The goal of every dividend investor is to create a portfolio that makes enough dividend income to live off. In order to reach this goal, investors need three ingredients: regular savings, quality dividend stocks and time.
The first step in your journey as a dividend investor is to spend less than what you earn. Unless you are counting on receiving a big lump sum from an inheritance or winning the lottery, living within your means and savings are the primary sources of investable cash.
The next step is to choose quality stocks, which have a history of consistent dividend increases. The best place to start is the list of dividend champions and the list of dividend contenders maintained by David Fish. In order to reduce the number of stocks to a more manageable list, they can create a set of rules for screening dividend investments. A screen I use includes the following parameters:
1) Valuation – P/E less than 20
2) Consecutive years of dividend increases – at least 10
3) Ten year dividend growth of at least 6%
4) Dividend Yield exceeding 2%
5) Payout ratio of less than 60% for common stocks. For MLPs and REITs look at the DCF payout or FFO Payout ratios.
Once the screening criteria are utilized, and the list of potential candidates is generated, it is time to thoroughly research every single income investment. Researching entails reading the annual report, press releases, slides from analyst conferences, analyst reports and keeping up with major developments. The goal of this exercise is to evaluate whether the company can increase profits over time. While this sounds like a major time commitment on the surface, the reality is that few companies change so much over the course of a year. As a result, once our investor spends a large block of time to gain an understanding of the business, any additional information that is material to a business would only take less than a few hours per quarter.
Another crucially important component of investing is time. Even if you purchased the best dividend stock in town, at the best price possible, an investor could still be exposed to meaningless noise, that might lead them to trade in and out of stocks. This activity could be bad for your pocketbook, since time in the market is more important than timing the market. Most investors that lose money are those who frequently trade, and never really end up grasping the power of compounding for those patient enough to let the seeds of their capital mushroom over time. Those who make money are those who think like long-term business owners. Time is an important ally for good businesses, and for the patient investors who hold on to those quality businesses. If the business manages to grow earnings and pay rising dividends, this can compound your money until you reach your financial goals. Things could change over time, and as a result people need to create mechanisms for dealing with change. In order to ensure the successful passive income compounding of the dividend portfolio over time, one needs to diversify, reinvest dividends and sell losers.
Diversification is an important tool in the arsenal of the successful income investor, because it protects them against the proverbial bad apple that can take a serious bite out of your dividend income at the worst possible moment. I often encourage investors to build a diversified income producing portfolio consisting of at least 30 - 40 individual companies, which are representative of as many sectors that make sense. As a result, even if one bad apple cuts or eliminates distributions, the total dividend income would not be affected by as much. In addition, once the dividend cutter is sold, the proceeds could be used to purchase another cheap company in the sector. By avoiding the major losses that could seriously derail the investment portfolio, the investor would have all the odds in his or her favor that would allow them to compound their profits.
Investors can either compound their dividend income by reinvesting automatically in the firms that generated the income in the first place or by taking the cash distributions and reinvesting in another stock once the proceeds exceed their minimum lot size. Investors need to add new capital or accumulated cash dividends to the companies that are attractively valued. However, they should not commit more than 5% – 6% of their portfolio to a single security. If the top security is one you are already overweight in, invest your funds in the next most attractively valued stock that has a portfolio weight with room to grow. For example, I have frequently purchased companies like Johnson & Johnson (JNJ), Chevron (CVX) and Phillip Morris International (PM), which is why they are overweight in my portfolio. Because of that, any new money I add would have to be allocated to other quality investment opportunities available at good valuations.
An investor, who follows these simple principles, should be able to achieve financial independence at some point in the future. The end result is directly correlated with the level of effort and resources committed to achieving it.
Full Disclosure: Long JNJ, CVX, PM
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- Dividend Champions - The Best List for Dividend Investors
- How long does it take to manage a dividend portfolio?
- How to think like a long term dividend investor
- Replacing dividend stocks sold
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