Since 1970, dividends have made up 40% of total returns for stocks in the U.S. and Europe, per data from JPMorgan cited by The Wall Street Journal. (Total return measures capital gains, plus dividends received.)
Here’s a look at Realty Income's (O) dividend yield over the last five years. You can see that the stock’s yield has ranged from a low near 3.5% to a high of about 5%. Income investors evaluating Realty Income might consider buying the stock when its yield is near its five-year average or higher.
“Remember that the stock market is a manic depressive.” – Warren Buffett
As time marches on and long-term business prospects come back in focus, a stock’s yield often reverts back to its norm.
If a company’s long-term growth prospects have improved, its stock will likely trade at a relatively low yield compared to history, reflecting its stronger growth profile. I will rarely, if ever, sell my winners, so I typically do not think about selling a holding just because its yield is relatively low.
On the other hand, if a company’s long-term prospects have dimmed, its dividend yield could remain at a higher level than it has in the past.
In situations where a stock’s yield is relatively high or low compared to its long-term average, investors should search for recent news on the business. The idea is to identify any material events that could strengthen or weaken the company’s moat and long-term outlook (not just its next few quarters of results), as well as the safety of its dividend.
These can be difficult judgment calls to make, so maintaining a well-diversified portfolio is critical. I also want to emphasize the importance of targeting the right type of company for most conservative dividend growth portfolios.
I prefer to invest in companies that possess the following characteristics:
- Simple, easy-to-understand business models that have withstood the test of time
- Reasonably diversified by products / customers / end markets
- Large end markets with moderate long-term growth potential
- Consistent free cash flow generation (i.e. money is left over after reinvesting in the business)
- Healthy credit metrics
- A proven commitment to paying and growing dividends
- Several enduring competitive advantages that I understand and believe in for the long term
- These factors typically combine for a strong Dividend Safety Score (61+)
By putting business quality first, rather than focusing on “cheap” stocks, I reduce a lot of the risk in my diversified portfolio and improve my chances of generating safe, growing income.
Using historical dividend yield charts as a valuation guide is most effective for the types of companies I like to invest in – mature, stable businesses that generate cash and have long histories of paying consistent dividends.
Using yield charts certainly isn’t perfect (no valuation approach is), especially for businesses that have a wider range of potential outcomes or very low payouts, but I’ve found its simplicity and ease of application to be very valuable for my overall portfolio management process.