Investors spend a large portion of their working years accumulating a sizable nest egg, that will support them in retirement. Once they approach the age to retire however, investors are typically sold on asset depletion strategies such as the four percent rule, which rely on selling off assets in order to meet expenses. Selling off assets to pay for expenses in retirement is akin to cutting off apple trees for lumber, instead of harvesting the fruit and living off the income from it.
The issue with selling off assets is that there is a higher logical risk that once investors run out of assets to sell, they would have no other source of income other than their labor. Instead, dividend investors focus on generating income from their capital in the form of dividend or rent income that lasts in perpetuity. As a result income investors would be able to create their own retirement paychecks from the income generated by their investments. As a result, they would not be dependent on market volatility to generate the income in retirement they need.
In order to ensure that income lasts in perpetuity however, income investors need to consider the following factors, when creating their dividend portfolios:
1) Do not overpay for investments
Investors should avoid overpaying for stocks, since this could bring down their long-term returns. Investors in US stocks in early 2000s were willing to paying high multiples, given the rosy outlook for the economy and tech stocks. Even some quality companies such as Johnson & Johnson (JNJ), Wal-Mart (WMT) and Coca-Cola (KO) were selling at unsustainable valuations. The subsequent twelve years of flat returns served as a strong reinforcer to investors that overpaying even for quality dividend growth stocks could lead to sub-par returns. It makes sense that when you pay 40 - 50 times earnings and you lock in a current yield of 1% or less, you are not going to earn a lot in dividend income even if distributions double every 6 - 7 years.
2) Do not chase yield
Many novice investors tend to focus exclusively on dividend yield when choosing investments. As a result, they tend to ignore factors such as dividend sustainability as well as corporations ability to maintain and grow distributions over time. Many investors who focused on high paying bank stocks in 2007 – 2008 were burned in the process, as many financials had to cut distributions to shareholders in order to raise money and remain solvent.
3) Analyze the company in detail first
Investors should perform a detailed analysis of companies they plan on investing in, before they put their hard earned capital to work. By analyzing the company’s business model, and how it earns money, investors should be able to determine whether it can afford to grow earnings in the future. Over time, the potential for an increase in earnings will determine whether a company can afford to grow distributions or not. Most companies that have been able to raise distributions for decades tend to have strong brand recognition, which have allowed them to maintain purchasing power with customers, who are willing to pay a higher price in order to obtain the quality product or service.
4) Focus on companies whose culture has resulted in long dividend track records
In their quest for generating income off their portfolios, investors should focus on companies which have the ability and willingness to pay higher distributions. Companies that have managed to boost distributions for at least ten consecutive years, have achieved this by properly balancing the need to expand with the need to avoid diworseification by distributing excess cash flows to shareholders. Companies which generate so much in excess cash that they do not know what to do with it, after funding their business expansion plans, are very likely to keep paying and increasing distributions to loyal shareholders.
5) Diversify your dividend portfolio
Investors, who plan to generate a defensible income stream, should avoid putting all of their eggs in one basket. A portfolio consisting of at least 30 individual securities representative of as many sectors in the economy as possible, has a much better chance of ensuring that the dividend stream will continue uninterrupted for the long run. While currently it looks like a no brainer to focus on high-yielding master limited partnerships yielding 6%, past experience should note that overcommitting to a sector could be dangerous to your financial health. Investors who were overweight financial sector in 2007, suffered steep losses in the capital and dividend incomes, as the financial crisis of 2007 – 2009 exposed weak balance sheets and companies cut distributions.
Investors, who follow these five simple principles, will be able to not only generate a sustainable amount of income from their nest eggs, but also grow cash distributions to compensate for inflation. By living off income from their investments, these future retirees would be able to have a sustainable income stream that would be entirely dependent on the underlying investments financial performance rather than stock market gyrations.
Some examples of solid companies with strong competitive advantages and good long term prospects for earnings growth include:
McDonalds Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has increased dividends for 38 years in a row and has a five year dividend growth rate of 13.90%/year. This dividend champion sells for 17.90 times forward earnings and yields 3.10%. Check my analysis of McDonald's.
Chevron Corporation (CVX), through its subsidiaries, is engaged in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has increased dividends for 26 years in a row and has a five year dividend growth rate of 9%/year. This dividend champion sells for 11.50 times forward earnings and yields 3.50%. Check my analysis of Chevron.
Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance products.The company has increased dividends for 31 years in a row and has a five year dividend growth rate of 8.10%/year. This dividend champion sells for 9.90 times forward earnings and yields 2.40%. Check my analysis of Aflac.
General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. The company has increased dividends for 11 years in a row and has a five year dividend growth rate of 11.50%/year. This dividend achiever sells for 18.70 times forward earnings and yields 3%. Check my analysis of General Mills.
Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. The company has increased dividends for 44 years in a row and has a five year dividend growth rate of 9.20%/year. This dividend champion sells for 15.80 times forward earnings and yields 4.70%. Check my analysis of Altria.
Full Disclosure: Long MCD, CVX, JNJ, WMT ,KO, AFL, GIS, MO
- The Four Percent Rule is Dependent on Dividend Yields
- How to live off dividends in retirement
- How to accumulate your nest egg
- Dividend Investing – Science versus Intuition
- How to define risk in dividend paying stocks?
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