Friday, January 29, 2016

How did I do in January?

To be honest, I didn’t do much investing wise in January. Of course, I didn't panic and I stayed the course. Per my earlier article I shared with you, I proceeded according to plan:

1) I maxed out 401 (k) and HSA
2) I reinvested the dividends in my tax-deferred accounts ( Roth IRA, SEP IRA, Rollover IRA)
3) I bought a CD as part of my CD ladder
4) Transferred all taxable dividends to checking, in order to spend them

So far I am finding that living off dividends and side income is a little challenging, though I expected that to a certain extent. This is because I am not taking advantage of low prices on dividend stocks ( though I am taking advantage of automatic purchases of stock mutual funds and dividend reinvestments). It is also difficult because my cash flows are uneven on a month to month basis. I have come to realize that cash is king indeed.

For example, assume that my portfolio consists of 10,000 shares of Coca-Cola and 1,000 shares of McDonald’s. Under current dividend rates, this portfolio will generate $3,300 in dividends in April, July, October and December, and $890 in dividends every March, June, September and December. This leaves the months of January, February, May, August and November without any cash.  This is where having approximately two months worth of expenses in savings is helpful - to smooth out short term bumps in cashflow.

Of course, I am doing all of this as a simulation to test how I would feel when I really do life off dividend income in a few years. As a portfolio builder, I am finding that my biggest regret is not being able to build my portfolio. However, I am still checking to see how I would do if there is a good number of potential dividend cuts in my portfolio. I am purposefully stacking the odds against me, in an effort to see how resourceful I am and how I handle myself when things go against me. While I am fine today, I want to be prepared for a worst-case situation 10 – 20 years from now, if things do not go in my favor. While others prefer to focus only on the upside, I prefer to stress test my portfolio and my assumptions. It is one thing to think through a decision tree involving hypothetical what could go wrongs, and quite another thing to experience that so that you can learn some resilience ( even if it is through a simulation).

Currently, my dividend income covers most but not all of my expenses, which is where I have to rely on the fickle nature of side venture for the gap. Based on the past, the sum of my dividend income and side income has exceeded expenses for the past 7 years, though it could always change. This will be interesting to watch if we start getting dividend cuts from the likes of energy companies. I am still working full-time as well, which reduces my ability to move to a cheaper location and cut costs. However, it is also possible that when I do retire, I may not be able to simply pack my bags and downsize for a variety of qualitative reasons. It is also possible that if I have been out of the workforce for 10 – 20 years, at which point my investments start failing to produce dependable income, I would most likely be stuck working a minimum wage job. So this would reduce my ability to simply move to a cheaper location.

If I end up purchasing a prime home residence, this may also reduce my ability to simply move at a moments notice ( though it would provide a low but stable return in the form of eliminating rent expense and result in an inflation adjustment for the value of the home and annual tax liability to the county along with a cool ).

On the other hand, if my investments fail me in 30 years, that would be fine since I may be eligible for social security then. I find it helpful to think about scenarios that could torpedo my retirement, and then designing potential mitigating factors against those scenarios. Perhaps this is an example of my professional deformation at best. On the bright side, I know that there will be a lot of scenarios in 30 years that I would not have even considered to be a remote possibility.

Either way, I believe that sustainable cashflow is king in retirement. It is helpful to be receiving cash flow from dividends, work and side ventures. Building a margin of safety in financial independence is helpful, which is one of the reasons why I am also slowly building out a CD ladder as well. While I aim to become fully financially independent in 2018 ( when dividends will cover my expenses), I may still continue working at my job as long as I enjoy it. (or for as long as they keep me)

To be honest with you, I am somewhat bearish on stocks, and think that we may see much lower prices down the road in 2016. My observations show that most investors are overly bullish on stocks, and they still have the buy the dip mentality. Of course, I am not good at market timing, since I believe that time in the market is superior to timing the market. As long as I am employed, I will keep really maxing out those pre-tax and after-tax dollars every two weeks, allocating them as mentioned before, and reinvesting those dividends.

This of course is a “temporary” solution to my wealth building, and doesn’t mean I have abandoned the dividend growth investing strategy. When I do leave this current job in one, five or ten years from now, I will be able to roll that money into a regular IRA for pre-tax dollars and Roth IRA for after-tax dollars. I believe that total returns on a portfolio of dividend stocks will be roughly similar to the total returns of a portfolio of mutual funds. The real selling point for me is the ability to essentially convert most of my assets from taxable into tax-deferred on a larger scale, and thus reduce investment tax liabilities for my generation and hopefully the next generation. I believe that this is an opportunity worth pursuing for a decent chunk of my assets. When I do have the ability to convert that money from funds to individual stocks in those accounts however in 1,5, or 10 years from now, I should have a list ready and prices at which to act.

On a side note, it is interesting to note that my S&P 500 mutual fund has managed to grow dividends every single year since 2009 – it is a dividend contender in itself.

I do like buying quality stocks but only at an attractive valuation. Unfortunately, most of the quality companies I like are still overvalued. For example, quality names such as Brown-Forman (BF.B), Colgate-Palmolive (CL), and McCormick (MKC) seem overvalued today. Even Hershey (HSY) and Diageo (DEO), which have fallen in price, seem to be selling at the top of the valuation I am willing to pay. It would be nice to be able to get those companies at 15 – 16 times earnings. These are indeed quality companies, because their earnings streams are relatively immune to the economic cycles, and are more dependable than the earnings streams of cyclical companies such as energy, railroads, industrials etc.

There are several companies in the energy arena whose share prices have really gone down a lot. However, given the fact that their ability to earn cash is impaired by low energy prices, it is yet to be seen whether they are true bargains or are value traps. For example, I believe that ConocoPhillips (COP) is cheap if oil prices double from here. In the meantime however, it is quite possible that they will cut the dividend. The only oil company whose dividend I believe to be safe in this environment is Exxon Mobil (XOM). However I find this quality company to be a little overvalued, because the share price has not fallen as much as it’s near term ability to earn money. It would be interesting to see if a potential stock market panic can result in the share price falling to $60/share.

Perhaps this is why I think that working a little longer might be beneficial from a the financial standpoint to beef up investable assets. If you are thinking of retiring in 2016, perhaps try to evaluate whether an extra year of work might not provide you with an extra layer of protection. Alternatively, if you are retiring to pursue that passion of yours, try to retire when it can cover at least 3 - 4 months of your annual expenses first ( assuming your investment income is already covering basic expenses).

Full Disclosure: Long XOM, COP, BF.B, CL, MKC, HSY, DEO,

Relevant Articles:

Not all P/E ratios are created equal
The Energy Company I want to buy
Living off dividends in 2016 – My New Goal
Life after Financial Independence
Margin of Safety in Retirement Income: How to create a fool proof dividend machine for retirement

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