Most readers know I focus on dividend growth stocks, which are companies that tend to grow distributions every year. I search for companies that typically yield more than 2.50%, have demonstrated growth in earnings and dividends over the past decade, and have a strong foundation that can support further distribution growth.
Per my dividend retirement plan, I expect to be able to cover expenses through dividend portfolio around sometime 2018.
However, I do focus on a lot of companies where average yield is somewhere in the 3% - 4% range. These companies have sustainable dividends, and dependable dividend growth rates, that are very likely to exceed 6%/year for the next decade.
Some readers have asked me however, why don’t I merely focus my attention on higher yielding stocks, that pay anywhere between 6% – 8% today, and speed up my financial independence. I could load up my portfolio with companies like:
Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. This master limited partnership has managed to increase distributions for years in a row, and currently yields 7.50%. Check my analysis of Kinder Morgan.
American Realty Capital Properties, Inc. (ARCP) owns and acquires single tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment grade credit rated and other creditworthy tenants.This real estate investment trust has managed to increase dividends for years in a row, and currently yields 7.60%.
Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. This real estate investment trust has managed to increase dividends for years in a row, and currently yields 5%. Check my analysis of Realty Income.
I equate higher yielding companies with higher risk. In a competitive marketplace for stock securities, a reasonable investor cannot expect to find higher yielding stocks, without incurring higher risks.
If a real estate investment trust (REIT) wants to buy an apartment complex that generates an 8% yield, it might not be a very good idea to issue stock or debt to investors that yields more than 8%. However, even if they end up paying a lower yield on equity or debt, but they need to refinance that debt in a few more years at higher rates, this could be bad for dividend incomes. The problem with most high yielding companies is that they are pass through entities, which essentially share all of their free cash flows with investors, by sending out fat dividend checks. This leaves those companies exposed to hiccups in financial markets, which are vital for their growth and for access to capital.
In addition, there is always the increased risk that those pass-through entity structures are abolished by the Tax authorities. With a pass-through structure like a REIT, master limited partnership (MLP), or a Trust, there is no taxation at the entity level. All the taxation occurs at the individual shareholder level. In comparison, corporations like Coca-Cola (KO) pay taxes at the corporate level, and then individual investors pay taxes on dividends they receive in taxable accounts. This is why pass-through entities like Realty Income, American Realty Capital Properties, Kinder Morgan Energy Partners can afford to pay such fat dividend yields – they essentially do not pay income taxes and rely on capital markets for capital on capital spending, and acquisitions. However, if the revenue starved governments decides to get a higher share of the tax mix, they could start taxing those entities. This would effectively reduce attractiveness of pass-through entities, lead to steep dividend cuts, and losses for investors.
This is why I believe that there is generally a higher risk of a dividend cut with high yielding stocks.
In addition, there is a high risk of lack of dividend growth. This will reduce purchasing power of my principal, and result in constant downgrade to my lifestyle.
I also believe that by owning a portfolio consisting predominantly of pass through entities, I am taking a concentrated risk, which is contrary to the ideas of diversification I have been preaching on for the past six –seven years.
If I needed $30,000 in annual dividend income, but only had a portfolio worth $500,000, I could do two things. The fist is to design a portfolio with an average yield of 6%, and call it a day. The second thing would be to invest in a mix of more reasonably priced companies, wait for a few more years of savings and patiently compounding my capital before achieving my goal. The risk with the first scenario is that those higher yielding stocks stop growing dividends, which would reduce purchasing power of my income. In addition, if there are dividend cuts, my lifestyle would be even worse off. If you need $30,000 to live on in year one, you would likely need $30,900 in year two assuming a 3% inflation.
What good is a high dividend stock that yields 6% today, if it gives me a 50% chance of a dividend eliminations within next decade, compared to a stock yielding 3% that has only a 10%-15% chance of a dividend cut. If I earn 6% this year, but next year I get a 50% dividend cut, I am not better off eventually than an investor who started out with a 3% yield that was unchanged in year two. As an investor, my goal is to maintain and increase my real income, and only suffer the least amount of losses. If I just focus on the yields today, I might end up missing out on the risks I am taking in the process.
With a more moderate dividend growth stocks yielding somewhere between 2.50% - 3.50% today, I have a better chance of reaching my goals, having a sustainable income stream, and a better fighting chances against dividend cuts and inflation.
I believe that I only need to get rich once. Therefore, my goal is to be patient, and build my dividend foundation slowly and carefully, rather than be in a hurry, and avoiding excessive risks.
Full Disclosure: Long KMR, KMI, ARCP, O, KO
- The Four Percent Rule is Dependent on Dividend Yields
- High Yield Dividend Investing Misconceptions
- Five Things to Look For in a Real Estate Investment Trust
- Dividend Champions - The Best List for Dividend Investors
- My Entry Criteria for Dividend Stocks
This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Ro...
Dividend growth stocks are the gift that keeps on giving . I like the fact that most of the work in selecting good dividend growth stocks is...
I have shared with you early in the year, that I am essentially living off dividends and side income in 2016. I am saving my other income i...
Last week I shared with you the list of 2016 Dividend Aristocrats and its performance over the past decade . In addition, I isolated twenty...
I pick my own dividend paying stocks in my taxable accounts, and wouldn’t have it any other way. I know some of you have mentioned that they...
Mark Seed is passionate about personal finance and investing and is the blogger behind My Own Advisor . Mark is currently investing in divi...
I am a fairly frugal person . An example of that is the fact that I drive a 15 year old car. I would likely keep driving this car until all ...
This is a guest post from Keith Park, who writes about dividend investing on DivHut . Keith has been a dividend growth investor since 2007 f...
My retirement strategy is focused on building a dividend portfolio of high quality blue chips, which are reliable dividend payers. For my di...
This is a guest contribution from Liquid at Freedom 35 Blog . Liquid is an avid investor in the North American financial markets and blogs a...