Wednesday, August 17, 2011

Why I am a dividend growth investor?

I am a dividend growth investor because my research has uncovered that dividend growth stocks perform very well over time. I purchase stocks in solid companies which pay dividends, and regularly increase them each year. This is the strategy I am using in order to live off dividends in retirement. My research shows that a portfolio of carefully selected dividend stocks will provide a sufficient income stream for me to live on, without having to touch principal. The fact that the companies I purchase also grow earnings to pay growing distributions each year means that over time stock prices would go higher, thus providing some protection to my capital from inflation.


My neighbor is not a dividend investor. My neighbor purchases index funds and hopes to rely on an asset depletion strategy commonly referred to as the four percent rule. You can read more about the original research about it here. Basically, my neighbor is relying on total returns from index funds, in order to fund their retirement. Historically, stocks have produced an annual return of 9% - 10% per year. If one owns $1 million worth of an S&P 500 index fund, their return would be approximately $90-$100 thousand per year. Thus, selling $40,000 worth of stock each year would lead to a portfolio value of 1,050 to 1,060 million by the end of first year.

This was a good strategy for generations of do it yourself index investors. Accumulate as much in index funds as possible, and then sell off 4% of your initial portfolio value each year, while also adjusting for inflation. The one problem that this strategy creates is that it leads to a rapid depletion of the asset base during extended bear market declines or during flat markets. Stocks do not go up or down in a straight fashion each and every year. Investors who retired in the early 2000s and 2007-2009 saw this first hand.

In fact investors who put $1 million in an S&P 500 mutual fund in 1999 and using the 4 percent rule for withdrawals now have only $360,000 left.
The calculations assume a 3% annual inflation rate and a quarterly distribution. In addition, investors would have sold more than half of the shares they originally owned by August 2011. Given the expected withdrawal of $55,369 in 2011, the portfolio would be depleted in 6.50 years if stocks do not appreciate by 2020.

I have always had an issue with index funds. They are a decent vehicle for accumulating wealth, as they provide ordinary savers with the ability to have exposure to the stock market without understanding much about it. However, the traditional methods of selling off portions of your portfolio each and every year, is similar to cutting off the tree branch you are sitting on.
That’s why the idea of creating a dividend portfolio makes perfect sense for investors who are retired and even those who plan to retire some day in the future. Using this strategy, investors only spend the dividend income generated by their investments. Dividend income is more stable in comparison to relying exclusively on price appreciation. If you compare the price returns of my benchmark the S&P 500 index to the dividend returns you would see why retirees prefer the stability of dividends in retirement.

Dividend investors should carefully select stocks with solid fundamentals which could afford to grow distributions for years to come. They should also have a set of written rules, which would help them in evaluating stocks. You could read more about my entry criteria in this article. Investors should also try to create a diversified portfolio in order to minimize sector risks on their dividend income. There are approximately 300 dividend growth stocks in the world. After further screening, the enterprising dividend growth investor would likely find a more manageable list of 40 -50 securities which could be accumulated at the right prices.

By relying exclusively on spending only the rising income stream, investors would avoid depleting their asset base by selling off shares every year. As a result, dividend investors would not have to sell in a depressed market in order to pay for their living expenses and risk depleting their assets. Instead, dividend investors generate stable dividend income which rises over time and ensures that they generate an inflation adjusted stream of income. Dividned growth investors could thus avoid paying attention to rising and falling prices, because their dividends arrive timely, like clockwork. In essence, it feels as if dividend investors are getting paid for holding these stocks. Contrast this to the traditional model of retirement investing, where a flat or declining market would lead to outliving your assets and having to return back to work at the most unfortunate times for you.

The types of stocks which could provide such a stable dividend stream of income include:

McDonald’s Corporation (MCD), together with its subsidiaries, operates as a worldwide foodservice retailer. The company has raised dividends for 34 years in a row and has a ten year annual dividend growth rate of 26.5%. Yield: 2.80% (analysis)

The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. The company has raised dividends for 49 years in a row and has a ten year annual dividend growth rate of 10%. Yield: 2.80% (analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 49 years in a row and has a ten year annual dividend growth rate of 13%. Yield: 3.60% (analysis)

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), provides supplemental health and life insurance. The company has raised dividends for 28 years in a row and has a ten year annual dividend growth rate of 21.3%. Yield: 3.20% (analysis)

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised dividends for 48 years in a row and has a ten year annual dividend growth rate of 12.40%. Yield: 2.80% (analysis)

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 24 years in a row and has a ten year annual dividend growth rate of 8.10%. Yield: 3.30% (analysis)

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company has raised dividends for 37 years in a row and has a ten year annual dividend growth rate of 17.80%. Yield: 2.90% (analysis)

Eaton Vance Corp.(EV), through its subsidiaries, engages in the creation, marketing, and management of investment funds in the United States. The company has raised dividends for 30 years in a row and has a ten year annual dividend growth rate of 12.60%. Yield: 3% (analysis)

Air Products and Chemicals, Inc. (APD) provides atmospheric gases, process and specialty gases, performance materials, equipment, and services worldwide. The company has raised dividends for 29 years in a row and has a ten year annual dividend growth rate of 10%. Yield: 2.90%(analysis)

Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, NGLs, crude oil, refined products, and petrochemicals in North America. The company has raised dividends for 14 years in a row and has a ten year annual dividend growth rate of 8.30%. Yield: 5.60% (analysis)

Full Disclosure: Long all stocks mentioned in this article

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13 comments:

  1. Really valuable post. Couple of points. You point up the importance of having a plan when you reach the so=called decumulation phase. Just taking 4% of your portfolio can be very harmful.
    I recommend ensuring that the portfolio is structured so-that 60% of income needs are met by interest and dividends. Secondly, put at least a year's worth of payment needs in a short-term bond fund. These steps prevent the negative impact of having to sell stocks at depressed prices.
    On the debate of whether to hold dividend paying stocks in general it boils down, to me, on whether you believe the company can best use its funds paying them out or reinvesting themselves. In some markets performance is best by dividend payers and in other markets best by non-dividend payers.
    Finally the indexes have plenty of dividend payers.
    Having said all this I read your site and others to get ideas which I have profitably acted upon :)

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  2. It just makes sense that you would want to try and live off dividends and leave your capital intact. I don't understand why your neighbor can't see the wisdom of this.

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  3. I love what you have to say about dividend investing vs index funds, but one problem for many retirement investors is that individual stocks are not offered in 401K plans, and in very few IRAs. In order to move money accumulated in a 401K to an IRA which could contain individual stocks, one would have to quit their job every so often. Dollar cost averaging into dividend stocks for retirement becomes a bit of a problem, given those constraints. Unfortunately, most folks don't save for retirement outside of the tax-advantaged plans.

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  4. I agree that it is better to live off of income than to touch your capital. However, wouldn't you need a much higher amount of money to live just off of the dividends.

    Secondly, is it not better to try and get superior total returns during the accumulation phase (assuming it is a tax sheltered account)? Someone could always convert their portfolio to dividends upon retirement.

    Lastly, you are overlooking the fact that most index etfs pay off the dividends to investors so an investor who has a balanced portfolio of index funds would produce a fair amount of income without melting down the capital.

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  5. can you tell me were you got those awesome carts from?

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  6. For investors focused on income, this is actually a very good time to invest!

    Some great picks you got there!

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  7. Great article! I think this sums it up pretty nicely. Who wants to cut off the branch you're sitting on? Not me!

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  8. Nice overview.

    As a gen-Xer, I rather like the idea of buying up solid dividend stocks before the Baby Boom generation realizes en masse that they really must have these stocks. It's all about supply and demand. You can't go wrong holding the supply that Boomers demand.

    Generational jabs aside, I wonder what happens to the stock price as dividends grow by 20% annually. Does the dividend yield go up more than the price? Or does price go up at the dividend growth rate holding the yield rate fundamentally unchanged?

    Along the same lines, it could be useful to compare dividend growth with earnings growth. I'm thinking that a company cannot sustain growing dividends faster than earnings. A company that is transitioning from low or no yield to high yield would for a time be pushing dividends ahead of earnings, but as it matures healthy earnings growth must lead dividend expansion. A company in decline, however, may need to expand dividends faster than earnings to support stock prices. A dividend growth to earnings growth ratio may help spot emerging dividend stocks.

    Thanks for the thoughtful post.

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  9. Great post! For the very same reasons, I am a dividend investor.

    One thing I know is that my dividends when re-invested have a compound growth whereas the index fund only looks like a compound growth graph when you go back 100 years.

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  10. Sir,
    I have been following your blog Dividend Growth Investor very keenly. You have inspired me to start investigating the S&P Dividend Aristocrats more closely. I have a particular question about your post at
    http://www.dividendgrowthinvestor.com/2008/04/historical-changes-of-s-dividend.html

    The pdf file (S&P Dividend Aristocrats from 1989 till 2004) you offered there was eye-opening for me. I was wondering if I could cite your blog as the source of data in my research. I was also wondering how you obtained this data since it is quite unique in the sense that it includes the dividend aristocrats way before the S&P 500 Dividend Aristocrats index was launched in 2005.

    I would very much appreciate your response to my inquiry at your earliest convenience.

    Thanks in advance

    ps: I tried accessing to you via istockanalyst as well, but I am not sure if the messaging works there. Henceforth, I posted my inquiry here as well.

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  11. Nice post. Current economic troubles make relying on market appreciation very dicey. Agree wi you re importance of sustainable rising income.
    Thanks for your insights.
    Michael

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  12. Obviously living of the dividend without touching the principal like in the 4% strategy requires a much larger saved up capital upon retirement to buy the same retirement income.

    it's fairly obvious as well that living off the dividend income leaves you with too much money upon death.

    though it is possible your strategy has a lower beta then the indexing strategy in that case your losses in a bear market might be smaller. in that case do not neglect to mention your neighbour will be able to grow his income far beyond yours in a bull market.

    other then that i don't like either strategy for retirees. Both of you (both you and your neighbour) have far too much equities and not enough bonds for a retiree's portfolio. From this perspective i like your strategy slightly better because it probably has less beta and that is favorably to you as a retiree.

    Actually i hold a diploma on investment advice here in the Netherlands and consequently i'm not particularly familiair with the American tax system. From what i understand capital gains and dividends get taxed..

    Unless you hold them in a tax exempt account in which case these comments do not hold up.

    It is quite unfavorable that dividend paying stocks get the dividend taxed every year. Whereas capital gains can be accumulated and harvested at a later date. With the 4% strategy it might be possible to sell the loss incurring parts of your portfolio and in this way avoid taxes for longer. Making your portfolio much more tax efficiënt.
    To avoid this taxation American firms commonly practice stock buybacks instead of dividend payments. It complets the same objective; returning value to shareholders. But in a more tax efficiënt way. Stock buybacks might be much better for you then the ever rising dividends.
    In Europe where the tax system is very different companies still mostly rely on dividend payments (and it's much higher on average)

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  13. Disclaimer: I am a dividend growth investor, that being said, I have noticed that when indexers have taken out 4%/yr adjusted for inflation, they don't follow the scenario you listed.
    If it is a down year for investments 'they' don't take out the full 4% or they don't take out the 4% plus inflation. They kind of go into emergency mode and cut back.
    At lest this is what I have gathered from the folks at the Early Retirement Forums http://www.early-retirement.org/forums/f28/how-did-you-adjust-to-making-regular-withdrawals-and-watching-your-balance-decline-35639.html just one of the threads.

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