Wednesday, June 26, 2013

Dividend Growth Investing is a Perfect Strategy for Young Investors

Imagine your perfect day. You wake up when you are rested, without the need of any alarm clocks. You then do some working out , followed by having a nice healthy breakfast. You then read at your leisure, have a lunch later in the day to beat the 11:30 – 1 pm crowds, and then review your brokerage accounts. You notice dividends from several companies are deposited today, and you decide to transfer them to your checking account. You check for any major items concerning your portfolio holdings, and spend a few hours researching a new dividend stock.

After that you get more time to concentrate on your activities, be it volunteering at the local homeless shelter, mentoring high school students, learning a new language or simply catching up on some good books. Later that day, you might decide to enjoy a few with your mates/gals. This dream is brought to you by dividend investing.

This is my retirement dream in a nutshell. The reason I started Dividend Growth Investor blog in 2008, is to write down ideas on how to make it happen. I believe that dividend growth investing works for all investors, regardless of their age. However, I do realize that older investors might have a preference for higher yielding stocks, while youngsters like myself can afford to build portfolios across the yield spectrum.

One of the most common misconceptions about dividend investing however is that it is not a good strategy for building your nest egg, and therefore it is not suitable for younger investors. Being a youngster myself, I (not surprisingly) disagree.

Younger investors are typically told to take a lot of risks early on, because they have time to recuperate those losses. I find this saying to be very dangerous for young investors. The problem is that taking risk is important, but it should not be mean gambling. Investors should only be taking on large risks when they have a strategy with positive expectancy of a positive return, while risk is minimized. If you invest in penny stocks, social media stocks, or if you bought dot-coms during the tech boom of the late 1990s, you took huge risks but you were likely making concentrated gambles. There is a cost to gambling, because losing your entire nest egg of $10,000 at the age of 24 means you will be poorer by $800,000 by age 70. This calculation assumes a 10% annual return for 46 years.

In contrast, with a typical dividend growth strategy, you get a slow and steady approach that will lead to a monthly passive income that will pay your expenses in retirement. Starting out early will be beneficial, because you would gain the necessary experience through trial and error, and find out the nuances that work out for you. This would make you successful, and ensure you maintain your success in investing. A big part of investment success is not losing too much in your investment career.

With this dividend strategy, we are focusing not on net worth per se, but on target annual dividend income. If your goal is to have a net worth of $1 million dollars, but you end up investing it in a relatively illiquid asset such as a personal residence, you might not be able to retire entirely on it. In some parts of the US, you might have to pay $20 - $30 thousand in annual property taxes plus paying for upkeep, maintenance etc. If instead you had a rental property generating $4,000 in monthly income or a portfolio of dividend stocks generating a similar amount, you might be set for life.

I believe that a new investor who does not have a lot of money today but who plans on accumulating their “financial nut” over the next years will be perfectly able to utilize dividend growth investing. With this strategy investors turbocharge the dividend income growth of their portfolios by putting money to work every month in stocks that regularly boost dividends, and then reinvesting those dividends selectively.

Since 2008, I have been on a mission to build up my portfolio income. Every month, I save an amount of money that I deposit in my brokerage account. I scan the market for investment opportunities all the time, followed by analyzing prospective investments. I identify dividend stocks for further analysis either by running my screening criteria against the dividend champions or contenders lists, by looking at weekly list of dividend increases as well as through interactions with other investors and the general method of my inquiry into business.

I do a complete stock analysis of each company I find interesting, in order to gauge whether the company in focus has any competitive advantages, pricing power and whether there are any catalysts for further expansion in revenues and profitability going forward. I focus on companies that can grow earnings over time, which will provide the fuel for future dividend increases. A rising earnings stream is also positively correlated with an increase in stock prices. You can have your cake and eat it too with dividend growth stocks.

My goal is to acquire the quality companies identified for purchase at attractive valuations. Entry price does matter to an extent, because a lower price provides a higher margin of safety in the investment and is equivalent to a higher dividend income. Of course, if you plan on holding stocks for 20 – 30 years however, it would not really matter whether you purchased Johnson & Johnson (JNJ) at $70/share or $75/share. If you overpay today however, it might mean that your returns in the first five years might be below average, until the growing earnings result in a valuation compression that would make the stock attractively valued today.

For my personal portfolio, I try to generate annual dividend growth in the 6-7% range on aggregate. My portfolios also yield approximately 3.50% – 4%. I achieve these aggregate figures by stacking three different types of dividend growth stocks, for maximum results. So far, I am able to cover approximately 50% of my expenses from my dividend income.

A few good picks include:

Coca-Cola (KO) engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. This dividend champion has increased distributions for 51 years in a row. Over the past five years, Coca-Cola grew distributions at a rate of 8.40%/year. Currently, the stock is trading above the 20 times earnings limit I have set for myself, but yields a very respectable 2.80%. Check my analysis of Coca-Cola.

Phillip Morris International (PM) manufactures and sells cigarettes and other tobacco products. The company has managed to grow distributions by 13.10%/year since the spin-off from parent Altria Group (MO) in 2008. I like the economics of the tobacco business, without the liability stemming from doing business in one country. PMI's revenues are generated outside the US, and therefore are not dependent on a single country's onerous laws on smoking. Currently, the stock is trading at 16.60 times earnings and yields 3.90%. Check my analysis of PMI.

Kinder Morgan Inc (KMI) is the general partner of Kinder Morgan Partners (KMP) and El Paso Pipeline Partners (EPB). It also owns limited partnership interests in KMP and EPB.  The most important asset is the incentive distribution rights structure, which provide for a 50% share of any future distirbutions growth over a certain threshold for KMP and EPB. Given the growth projections for energy assets in the US, and Kinder Morgan in particular, this stock can achieve high single digit dividend growth for at least the next five years. Currently it is yielding a very attractive 4.20%.

Procter & Gamble (PG) engages in the manufacture and sale of a range of branded consumer packaged goods. This dividend king has increased distributions for 57 years in a row. Over the past five years, Procter & Gamble has managed to boost distributions at a rate of 12.20%/year. Currently, the stock is trading at 17.20 times earnings and yields a very respectable 3.10%. Check my analysis of Procter & Gamble.

Let’s see how a portfolio stacks, where a young dividend investor puts $3000/month in 4% yielders that grow at 6%/year.



After five years with this approach, you would be earning $750 in monthly dividend income. Ten years after starting this strategy you will be earnings $2,000 in monthly dividend income. Fifteen years after beginning your dividend investment journey, you will be making almost $4,000 in monthly dividend income. This slow and steady approach is very boring, and it is not as exciting as tripling your money in Tesla (TSLA) in less than a month. However, more investors who focus on long-term wealth accumulation potential of dividend growth stocks will be better off than investors who gamble on the next big growth stock.

An investor with a vision will look beyond the 3%- 4% current yields today, but look at the potential for higher distributions over time. An investor that starts small at a young age, builds a diversified portfolio of income producing securities with growing distributions when valuations are right, reinvests these rising distributions into more stock and continuously adds to his portfolio, will achieve wealth at a relatively young age.

Full Disclosure: Long KMI, KO, PM, PG, JNJ, KMR

Relevant Articles:

Check Out the complete Archive of Articles
Dividend Stocks for Young Investors
My Dividend Retirement Plan
Dividend Growth Strategy for Retirement Income
Buy and hold dividend investing is not dead
- Carnival of Personal Finance #421

27 comments:

  1. I really wonder how any young investor can put 3k each month in dividend stocks ;-)

    anyway, i am not sure if its still adivsable to buy stocks that have already reached their best stage. growth is very limited to market growth levels. I agree they would have been great investments 20 years ago.

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  2. DGI,

    Great article!

    This one almost seemed tailor made to my own situation, as that's the exact strategy I'm following and about how much I'm investing per month. Your spreadsheet looks about right to me, as those are the same numbers I've been looking at.

    Keep up the great work!

    Best wishes.

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  3. Rico - simply take a zero off the end of the numbers in the example, and adjust accordingly. 300/mo invested yields $75 a month after five years.
    Though, given some of the incomes I see young people sharing on the financial blogs, I wouldn't be surprised to find that quite a few young investors could put away significant sums while they're still young.
    Given this old guy's slightly longer perspective on the market, one can always say that stocks would have been a better deal twenty years ago. I wish I'd started seriously investing forty years ago, but I have to work with the time I have left, young folks simply have a longer time horizon in a market which increases in value over the long term - despite occasional short term major fluctuations.

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  4. Could you share your stock screen?

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  5. hi there ,

    good article !

    just one comment : you need to mention that your quoted income from dividends is gross income . it will be much less after taxes deduction .

    keep up the good work !

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  6. Rico,

    A young investor will likely be speculating on the FB, TSLA & other unproven concepts. They will most likely be losing a ton of money with those speculative plays, get turned off stock market, and never reach financial goals after that.

    The good thing about divided stocks is that very often they are priced very reasonably for the growth they are offering. Did you know that for the past 50 years, IBM had better growth than XOM? However, the investment that did better was XOM, because it was always undervalued, paid a higher dividend. This is because XOM delivered growth which was reinvested at consistnetly low prices. IBM shareholders on the other hand reinvested their low dividend profits into overvalued stock.

    An investor in their late 20s early 30s can easily put $3K/month if they have their priorities in order.

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  7. Mantra,

    Thanks for stopping by. The commenter above doesn't really undertand that you have been putting over $3K/month for 3 years now.. And you are young too ;-)

    Jon,

    The best time to plant a tree is 20 years ago. The second best time is today.

    George Goerlich,

    It might be helpful to check out the archive if you are looking for a specific article:

    http://www.dividendgrowthinvestor.com/2013/03/complete-list-of-articles-on-dividend.html

    I have written about entry criteria below.

    http://www.dividendgrowthinvestor.com/2011/03/my-entry-criteria-for-dividend-stocks.html


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  8. Micha,

    The tax rates would vary for everyone. For some it would be 0%, while for others it would be 15%. Further complicating calculation is not going to add much value.

    However, currently you can put away as much as $23,000 in a combo 401K and an IRA every single year. This would not only provide a deduction for you today, but also result in tax free compounding of investment capital. This is equivalent to $2K/month. The other $1K can be in taxable.

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  9. I agree that $3,000/month is a dreamy, unrealistic figure for many young people, myself included.

    I've been reading this blog religiously for years and after seeing those numbers this is the first time I've felt genuinely discouraged.

    I think the point could have been illustrated with with a more modest number.

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  10. This is an interesting article about FASB changes in recognizing revenues at Insurance Cos (I know you really like Aflac).

    http://dealbook.nytimes.com/2013/06/27/insure-hed-tk/

    I love finding changes from NGOs or Govt that could affect reporting, but don't actually change how profitable the company is. Hopefully, this will cause insurance cos like Aflac to be "less valuable" to the street.

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  11. I would also like to say great article.
    With the recent bad news and market turndown, it's nice to hear some reasonable words to keep one on track.
    With drops of 10% in some of your picks in a relatively short time and doom and gloom on every media outlets lips, you start to second guess yourself.

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  12. Hi Anon,

    Dividend Mantra does save $3000/month, he is 28-29, and has a normal job. But I agree that everyone's situation is different. Why do you get discouraged so easily? Why can't you simply use the spreadsheet as a tool, and then calculate the outcome based on your " reasonable amount" you can save? Example, if you can only save $1000/month, in 15 years you will generate one-third of the $3976 in monthly income shown on the spreadsheet.

    However, if you cannot save money, you will not be able to find the funds to use any strategy available for retirement.

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  13. The other Anon,

    I would check the article.

    Paul,

    The media has to fill their airwaves 24/7/365. That's why you should not listen to them for financial advice - it's entertainment. You should stick to the facts when it comes to investing.

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  14. DGI,

    I am recently 26 and I left college about a year ago. It took me about 5 months to find a job and another 6 months to get my feet really under me. I make 52k a year which translates to 3k a month after taxes. I obviously can't invest all of that since I help support my parents, pay for my fiancee to live while she's studying to become a midwife, and I have my own school loans to pay back. I'm throwing as much money as I possibly can at dividend stocks, but my real question is how much should I invest at one time? I've typically been saving 400 a week, and investing it right away. I have to pay a commission of 4.95 at Tradeking. Should I be just eating the commission even though I'm not buying many stocks, or should I wait until I have save a certain amount to buy. Should I wait until I have 1000 dollars in my brokerage account before I buy stocks for example. I'd love to get whatever advice you and the community would provide as this is my ~second month of investing.

    Thanks,

    Justin

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  15. Justin,

    It is admirable that you are helping out so many people close to you at such an young age.

    I think that you should not get discouraged from putting $400/month in dividend stocks. Some of my first investments were in the $50- $100 range.

    Between 2006 and 2010 it was possible to get free trades. Unfortunately, it is pretty impossible to do that today.

    As for dividend investing, I think that it might make better sense waiting until you get to $1000, might be "cheaper" from a transaction cost perspective. That way you get a 0.50% one time cost, versus 1.25% at $400.

    Your other route could be to open brokerage accounts that offer free trades for a certain period of time, or cash brokerage bonuses for new accounts. Optionsxpress offers $100 for new holders who put $500 I think if you get a referral ( I can help ;-)), which is good for like 11 trades there. Also Sharebuilder always has a $50 cash promotion incentive for opening a new account with at least $50 or $100. The promotion is equivalent to 12 trades at $4.

    It looks like you are putting away about $5K/year. Depending on your retirement goals, you might be better off to put it in an IRA, and get a tax-deduction on that amount right away - you could be better off by more than $1 grand/year.

    Of course, since I do not know you complete situation, please take this with a big grain of salt. The decision of what to do is ultimately up to you.

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  16. Great read. I enjoy your website. I am lucky to own 5 of the 6 stocks you mentioned you had in this article.

    I did have one question. What do you think of the Big 5 Canadian Banks?

    These banks have strong dividends, strong balance sheets, and are trading at very low p-e ratios.

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  17. Anon,

    I own all 5 Canadian Banks - about 1.50% of total portfolio is in them, almost equally weighted. I actually like them better than the WFC of the world - I think I am the only one thinking that however.

    ReplyDelete
  18. Hi, being with this blog for a few months and I really like to dividend investing as my strategy for retirement. I am probably a few readers from overseas, 30 this year and able to save 10% of my income for investing. My portfolio just started recently and looking forward to build them.

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  19. As many of your readers have indicated, the $3,000 amount is unrealistic for the vast majority of young investors. So dropping a zero from the analysis doesn't make it less compelling, just more realistic. Remember that Americans have one of the lowest savings rates in the world.

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  20. CDJ,

    You should not let humble beginnings kill your motivation. The most important thing to do is start dividend investing, even with only $100/month. I agree that $3000 might be a stretch for someone right after college, but in my personal experience it is possible for someone in their 20s to regularly save that much every single month. This could be you!

    After that however, the amount you can put away is limited only by your imagination. With hard work, persistence, a little bit of luck, and imagination, a young person in their 20s CAN get to saving AT LEAST $3000/month. I have done it, and so has my friend Dividend Mantra. Why can’t you do it?

    You know, just give yourself a high amount as a goal to achieve. Even if you “fail”, you would still be much better off.
    Of course, the premise of the article is not at all concerning with the $3000/month. The ideas are applicable to everyone, regardless of whether you save $300, $3000 or $30,000 every month. Do not miss the forest for the trees.

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  21. Starting to invest at a young age pays off. For someone who has taken debt (God forbid, an education loan) it’s challenging to break-free from the mounting debt and even think of investing.

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  22. I don't think three thousand a month is out of reach if you make saving a priority. This is the typical naysayer remarks that I hear from friends and coworkers all the time about how they can never save, never retire, never get ahead. Yet, they make poor financial decisions on a daily, weekly and monthly basis.

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  23. Hi,
    I just wanted to say I enjoy your articles a lot and because of this post I decided to change my lifestyle a bit and relocate to reduce my rent by $400 a month, so I could save more. The new place is slightly less nice, but those savings will go towards buying stocks and building that portfolio.

    I started learning about finance and investing about 10 months ago and started my drip portfolio last month. I am 27 and I sometimes feel I am 'late to the game', but this is still better than starting when I would be older. If I ever have kids I hope to develop their financial intelligence at a young age or early teens which my own parents unfortunately did not do.

    I am maxing out my 401k and Roth IRA contributions and can currently save about $2000 a month in another individual taxed account. The goal is to reduce my expenses further and save up to $2500/m. Getting expenses down even further would become quite tricky but I want to try and challenge myself to see how frugal I can really live and how low I can get my expenses if I tried my best - even if I only do it for a single month.

    My question is if you guys are maxing out your 401k ($17500/y) and Roth IRA ($5500/y) as well and manage to save $3000/month on top of that?

    Unfortunately my current status does not allow me to make extra side income, but when that changes I do think a side income from side businesses will allow me to invest even more, especially because I have skills that can set me up for royalty type of passive income.

    I have saved up money from before that is currently not yet invested and intend to make a checklist of stocks I have analyzed and invest positions of around $3000 per stock. This kind of size seems enough to warrant the cost of the trade. Initially this does mean I am not that heavily diversified with around 10 positions, but as the months go by more stocks are added.

    Perhaps a $2000 position and 15 stocks may be better initially and build that out into larger positions as opportunities arise. Or I would find a different kind of metric such as the sharpe ratio or market cap (doubtful) to figure out my position sizing. Any thoughts on this?

    Thank you for your interesting blog and also for the discussions in the comments, I try to learn something every day and this type of articles help a lot!

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  24. Great read DGI...

    The key is not how much per week / month / quarter, it is formulating a plan and starting to invest... this should start with developing a budget and figuring out just what you earn and what you spend. That is probably the most scary moment most people have ... because it strips away the veneer of safety and security that your regular income being greater than all your expenses provides.

    When I was 3-5 years out of college, the hardest trait to master is discipline ... I know from my own experiences ... it was easier to save some cash and take a holiday, buy a new suit or just blow a bunch of money partying and/or gambling and having a whale of a time than 'paying myself first' into the investment account and covering bills and play money with the left overs... I know I didn’t start investing regularly until I was 27 … after about 4 years of permanent full time employment…

    Having pursued the DG strategy relatively aggressively over the past 3.5 years I can tell you that seeing those dividends tumble into your broker cash account each month is a wonderful thing ... dividends begets dividends ... so not only are you deploying your own personal exertion earned cash each month ... but you also have a steadily growing passive income to invest as well ... after working the strategy for some time it starts to add up … it feels like a nice ‘assist’ … some months you will have more costs than others … maybe insurance or even an unexpected cost … but you will typically have some paid dividends in the your account … the market dips or a target of your enters the ‘zone’ … and you have the ability to take advantage …

    For me, as a simple reminder as to why I pursue this strategy I calculate each month what my annualized current dividend is … and then break it into months and weeks … it will start off small … but over time … as it starts to rise you then relate it to your expenses and what your passive income can now pay for … it is a powerful tool and motivator … forget about “the number” … worry about “your number” … i.e. what cash do I need each year to cover my expenses and live a relatively comfortable existence … that is your target … that should be your only target…

    Best of luck

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  25. This comment has been removed by the author.

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  26. If some people are afraid of Dividend investing, I encourage them to start with a quality monthly income fund. They give you a 3 to 4% dividend paid monthly.

    Someone new to that feels good about getting that little gift every month and seeing something happen with their investment. Plus each month the dividend is more then the last month.

    It's just a simple fairly low risk way to teach people about how the whole process works.

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  27. Someone noted taxes, but I didn't notice inflation addressed in the article, unless the 6% yearly increases are after inflation.

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