Why I’d rather buy growing dividends than chase the highest ASX yields

A big dividend yield can be hard to ignore.

When an ASX share is offering 7%, 8%, or even more, the potential income can look much more attractive than a company yielding 3% or 4%.

But if I were building a passive income portfolio for the long term, the starting yield would only be part of the decision.

I want the income to grow

A lower yield can become much more valuable if the dividend keeps increasing.

Imagine buying a company yielding 4% today. If its earnings continue growing and management steadily lifts the dividend, the cash received from that original investment could be considerably higher several years from now.

That is particularly important for investors who do not need the income immediately.

Inflation means a fixed dividend becomes less valuable over time. An income stream that can rise with earnings has a much better chance of maintaining its purchasing power.

Woolworths Group Ltd (ASX: WOW) is the type of business I would consider from that perspective.

Supermarket spending is relatively resilient, and Woolworths has opportunities to grow earnings through population growth, online retail, and continued improvements across its operations.

Its yield may not grab as much attention as some higher-yielding ASX shares, but I would be interested in what the dividend could look like years from now.

A huge yield can sometimes be a warning

Dividend yields rise when share prices fall.

That means an unusually high yield can sometimes appear because investors believe the company’s earnings or dividend are under pressure.

If a share offers a 9% yield and subsequently cuts its dividend in half, the original headline number becomes fairly meaningless.

This is why I would spend more time understanding the business than comparing dividend percentages.

Can earnings comfortably support the payment? Does the company need substantial capital to keep operating? Is debt manageable? Does management have room to increase the dividend if profits grow?

Those questions tell me much more about the quality of the income.

Infrastructure can provide another route

Transurban Group (ASX: TCL) is another business I think can make sense for long-term income investors.

Its toll-road network benefits as traffic grows over time, while toll increases can provide another source of revenue growth.

That creates the potential for distributions to increase as the underlying business expands.

Infrastructure also brings something different to a portfolio dominated by banks and traditional dividend shares.

I would still pay close attention to debt and valuation, particularly because infrastructure businesses can be sensitive to interest rates.

But the ability to generate growing cash flows over a long period is what would interest me most.

Income and growth can work together

I do not think passive income investing needs to mean sacrificing capital growth.

A strong business that reinvests part of its profits effectively can grow earnings, increase its dividend, and become more valuable at the same time.

That combination is what I would ideally want.

It may produce less cash in the first year than simply buying the highest-yielding shares available, but I think the long-term result can be far more attractive.

Foolish takeaway

If I were building an ASX passive income portfolio, I would not rank shares by dividend yield and start buying from the top.

I would look for businesses that can support their payments and have a reasonable chance of increasing them over time.

For me, a 4% yield that keeps growing could prove far more valuable than an 8% yield that eventually disappears.

The post Why I’d rather buy growing dividends than chase the highest ASX yields appeared first on The Motley Fool Australia.

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Motley Fool contributor Grace Alvino has positions in Transurban Group. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Transurban Group. The Motley Fool Australia has positions in and has recommended Transurban Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.