distribution growth achieved at Magellan Midstream Partners, which only yields around 5%.
What difference does a few percentage points make? You might be surprised! Over the past decade Enterprise's distribution has increased by around 70%. That's not bad, but Magellan's distribution has grown by 170%! If you had bought Magellan 10 years ago, your income stream would be larger today than what you would be getting from a similar investment in Enterprise. And it all boils down to the difference in distribution growth rates.
Clearly, it's important to understand some background here. For one thing, Magellan is conservatively run and has low debt relative to peers. This allows more cash flow to pass through to the distribution. Low debt and a relatively low yield also mean the partnership has ample access to low-cost capital when growth opportunities present themselves, which helps boost growth over time.
While these facts are important, the real story is that looking past yield to dividend growth rates can help you earn thousands. And it explains why you might prefer to own Magellan over Enterprise if you are looking at the midstream space.
No silver bullets
I don't want to give you the impression that looking at yield relative to history and dividend growth rates will solve all of your dividend investing problems. It won't. These metrics, however, are two important tools that you should add to your investing toolbox. They give you information that yield alone does not. And if you take the time to dig into these metrics, they could easily earn you thousands.