Dividend Growth Strategy for Retirement Income

Dividend growth investing is a simple strategy that allows investors to generate a sustainable stream of income in retirement that will outpace inflation. In this article I will provide a high level overview of the complete strategy I follow in my personal investments.

The most important starting point is the entry criteria. Every month, I screen a database of 300 dividend achievers using several quantitative criteria such as dividend payout ratio, dividend yield, price/earnings ratio and dividend growth. This reduces the list of quality dividend stocks to just a handful. It is important to keep repeating this process every so often, as different dividend stocks will be attractively valued at different periods during your investment criteria. Procter & Gamble (PG) and McDonald’s (MCD) are two companies that frequently pop up on my screen.

After the initial screening process, I end up analyzing each of the candidates in detail. I look at the trends in earnings, dividends, returns on equity and dividend payout ratio. I also read company annual reports, analysts estimates, research articles and press releases in order to gain a perspective on whether the company has any competitive advantages and try to assess whether its success will continue in the future. You can read my analysis of Procter & Gamble (PG) and my analysis of McDonald’s (MCD) in the links above.

After I have determined that I like certain companies, I note the maximum price I am willing to pay, given current fundamentals information. In the case of McDonald’s (MCD), the company earned $5.27 /share in 2011 and has an indicated annual dividend of $3.08/ share. This means that the highest price I am willing to pay is $105, which is equivalent to 20 times earnings. For Procter & Gamble the maximum price would be $71.80 /share. If the stock trades below these prices I buy, granted that I have the needed cash on hand, and the companies are not overweight in my portfolio.

I typically buy stock in $1000 increments. My broker used to offer free trades every month, which meant I could buy several stocks in $250 or $500 increments. Unfortunately, with $3 commissions, I have to spend a higher amount in order to make individual stock picking economically viable for me.

If I were just starting out, I would focus on slowly building a diversified dividend portfolio over time. The goal is to have at least 30 individual securities representative of the ten sectors that comprise the S&P 500. Some sectors are not very friendly for dividend investors due to the cyclical nature of their business. I try to avoid diversifying at all costs, as I try to get exposure to a certain sector but only if the individual stock pick is right. In addition, I try to maintain equal weights in my portfolio. Unfortunately, this is very difficult, since not all of the stocks I own are buys at all times. As I continuously add funds to my portfolio, the relative size of some positions keeps decreasing. Family Dollar (FDO) is a prime example of this trend, as is Yum! Brands (YUM). I try to not be overweight in certain positions however, and would prefer to buy a new stock, rather than have an above average allocation to the same five or ten stocks.

For example, McDonald’s (MCD) and Procter & Gamble (PG) have been attractively valued for me since 2008. That does not mean that I keep adding to both positions every month. I try to scour for rare opportunities such as market corrections to increase my exposure to stocks which are rarely on sale. But if MCD and PG are the only ones that are priced right, I might have to add to them. That is rarely a case though; as I usually have at least 10 -15 candidates ready to be invested into. Check this article on choosing between dividend stocks.

I rarely reinvest dividends automatically. I wait for dividends to accumulate to $1000, and then use the proceeds to purchase a stock position in a company meeting my criterion from above. I regularly monitor my positions, and note any dividend freezes and any major corporate actions which could affect long term prospects within the company. Just because the company missed Wall Street estimates by a penny however, would not make me want to sell a stock. If this was because the company’s business is deteriorating however, then this is a warning sign. When companies I own boost distributions, that keeps or even increases the purchasing power of my income.

I only sell stocks if one of these events occurs. Otherwise, I simply hold on to stocks that are no longer buys. I do not add any funds to them, and over time these positions shrink in significance. Once I sell a stock however, I try to replace it with another candidate from the same sector. For example, when I sold State Street (STT) in 2009, I purchased shares in Aflac (AFL). When I sold General Electric (GE) however, I purchased shares of Kinder Morgan (KMR)(KMP), because it made logical sense.

I do not chase yield, and I do look to make sure the dividends I receive are sustainable. I believe that it is possible to create a portfolio paying 3%- 4% in today’s environment, which will double distributions every 10 – 12 years. I do not expect on selling shares in order to fund my retirement. I expect to live off the income from the portfolio. I do try to select companies which will increase earnings over time, which will help them in affording a higher dividend payment over time. These types of stocks will likely generate capital gains over time, which will maintain the purchasing power of my portfolio over time. I would not panic however, if the stocks I owned decline by 40%- 50%, as long as the fundamentals are still intact. I do expect capital gains from my income stocks however, as historically 60% of total returns have come from appreciation.

Full Disclosure: Long KMR, AFL, PG, MCD, YUM, FDO

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