Thursday, December 10, 2015

The Humility Dividend Growth Portfolio

I have been investing in dividend stocks and writing about it on this site for almost eight years. My portfolio has increased several times in value over that period, fueled by my consistent contributions, increases in share prices and the constant reinvestment of growing dividends into more stocks. I am not sitting on my laurels however. On the contrary, I am spending a lot of time every week searching for attractive opportunities to add to my portfolio, monitoring my holdings and learning more about investing in general. I also spend a lot of time thinking about investments in general, my goals as an investor, and the risks that could prevent me from achieving those goals.

The more I learn about investing, the more humble I tend to become. One thing I have learned is that there is a lot out there that I do not know about. As a result, I have become much more humble than before. I accept that a lot of things can happen, but yet I would still like to be financially independent. I often scratch my head when someone argues with me about investing in hot growth stocks, in social media stocks, for not frequently churning my portfolio, for not withdrawing money from my principle, for only focusing on companies in the sweet spot, not investing in high yielding stocks, not concentrating my portfolio etc.

I am scratching my head because the person telling me that is obviously overconfident in their abilities. This is particularly dangerous from individuals who are ignorant of facts, and are not thinking probabilistically.

I realize I might be ignorant as well, which is why I try to keep learning about investments every single day, and keep an open mind. I also try to devise systems to protect me from risks.

As my portfolio has grown in size, and amount of dividend income has grown to cover close to 60% - 80% of expenses, I have become more cautious. I believe one needs to accumulate their nest egg only once in their lifetime. Therefore, I do not want to take excessive risks in order to prove something that doesn’t matter to people whose opinion is not worth much anyways. An investor puts money differently, depending on the size of their nest egg. If you owned only $10,000 worth of stocks, you can afford to take risks, because even if you lose everything, chances are you can save that amount within a few months/an year and be back in the game in almost no time. However, you will invest $100,000 in a much different fashion than the $10,000, because the former will take you several years to accumulate. Needless to say, if your portfolio is in the mid to high six-figures and even in the seven figures, you will be less prone for excessive risk taking. The goal is to preserve your nest egg, and live off its stream of income, so that you can own your time. If you want to be a big shot with your money, you might end up becoming really rich if you are successful. However, if you are not successful, you would end up losing that money, and you would be much worse off since you would have to spend another lifetime building that nest egg. Unfortunately, for most of us mortals, we are only given one lifetime to live.

I will let Warren Buffett speak to this with this quote on the Geniuses at the over-leveraged hedge fund Long Term Capital Management (LTCM) that failed: "To make the money they didn’t have and they didn’t need, they risked what they did have and did need–that’s foolish, that’s just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense."

Luckily, I am focusing myself mostly on companies that regularly grow dividends, which limits my investable universe to less than 300 companies (with at least a ten year streak of consistent annual dividend growth). These are companies with great business models, that generate so much in free cash flow, that they end up showering shareholders with growing dividend payments. There is an edge in investing in those companies, since most of them are mature, generate stable cash flows and are established leaders in their respective fields. Even if they ultimately stop doing as well, this would usually occur many years after my purchase. Therefore even after a dividend cut there is a high likelihood that prices I sell at will be higher than prices I paid. Plus, based on my history with dividend growth stocks and my research, only a portion of companies end up cutting dividends.  For those companies that do well however, the compounding effect of reinvesting those rising dividends over a 20 year period is going to result in some amazing results.

But, have you heard that past performance is not an indication of future returns? I have learned that his could be the case. That is why I need to prepare myself for risks I can think of today, but also be in a situation to be prepared for risks I cannot even imagine today. For example, few people in 1990 could have forecasted that Eastman Kodak would be toast within two decades. Ok, perhaps Bill Gates knew that in 1991. Nobody in 1974 would have even thought that the third largest company in the S&P 500 will be bankrupt within 38 years.

This is why I am intentionally trying to create redundancies as I build my dividend growth portfolio, in order to make sure I have breathing room in case the unexpected happens. I do not want to be in a situation where I have been retired for 20 - 30 years, and then I run out of money.

For example, I was once out of the workforce for a period of 1 - 1.5 years, while I was working on an advanced degree. As I was looking for a job, I interviewed a lot. Surprisingly, a large portion of the interviewers were asking me about the reason behind my employment gap. Imagine if I had been out of work for 20 - 30 years.

The chances of finding a job after a 20 – 30 year absence from the workforce would be remote. I also do not have the desire to be a financial independence guru, and having to post about how awesome traveling around the world is or doing nothing is, in order to generate advertising income or sell books.

The goal of my investing is to generate dividend income that will pay for my expenses in retirement. I will consider myself financially independent only when dividend income covers expenses by a factor of 1.3 – 1.5. This will leave me with some breathing room in case my expenses rise faster than expected, or if there are some freezes or dividend cuts.

The goal of dividend growth investing is that dividends grow every year above the rate of inflation, which preserves purchasing power of income. Historically, dividends have grown approximately at a rate of about 2% above the rate of inflation. I plan on placing the excess dividend income back into the portfolio. This leaves breathing room in case there are dividend freezes or dividend cuts down the road. I believe inflation to be the arch enemy of the retired investor, since it raises the pricing of everyday goods and services every single year. While those inflation increases are small to notice initially, they tend to compound over time, which leads to some drastic changes in prices.

I do not want to sell stocks and eat my capital. This will leave me exposed when stock prices go nowhere for 15 - 25 years or they go down. Selling stock also reduces my flexibility to deal with unknown events. I have read the studies behind the four percent rule and have come to the conclusion that it was successful in the past mostly because the average yields on stock indexes and on government bonds were slightly above 4%. Ironically, according to those studies, if one withdrew more than the amount of income generated from those portfolios, they have a high risk of running out of money if they didn’t time their retirement year correctly. I am highly skeptical that anyone can predict where stock prices are going in the near term, which is why I am not going to sell off portions of portfolio to fund living expenses.

The goal of diversification is that a few bad apples, or a bad sector do not derail my retirement. I have positions in approximately 100 dividend paying stocks today, although the first 50 of them account for over 90% of my portfolio. I want to reduce the risk of stock selection as much as possible, in order to reduce the chance that I lose money because of my ignorance/bad timing/unforeseen events. For example, in the energy sector I own stock in almost all of the oil majors, except for Total (TOT) due to the French withholding taxes on dividends. This means that if one of those majors has a big problem such as an oil spill, nationalization of large portion of reserves or something else, I would be relatively fine. Of course, when oil and gas prices decrease by 50% in the next few years and stay there, all energy companies would likely freeze dividends and suspend share buybacks Some might even start cutting dividends.

This is why it is also important to hold a diverse portfolio of companies that are purchased at attractive prices, which also are representative of as many sectors as possible. Of course, that doesn’t mean sacrificing quality for the sake of diversification or purchasing Brown-Forman (BF.B) or ADP (ADP) at 25 – 30 times earnings for the sake of diversification. However it is important to not be overly concentrated in a given sector.

Diversification is also a protection tool against risk of poor stock selection. For the past eight years that I have focused exclusively on dividend growth investing, my stock selections have done really well. However, I was aided in part by accumulating most of my stocks at much lower prices than today between 2008 – 2012. I was able to identify some overlooked bargains in 2013, but so far in 2014 and 2015 I am having a much harder time than ever to deploy my capital. Going forward, I expect to make a lot of stupid decisions in retrospect, which is why I need protection from my potential ignorance. I am not saying it will happen, but I do want to be prepared just in case I am not very sharp in old age.

As I mentioned earlier, I would only consider myself financially independent if I earn enough in dividends to cover 1.3 – 1.5 times the amount of my annual expenses. I expect to hold the portfolio of companies producing exactly the amount of dividend income I need in taxable accounts. The rest will be held in tax-deferred accounts such as Roth IRAs or regular IRAs ( after I rollover my 401 (k)). I then plan on converting the 401K or regular IRA’s into Roth IRA slowly, in order to stay in a low tax bracket and pay as little as possible on the conversion. By ultimately having a portion of my funds in tax-deferred accounts, I will not have to pay any capital gains or dividends taxes for several decades. By striving to eventually put most of those tax-deferred amounts in Roth IRA’s, I would end up with a stream of income which will not be taxed, according to current tax legislation. I am trying to diversify my tax base, in order to be able to reduce impact of hikes on dividend and capital gains taxes down the road.

To summarize, I am trying to create a bulletproof dividend portfolio by creating a system of overlapping redundancies, in order to increase my chances of staying financially independent after I reach my dividend crossover point. This is because I hope to be able to live off that portfolio for at least 40 years, while experiencing recessions, depressions, bear markets, company failures, wars, technological breakthroughs and product obsolescence that could drastically alter the way our world looks in the future. As a result, I am approaching this as a person who doesn’t know much, and therefore leaves a lot of leeway for margin of error. I want to view eventual longevity in my life as a blessing rather than a curse, which is why having the portfolio throw off cold hard cash for at least 40 years will be very important.

Relevant Articles:

How to properly weight dividend portfolio holdings
Margin of Safety in Financial Independence
Investors Should Look for Organic Dividend Growth
Achieve Financial Independence with Dividend Paying Stocks
Entering Wealth Preservation Mode

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