Wednesday, May 7, 2014

Personal Dividend objectives versus the market environment

Successful dividend investing is an outcome from following a sound investment strategy and having a small dose of luck. Another very important factor however is investor psychology. If investors have incorporated unrealistic objectives when they set up their strategy, they might end up setting themselves up for failure.
One example of unrealistic expectations that quite a few dividend investors have is the hunger for high yield stocks. These investors are searching for companies yielding 6 percent or more. The typical dividend growth stock with sustainable distributions and with reasonable chances of continuing future dividend increases yields anywhere between 2% - 4%. The reason why these investors need a high yielding stock is most probably because of inadequate retirement savings. An investor with a $500,000 nest egg can easily earn $15,000 - $20,000 from a diversified dividend portfolio today, which would boost distributions above the rate of inflation for decades to come. However, if our investor requires at least $30,000 in annual distributions from their income portfolio, they have only two options left. The first one is to come up with an extra $300,000 or to focus on higher yielding stocks in order to address the income shortfall.

This increase in dividend yield however, carries with it a disproportionate increase in risk to the principal and income.

The issue with most high yielding stocks is that they are typically concentrated in just a handful of sectors. Currently, it is possible to easily find stocks yielding above five to six percent in master limited partnerships, real estate investment trusts, some utilities, tobacco, and telecom stocks to name a few sectors. This exposes the investor to sector risk, as it leaves the portfolio undiversified.

The second issue is that most of these companies already have very high distribution payout ratios. As a result, they cannot afford to boost dividends above the rate of inflation. This inability to boost dividends, leaves retirees exposes to the decreases in purchasing power of their income over time. Over a typical 30 year retirement, this could mean consistently downgrading your lifestyle.

Third, because these companies have very high distribution payout ratios, they have a higher chance of dividend cuts than your regular dividend stocks like Procter & Gamble (PG) or Coca-Cola (KO). When a company with a high payout ratio experiences declines in earnings, it would be much more likely to cut distributions than a company with a low dividend payout ratio.

Fourth, most companies that pay high dividends can lose principal much faster if the distributions are cut or eliminated. For example, when Centurylink (CTL) cut distributions in 2013, its stock fell by more than 30% in a single day. When American Capital (ACAS) eliminated dividends in 2008, its stock fell by 40% on the day and was down 90% within a couple of months.

Fifth, the concentrated portfolio of high yielding stocks could be more vulnerable to certain types of risks such as a rise in interest rates, than your normal dividend growth portfolio. The low interest environment has led plenty of yield hungry investors bid up income stocks to unreasonably high valuations. When interest rates start inching up, these companies would likely drop in price. In addition, because many of these high yielding companies rely on continuous debt and equity offerings to grow or maintain their asset base, this increase in cost of capital would increase the risks of dividend cuts.

Unfortunately, investors cannot expect to construct unrealistic portfolios while having only their own goals and objectives in mind. Instead, investors need to realistically focus on what the market offers right now, and make the best out of it. Investors need to focus on building a diversified income portfolio, which grows dividend income every year, includes companies with strong earnings growth potential that have been purchased at attractive valuations. Each of these investments needs to be analyzed in detail, with its past record and prospects researched very well. Investors should not tell the market what they want from it, but what market can offer them at the moment. Imposing your will on market will likely lead to disappointment down the road.

Full Disclosure: Long PG, KO

Relevant Articles:

How to be a successful dividend investor
How to read my stock analysis reports
How to define risk in dividend paying stocks?
The Tradeoff between Dividend Yield and Dividend Growth
The importance of yield on cost

8 comments:

  1. Would you still include some of them if they met your criteria?

    ReplyDelete
    Replies
    1. Hi Mark,

      I want to clarify, what do you mean by "them"? Did you mean "high yield stocks"? Please advise!

      DGI

      Delete
  2. My personna; objective is to get a 10% div increase yr - yr.
    Some high? Not really. !) Dividend increase from the various stocks 2) he dividends are re-invested in to more stocks or increasing present holdings - therefore more dividends 3) Contributions to pension palns are maxed out every year (in Canada that is RRSP & TFSA) so more dividends.
    Last year I got a 17% increase and so far this year I am well on track to beat the 10% objective again.
    SO that 10% yearly dividend increase is not pushing the limits, in my opinion. And it is just like a bell curve. Each year the amount increases

    ReplyDelete
    Replies
    1. Does that 10% includes dividend growth and the reinvestment of those dividends? If so, it is easier to achieve than a 10% pure growth in dividends

      Delete
    2. Hi DGI.
      Yes, all divs are re-invested. Plus I do increase the funds available within my RRSP and TFSA to the max allowed each year so that makes for more shares apying me dividends. Couple that with the various div increases from some companies and it is easy to achieve a good dividend growth Yr 2 YR. So it is actually fairly easy to achieve a 10% dividend growth each year.
      And as I mentioned the 10% is fairly reasonable so I do not get stressed out.

      Delete
  3. How do you think about holding vs. deploying cash in this market? I do hold approximately 30% of my portfolios total value in cash. I'm conscious that I'm losing some dividend income but I hope I can use these funds at better valuations. How do you do?

    ReplyDelete
    Replies
    1. You might enjoy this article: http://www.dividendgrowthinvestor.com/2013/08/should-i-buy-dividend-stocks-now-or.html

      Best Regards,

      DGI

      Delete
    2. It is always risky to hold an all equity portfolio. I have been doing that for several years, before 2008, and have seen the ups and downs.
      It all depends on your objectives. I naturally do not like to see the portfolio go down but if you have chosen well they will come back, depending on your time horizon and obviously the quality of the stock.
      My objective is to grow the dividend stream. Even at the lows of 2008/09 the dividends kept coming in allowing me to purchase and diversify my holdings. So now, while not nice to look at, I do not get stomach cramps if the portfolio value drops by several thousand in a day. It can also improve by several thousand in a day. Just keep those divs coming in.

      Delete

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