Dividend growth investors are interested in just one thing: stable dividend payments, preferably with a high initial yield and double digit growth rate. However, not all dividend stocks offer a juicy yield on cost or strong yearly increases. Dividends differ between sectors to the point that even the Euro Dividend All-Stars look like a patchwork of industries and yields. But why exactly do some sectors offer a higher yield than others?
This question has been at the back of my mind ever since publishing an article on the necessity of dividend income diversification as opposed to exclusively focussing on portfolio diversification. After all, a well-diversified passive income stream is bound to have an effect on your portfolio allocation because dividend payments are higher in some industries.
If you were to ask junior investors which stock sectors offer the highest yields, the answers would probably be a unanimous “telecom and utilities”. That’s no surprise with the world’s largest telecom operators paying a dividend well north of 4% at the current market highs. British Vodafone (LON:VOD) offers investors 4.7%, whereas overseas AT&T (NYSE:T) goes beyond even that with a yield of 5.6%.
Even closer to home – for me at least – telecom providers are known for their generous dividend schemes. Even though it hasn’t adopted a dividend growth policy, Belgian former state-owned operator Belgacom (EBR:BELG) rewarded investors who bought into the stock on January 2, 2014 with a yield of over 10% that year.
Of course, this phenomenon is no coincidence. The relationship between the type of business a company is running and its dividend policy is a logical one. As such, high dividend payments strongly correlate with a firm’s business model itself.
Let’s take a look at what constitutes fertile ground for high dividend yields in the utility and telecommunication industries.
1. High barriers to market entry
A difficult to enter market is one of the main reasons why many Western countries created antitrust and regulatory agencies. In the European Union the task to ensure easy market access and a competitive market falls under DG Competition from the European Commission together with the competition agencies of the member states. Despite the Commission’s best efforts, some industries still don’t enjoy a fully transparent and open market like others do.
The previously mentioned telecom and utilities sectors are by far the two best examples in this context because of their large infrastructure and networking costs. As a result, the amount of capital needed to enter a new market and compete with established players is simply too large.
In Belgium, for example, utilities like Elia System Operator (EBR:ELI) enjoy a de facto monopoly, driving up earnings and rewards to shareholders in the form of dividends. British National Grid (LON:NG) and Spanish Enagas (BME:ENG), both solid dividend growers, show that the same market effects play in other countries too.
2. Stable income
On top of low competition, utilities and telecom also enjoy stable income. People aren’t going to turn off their lights or heat when they hit a rough patch, just like they increasingly can’t live without internet access anymore. As such, utilities and telecoms also enjoy what makes many health care stocks so attractive: regularly returning business.
A steady and relatively certain stream of income makes it very easy for a board of directors to offer shareholders a high dividend payment. After all, even when the economy is lagging, the company’s profit and its distribution won’t be under much pressure. Warning signs of business turning bad often rear their ugly head well in advance too.
This principle obviously doesn’t just apply to telecom or utilities. For example, German reinsurer Munich RE (ETR:MUV2) enjoys stable income from its insurance premiums, thus allowing it to run a high risk-based business – literally! The same goes for real estate investment trusts like Realty Income Corp (NYSE:O) or Home Invest Belgium (EBR:HOMI).
3. Low business growth
Even though utilities and telecoms are often large, established companies sporting massive economic moats, their geographically limited operations make it so that their business growth is on the lower side of the spectrum. Besides, it’s much easier to grow and expand organically if you’re a small-cap rather than a large-cap corporation.
For example, a telecommunications operator has less of a need to re-invest earnings into the business when compared to technology stocks. Tech companies are traditionally known for their high growth but low yields or even lack of dividend payments simply because they put the money they do make towards building the business.
It took Microsoft (NYSE:MSFT) over 15 years before it became the technology darling it now is to many dividend growth investors. During that time the company underwent massive growth until it reached critical mass and stable earnings. Now it enjoys many of the same perks as large telecom providers, thus making a relatively high yield compared to its industry peers a possibility at 2.6%.
The logic behind some investing phenomena isn’t overly complicated, as you can see. If it looks like a duck, swims like a duck, and quacks like duck, then it probably is a duck. The reasoning behind the high yield of utilities and telecom companies isn’t a whole lot more complicated than that.
Because of their strong market position, stable income and earnings, and low-risk environment it comes as no surprise that the aforementioned industries offer such great yield to investors even with the market at an overall high level. That’s why you’ll see a lot of new investors flock towards utilities and telecom, even though the growth prospect of such stocks is relatively low.
Ultimately, a good portfolio should have a mix of high-yielding stocks and companies offering a lower but more growth-oriented yield. Even though utilities and telecoms offer a good and solid way to get your dividend income off the ground, high growth stocks will play catch-up with them in a couple of years.
Do you hold many high-yielding utility or telecommunication stocks in your dividend growth portfolio?