Here is the simple answer: live off dividends
Here is the longer answer –when you live off the income that your portfolio produces, the chance that you will ever run out of money is greatly reduced. If you have to sell portions of your portfolio and thus rely on finding someone else to sell at higher prices than you bought, then you have a higher chance of outliving your money.
It is very easy to monetize a pile of cash, and convert it into a neat dividend machine, which will deposit cold hard cash into your brokerage account regularly. You can then use that cash to either spend or to reinvest into more dividend paying stocks, paying even more cash.
As I discussed earlier, there are largely two types of dividend growth investor investors. The first group are those who have been putting money mostly in dividend growth stocks regularly, reinvested dividends, and maintained their portfolios. The second group include those who are trying to convert a nest egg accumulated over a lifetime of hard work, or an inheritance or another pile of cash received recently as a lump-sum. Those are the ones who want to learn how to pensionize their assets, and live off that pile, while also minimizing the risk of loss to the minimum.
If you are building a dividend growth portfolio from scratch, the first step is to start slow. Get a list of dividend growth stocks and identify the leaders in their industries that also have dividend growth streaks. A long streak of regular dividend increases shows a company which is prospering, as evidenced by the higher amounts of cash it sends to shareholders. A company cannot fake cash for long, which is why many investors consider the proof of regularly increasing cash dividends as proof that earnings are increasing and business is good. It is also important to understand which stage of dividend growth the company is. You are mostly interested in companies that manage to increase dividends because their earnings improved over time. When earnings and dividend growth go in lockstep, you know you have found a candidate for further research.
If that candidate is available at a good price, then it can find a place in my portfolio. I usually try to avoid paying more than 20 times earnings for a company. I also require adequate dividend growth exceeding 6%/year, rising earnings and dividends, and try to understand if the company can continue its growth. Most often, I have found out that a body in motion, keeps its upward trajectory for years to come, until something changes. When something does change, the company cannot fake cash flow anymore, and they either freeze or cut dividends. I am a very patient investor, and will hold even through long periods of time while a company works its issues out, as long as my payout is at least maintained. I won’t add any more funds to this position, and would monitor it more closely, but would not sell it. If however a company does cut or eliminate distributions, I am out one second after the announcement. I can get back in if they start raise dividends again, and I believe earnings can grow and sustain the streak again. Having an exit plan is as important as having an entry plan.
I also try to build my dividend portfolio stock by stock, in an effort to have a diverse stream of cash coming my way. I do not want to be overly dependent on any single company for my dividend income, or a single sector. The nature of dividend growth stocks means that I own too many consumer staples and energy companies unfortunately. It is also important not to diversify just for the sake of diversification, but genuinely look for companies which you believe will be there in 20 – 30 years, and possibly earn more to pay more in dividend income. If there is a high confidence that a company will be there in 20 – 30 years, that increases the chances that it will be hopefully earning more over those years and rewarding that shareholder with more cash. Those growing dividend payments will protect the dividend income of the investor from the destructive power of inflation.
It is also important to dollar cost average my way into those quality companies. Remember, Rome was not built in one day. Your portfolio should not be built in one day either. When I dollar cost average every month, I put money to compound for me in some of the best businesses in the world today. I ignore noise such as “the market is overvalued and will crash” or “the market has crashed and will crash further” and keep buying through thick and thin. That way I have a psychological advantage, because I will be putting money regularly, while everyone else will be panicking and selling during the next bear market or piling most of their money right when the current/next bull market is about to end. I don’t have to worry about ups and down, and I ignore market fluctuations, because I am investing in real businesses, not some lottery tickets. I also invest for the next 30 years, plan to live on dividends that are derived from earnings, which is why fluctuations today don’t really impact me. What impacts me is only how the business does over those 30 years.
This is essentially what many trust funds and some major foundations have been doing for decades. If you look at the Hershey Foundation or the Kellogg Foundation, you will notice that a large portion of their income comes in the form of stock dividends. Those dividends are spent for charitable purposes. Of course, this has not stopped either Kellogg (K) or Hershey (HSY) from prospering as well. You can also look no further than the descendants of Standard Oil, whose trust fund accounts are filled with shares in Exxon Mobil (XOM), or Chevron (CVX) to name a few, which have been able to raise and pay stable dividends for a century. If those foundations or trust fund babies have been able to live off their portfolios using dividend growth stocks, then why can’t someone ordinary like me live off dividends generated by my portfolio for about 30 – 40 years?
To summarize, I plan on creating a diversified portfolio of dividend growth stocks, by slowly dollar cost averaging my way into attractively valued quality companies over time. By only spending the dividend income, I believe I am being more conservative than investors who sell off portions of their assets in retirement, which dramatically the lowers chances of me running out of money in retirement. In addition, I would not be at the mercy of stock market prices and risk selling when prices are low, but I will be getting cash no matter what stocks do. I will be essentially share in the profits of the enterprise and be essentially paid to hold interest in some of the best businesses in the world.
Full Disclosure: Long K, XOM, CVX
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Monday, January 26, 2015
Here is the simple answer: live off dividends
Wednesday, January 21, 2015
Successful dividend investors understand that a steadily rising dividend payment only tells half of the story. Most dividend paying companies that have been able to consistently raise distributions for at least one decade have enjoyed a steady pattern of earnings during that period of time.
As a dividend growth investor, my goal is to find attractively valued stocks that consistently grow their dividends. I run screens on the list of dividend champions and contenders using my secret entry criteria, and then look at the list company by company. Not surprisingly, I look for a record of increasing dividends. But I look for much more than that in a company.
In a previous article I discussed the three stages that dividend growth companies generally exist in. My goal is to focus on those in the second stage, although I might occasionally select a company from the first phase. However, I try to buy not just companies that have a record of raising dividends, but those that have decent odds of continuing that streak for the next 20 – 30 years. Not every company will achieve that, but for those that do, they would generate the bulk of portfolio dividend growth. The hidden source of dividend growth potential is expected earnings growth.
As you can tell from looking at my stock analysis reports, I look for companies that can increase earnings per share over time. Rising earnings per share can essentially provide the fuel behind future dividend growth. For example, Colgate-Palmolive (CL) has increased dividends for 51 years in a row. Over the past decade, it has managed to increase EPS from $1.17 in 2004 to an estimated $2.93/share for 2014. This has allowed the company to increase annual dividends from $0.48/share in 2004 to $1.42/share. The rest has been invested back into the business, to fuel potential for more earnings growth.
A company that is unable to grow earnings over time can only afford to grow dividends for so long. For example, Diebold (DBD) has managed to increase dividends for 60 years in a row through 2013, and had a very current yield. Unfortunately, the company has been unable to grow earnings as of lately, and the dividend payout ratio is reaching the limits of what a sustainable distribution could be. As a result, the stock has kept dividends flat in 2014, and as a result its streak of dividend growth is over. Therefore, the list of dividend kings will shrink for the first time since I have been tracking it.
Just as with dividend growth, I take past records of earnings growth with a grain of salt. You want to think about catalysts that would help propel earnings higher. For example, in the case of Colgate-Palmolive, the company has strong branded and relatively inexpensive products that consumers buy on a frequent basis. Most of these purchases are repeat business for Colgate – Palmolive, and consumers tend to stick to the brand of say toothpaste they have been using for years. Most consumers will stick to a brand whose quality they trust, and might not even notice a slight increase in prices over time. If you like Colgate toothpaste, and you care for your teeth, you would not substitute it for a generic brand that might be 50 cents cheaper. With this pricing power, Colgate can effectively manage to pass on costs to consumers. This could result in rising profits over time.
You can see that the qualitative analysis is important. If a company has strong brands, and competitive advantages, it can afford to increase prices, and that would not affect profits generated from loyal customers. This can generate profits to fuel dividends for years to come. For example, US companies such as Altria Group (MO) sell an addictive product, whose prices have been increasing for years. Despite the decrease in number of users over time, the increases in prices and constant looking for efficiencies has led to rising profits for decades. This stream of rising profits has fueled the dividend growth behind Altria, which has managed to reward shareholders with higher payouts for over 45 years in a row, adjusting for spin-offs of Kraft and Phillip Morris International (PM).
What you want to avoid is companies that offer commodity type products, companies that could lose leadership positions due to technological change as well as companies that are cyclical in nature. A commodity company is usually a price taker, not a price setter, and therefore does not have the pricing power of a Coca-Cola (KO) or Colgate – Palmolive for example. This can lead to erratic earnings, as prices would fluctuate depending on economic conditions for example. As a result, very few steel companies have managed to maintain an unbroken record of rising dividend payments. The only exception seem to be oil companies, some of which have been able to reward shareholders with rising payouts for over 25 years. This could be due to the nature of oil and natural gas, which once used, cannot be re-used, unlike other commodities such as steel and gold.
You also want to avoid companies which have gotten temporarily lucky. A prime example include some gold companies, which have records of raising distributions for one decade. Unfortunately, this coincides with the boom in gold and silver prices since the bottom in 1999. Even worse, many of these companies have pretty low payouts, which might make it easy to become a dividend achiever, but the paltry yields would be a turn off for investors.
Last, but not least, companies whose products or services could be deemed obsolete by shifts in technology, will not be able to earn sufficient profits to maintain a growing stream of dividend payments. Technology companies seldom have the durable competitive advantages that would make them holds for 15- 20 years. I cannot predict whether Intel (INTC) would still be in a competitive position in 2028 – 2033, or its products would be obsolete. However, I can pretty reasonably expect that people would still eat their favorite potato chips made by PepsiCo (PEP) or drink their favorite Coke or another one of the 500 drinks that the Coca-Cola Company (KO) makes.
In summary, a company that manages to grow earnings over time, should be able to afford to reward shareholders with a growing dividend income stream. Investors should analyze each company in detail, and determine if it has the qualitative characteristics that would allow it to grow earnings. If those characteristics are met, then the job of the investor is to acquire such securities at reasonable valuations as part of their diversified portfolio.
Full Disclosure: Long CL, PEP, KO, CL, MO, KRFT, PM, MDLZ
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Monday, January 12, 2015
Imagine that you are able to receive a lump sum today, due to an event such as a sale of a business, cashing out of a pension, inheritance or winning the lottery. After you rejoice a little, you start asking yourself what to do with the money. I keep asking myself the same question quite frequently, and think my way through this “problem”.
If I received a lump-sum payment today, I would approach it differently, depending on the level of experience I have, the time I am willing to commit to investing per week, and the level and effort of continuing investing education I am willing to commit myself to. For sake of comparison, lets imagine that I am about to receive $1 million tomorrow.
The easiest option is to build a portfolio consisting entirely of mutual funds, covering indices such as S&P 500, US Total Market Index or a World Total Market Index. This would be in a situation where I didn’t know much about investing, didn’t have the time nor inclination to spend too much time on it, or decided it would have been too big of a hassle for me to pick stocks individually. I would basically put the money in a ladder of Certificates of Deposit first, and have an equal amount of those CD’s expire every month for 24 – 36 months. That way, I am mentally removing the pressure of having to invest all money at once, and I am also removing the opportunity to invest most of the money in my cousin’s business idea of a social network for cats (Catbook anyone?). As an equal amount of money is available each month, I will have it invested in the mix of stock funds. The purpose of dollar cost averaging is to avoid putting all the money at once, in order to avoid the risk of putting the money at the highest prices. By investing an equal amount each month, I am increasing chances that I will get decent prices for stocks I buy, and avoid overpaying. I will also miss out if prices keep going straight up for those 24 – 36 months, but that would be a risk worth taking, since it would also mean I would not put all money right before a major correction. The conventional way of this portfolio is to sell a portion each year to cover expenses. This could work in most situations, unless of course the stock market is down right when you start withdrawing or if the stock market is flat for the majority of time.
The other option I would take if I were willing to put the time and effort into it would be to invest the money in dividend paying stocks directly. I would still start with a CD ladder however, and put equal amounts into attractively valued dividend paying stocks every month for 24- 36 months. I would start by screening the list of dividend champions and dividend achievers every month, identify companies for further research, and put an equal amount of funds into the ten most promising ideas every single month. I would rinse and repeat every single month for 24 – 36 months. Over time, I should be able to gain some sort of understanding behind a large portion of those dividend champions, through regular reading and research about these companies. As the knowledge of each company is accumulated, it would be much easier to act. This process could take a lot of time at first, since it would require spending time researching whether the companies that met a basic entry screen are worth my money. After that however, additional follow-ups on each company should not take that much time each year on average. My goal would be to have a portfolio consisting of at least 40 different dividend paying stocks, representative of as many sectors as possible. That doesn’t mean owning utilities just so you own utilities. It means buying into companies selling at attractive valuation, but also making sure that I do not concentrate too much in a particular sector such as financials for example.
I would also build a portfolio around the three different types of dividend growth companies I have previously identified. The biggest mistake to avoid is focusing only on current dividend yield, without doing much additional work about its sustainability, potential for growth, understanding of the business etc.
Living off dividend income is pretty easy, once a portfolio is set up. When I receive dividend checks directly deposited in my brokerage account, this is cold hard cash I can do whatever I want with. I do not have to stress over whether we are about to enter a bear market, and I would run out of money simply because prices are depressed. I would receive cash dividends, which will get increased above the rate of inflation over time. I would likely accumulate all dividends for a three month period, then spend it equally over the next three monhts. If there is anything left over, I would reinvest it into more dividend paying stocks.
I have chosen of course to focus on selecting individual dividend paying stocks. It is cheaper in the long run to build a portfolio of dividend paying stocks, and rarely sell them. I only sell when dividend is cut or eliminated or when stocks are acquired for cash. I also try to outguess valuations from time to time, but my results have proven that I should not do that. In majority of situations, I am better off just sitting out there, doing nothing. This is the most difficult thing to do in investing.
My portfolio is generating dividends every month, quarter and year. The holdings I own tend to increase those dividends over time, maintaining purchasing power of income, and making my shares more valuable. While stock prices fluctuate from year to year, dividend income is always positive, it is more stable, and thus it is better tool to use when designing a portfolio to live off of. Plus, even the cheapest mutual funds that cost say 0.10% per year are more expensive on a portfolio worth $1 million, since they result in $1000 in annual costs. With brokers such as Interactive Brokers, I would have to make 1000 investments at $1/trade in order to reach the same costs per year. In addition, I would be able to hold on to most stocks and only buy shares in companies which I find properly valued, and possessing the characteristics I am focusing on. I could also avoid selling shares and incurring taxable expenses merely because an index committee decides to remove companies from their lists.
I like the fact that the companies I own provide me with fresh cash in a regular, predictable patterns. This is similar to what my experience is when working – receiving a paycheck at an equal intervals of time. With dividend stocks, I do the work upfront in selection at proper valuation, and then receive the cash for years if not decades to come.
In summary, it makes sense to spread out the investment of a lump sum received in order to reduce investment risks, and reduce the impact of mistakes. The investor who manages a considerable amount of funds should have the goal of preserving wealth first, so that it can last for decades. This will be achieved by spreading purchases over time, diversifying the portfolio in at least 40 individual securities from a variety of sectors, continuing their quest for investment knowledge and requiring quality and attractive prices in the types of investments they purchase.
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Wednesday, January 7, 2015
One of the dumbest arguments against dividend growth investing is showing a single investment that failed, and thus implying that the strategy is not good. An opponent of dividend growth investing would usually use a company like Eastman Kodak, General Motors, or one of the major banks like Citigroup (C) as an example of type of stocks that investors believed to be buy and hold forever.
There are several logical flaws with this argument.
The first issue stems from the fact that only some of the banks used in this argument have ever been dividend growth stocks at the time of their demise. General Motors, which was one of the bluest of blue chips for decades, had never been a dividend growth stocks, because of the cyclical nature of its distributions. Eastman Kodak was a dividend achiever once, having raised dividends for 14 years in a row through 1975, when the Board of Directors elected to freeze distributions. This was over 37 years before the company declared bankruptcy. Since 1975, the company had raised dividends off and on, but never for more than five consecutive years in a row. After the company cut dividends in 2003 however, no objective dividend investor should have held on to the stock.
The second issue with the argument assumes that there is a strategy that is better than dividend growth investing, which is why failures are always exaggerated, while dividend growth successes are simply ignored. The thing about every single investment strategy out there is that only a portion of the investments you make will be winners. Even Warren Buffett has not made money on every single investment he has made. The man is happy if he can find a 40% hitter, and stick to them. A rational investor cannot expect to win on every investment he or she makes. However, if they maximize their gains by sticking to their stock holdings that are successful, they would more than make up for the losers over time.
The third issue with this argument is that it ignores how General Motors, Eastman Kodak and the banks such as Citigroup were actually part of the S&P 500 or Dow Jones Industrial's Averages at the times of their dividend suspension or cuts. These companies were once regarded as the bluest of blue chips, and were members of all other major proxies for US stocks. If these are examples that should prevent investors from following a certain strategy, it looks like since these companies failed, the argument should be that investors should not buy stocks or should not buy index funds altogether. If investors are afraid that one or several of the companies in their portfolio will fail at some point in the future, they should never invest in index funds, or follow any stock investment strategy. Now that I have stretched the original argument, hope you can see its ridiculousness.
The other issue with the argument is that it ignores the fact that dividend investors hold diversified income portfolios, consisting of over 30 individual securities. If a few companies that the dividend investor has identified fail, that would surely hurt. However, the portfolio base would not be in dire straits, as the rest of the components would pull in their weight and raise dividend income over time to eventually reach record territory once again.
Another item with index funds is that they are not a magic panacea for poor investor performance. If the investor panics during bear markets, takes excessive leverage, or decides to wait in cash for months or years until the prices get cheaper, they might not make much money. Of course, index funds change approximately 5% of components each year. Those indexes look like daytraders when compared to dividend growth investors, who rarely sell, and hold through thick or thin.
The last issue with the argument is that it never provides alternatives to dividend investing. As a dividend investor I have spent thousands of hours researching and fine-tuning my investment strategy, and by digging through the information about the companies I am interested in. I have chosen to follow a strategy because it fits my goals and objectives. I typically ignore naysayers who tell me my strategy is bad, without providing me any clear alternatives to that.
In my dividend investing I expect that roughly 20% or so of companies I invest in will generate the majority of dividend and capital gain profits. The remaining will either break even or produce net investing losses. If the companies in the winning group go up tenfold in value with dividends reinvested over the next 20 years, with 40% doubling on average, while the companies in the losing group lose 50% of their value, I would expect that I would end up with a portfolio that could triple in value over a 13 - 14 year time period.
You are not going to come up ahead on all investments you make in your lifetime. But if on aggregate the ones you own end up throwing up more in income over time, you should do quite well for yourself.
In order to find quality dividend stocks for my portfolio, I start with the list of dividend champions, take them through my screening criteria, and then analyze each candidate one at a time. I then do the same exercise using dividend contenders/dividend achievers lists and try to make investments every month in those that offer the best values at the moment.
Full Disclosure: None
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Monday, December 22, 2014
Many investors I know follow different investment principles, such as that to "Buy low, sell high" and "Buy and hold forever". To many investors, purchasing dividend paying stocks at 52 weeks highs or all-time-highs seems like anathema, since it would run contrary to their beliefs of buying low.
I expect businesses I own to keep expanding, selling more products, generating higher revenues and earnings, while showering me with more cash dividends each year. In the meantime, those rising earnings and dividend make businesses more valuable over time, as they increase their intrinsic value. Therefore, in a somewhat efficient marketplace for securities, I expect stock prices of successful businesses to follow and keep hitting all-time-highs over time. Of course, I do not focus on stock prices as much, as I do on values. I have found that focusing too much on meaningless short-term stock price fluctuations is not helpful to my long-term wealth building. This is because I feel the urge to do something, which is dangerous to the compounding of wealth. As a long-term investor, the goal is to set-up a portfolio, and look at annual reports, and quarterly press releases as well as major announcements such as dividend increase, mergers & acquisitions to name a few. I focus on valuation today, compare valuations between different companies between industries, and make estimates of future growth based on sustainability of business model ( does the company have any moat).
Many of the quality businesses I focus on here tend to increase intrinsic value over time. As a result, waiting for the perfect price might let you sitting in the dust. This doesn’t mean to throw all caution out the window and buy regardless of valuation, and without requesting some margin of safety in the event that future is not as rosy as expected. However, if you find a company that sells at an all-time high and say 19 – 20 times earnings, you might have to start accumulating shares if you believe there are good prospects down the road. If earnings per share double in seven years, and the P/E compressed to 15 – 16, the stock could still end up much more expensive in 7 years. If you add in the missed compounding from reinvested dividends, the opportunity cost of sitting in cash might be pretty high.
If you think about it, the all-time high of Coca-Cola from 1987 is much lower than the range it sells for today. In fact, if you purchased Coca-Cola at 52 week highs as long as it sold below 20 times earnings throughout history, you would have done pretty well for yourself. It is true that it is much better to buy quality dividend growth stocks at the lowest prices possible. If you have a long-term horizon like me, that spans at least 15 – 20 years from now, you can afford to view one or two year periods as mere noise.
To me, it is more important to focus my attention on the best values at the moment, and then analyze them for future growth. If the best value today sells at an all-time-high, I would not be worried. I actually read a study, which found that actually purchasing companies that hit all-time-highs has resulted in above-average gains to investors. I know that this was more of a timing strategy than buy and hold, but the results are nevertheless very interesting. The more experience I gain, the more I realize that getting the right entry price is important. However, it is much more important to identify a quality earnings and dividend grower, which manages to earn more money over time, and thus making the business more valuable. If the company has the type of business that sells a unique product, has strong pricing power, and has great earnings growth visibility, then it is fine to pay 20 times earnings for it. This is the type of situation that Warren Buffett describes in his famous saying " It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
My dividend growth strategy is essentially a strategy of following long-term trends in company fundamentals, specifically their dividend rates. Essentially, once I purchase shares in a company, I hold on for as long as the company raises dividends. Even if a company stops growing dividends, I will keep holding on to it, but allocate them elsewhere. It is important to reinvest dividends selectively, into the best values and qualities found at the moment, and not mindlessly reinvest into the same company regardless of valuation. If valuations become too overstretched however, such as in situations where future growth expectations do not justify a P/E of 40, it might make sense to dispose of the security. The situation where I typically have done most of my selling is after a dividend cut. I have found in analyzing my investments that selling a mildly overvalued company to purchase a mildly undervalued is mostly a mistake. If I identify a mistake in the original thinking I may have done, that led me to an investment in the first place, I would sell as well.
On the other side of the equation, just because a company is cheap, and is selling at a 52 week low does not mean it is an automatic buy. Investors who only focus on stock prices, without understanding anything about the business, growth prospects, are probably speculating.
To summarize, just because a company is selling at a 52 weeks high, does not mean that it should not be considered or it should be sold automatically. A new investor should evaluate the value by looking at business fundamentals, catalysts for future earnings growth, and valuation before committing their hard-earned money to work. For those who already hold shares in a company which is hitting a 52 week or an all-time-high, they should continue monitoring their investment, and check whether earnings are growing and that there are catalysts for further growth. One of the hardest things for investors to do is to just hold on to their best ideas, as they prove them right, and not sell and buy something that appears cheaper but leaves the investor worse off in the long-run.
Full Disclosure: Long KO and BRK.B
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Wednesday, November 19, 2014
I enjoy dividend investing, because it is always challenging but it is also very rewarding. I have a set level of basic guidelines such as my entry criteria I apply on the list of dividend champions and achievers, in order to identify companies for further research. I then maintain a list of companies that I have analyzed, which I monitor very often for any weakness for a buying opportunity. In addition, I also monitor my existing positions in order to identify any laggards that are either cutting dividends or might not deliver as much as previously expected.
My investment analysis goes beyond reading annual reports and research. I also try to learn as much as possible about the stock market, investing and general business knowledge. In other words, I keep learning as much as possible in order to make myself a better and more rounded investor. Most of things I learn go through my filters, and are rejected as unsuitable for my strategy. Some investment gems are tested and a few are implemented in my tools of the trade. I do eat and breathe investing, and the knowledge I have accumulated in the process has allowed me to develop an independent view on the subject, which works for me. I invest my money based on my own analysis, and end up earning dividends and capital gains, although sometimes I generate capital losses in the process. Surprisingly, I have often found that I am usually right when most other investors are opposed to my ideas.
Sometimes, I also learn from the intelligent comments from my readers. A lot of the times however, I end up interacting with investors who clearly should not be putting their money in anything else than an FDIC insured bank account. Many times these investors are arguing with me, and end up informing me that my view is incorrect. After reviewing their objections, I typically find out that these investors are not performing objective analysis of investment situations either because they are blinded by high current yields or because they are not taking into account some other factors. A third scenario that could sometimes include bits and pieces of the items mentioned earlier is the situation where investors are simply following someone else, without doing their own due diligence.
Back at the end of 2012, I posted an analysis of Abbott Laboratories (ABT), right before the company split into Abbott and Abbvie (ABBV). At the same time I also mentioned that I had recently added to my position in the legacy Abbott Laboratories. While many investors had valid comments about this investment, there was one investor whose main concern was very flawed. If they had mentioned that Abbott was not the wisest decision, stemming from the fact that it was not possible to determine if the two new companies would continue the long streak of dividend increases or that synergies between the two companies would disappear after the split, that could have been a concern worth raising. However, the main argument from the investor with the flawed thinking however was that David van Knapp had recommended selling the stock.
I think that blindly following someone’s advice to be the worst sin of investing. If you follow someone’s ideas to purchase a stock, you are immediately at a disadvantage because you would not be the first one to learn about future investment moves. In fact, if the original “guru” ends up selling their position, without notifying the follower, the follower might end up losing money. In addition, if the “guru” buys a stock, which then promptly falls by 50% or more, as plenty of good quality stock prices did in 2008, an inexperienced investor might get scared, and sell at a loss. You might think that only inexperienced investors do this, but in reality everyone is influenced by authority a little bit. I sometimes find myself influenced by authority figures such as Warren Buffett, and thus justifying certain investments with the mere fact that Buffett has purchased them for Berkshire Hathaway (BRK.B). Following a guru however, is never a good reason to purchase or sell a stock. However, performing an analysis of a stock that a guru purchases, and then determining if it is a buy is perfectly fine.
Back in early 2010, I analyzed Realty Income (O), and found it to be a buy. However, many investors dismissed my analysis, because hedge fund manager Bill Ackman was short the stock. Yet, his thesis was flawed, and contained a lot of holes - and the investment has doubled since then. I held on to my stock during that time period, and added to it. Back in 2013, another investor was short Digital Realty Trust (DLR). I called our his manipulations and held on to my position. Someone on Seeking Alpha objected to my analysis, and their primary argument was that I was not a billionaire. Yet the conviction in my own analysis provided me the strength to hold on to my stock positions. If I had merely followed someone blindly into a stock, I would have bailed out at the first sign of trouble.
Another interesting factor about dividend investing is that some investors simply refuse to do their own independent research. One of the questions I always receive from investors is for the list of my current portfolio holdings. I first posted a snapshot of my portfolio four years ago, but since then the page has been out of date. I have since shared my dividend holdings with subscribers of my mailing list. There is a reason why I don't make this list easily available, unlike other sites dedicated to dividend investing. My thinking is that if I posted my holdings, I would actually be doing a disservice to novice investors. I would much rather have patient readers who review my thought process through my regular postings that describe somewhat recent events, from which they could hopefully learn something. If I posted my portfolio and made it easy for anyone to check it, I would usually risk someone seeing what I owned and then purchased it without giving much thought about it. Unfortunately, my portfolio has been built slowly over a timespan exceeding several years. Just because I found Family Dollar (FDO) to be attractively valued in 2008 and initiated a position at $24.99/share, might not mean that Family Dollar is a buy today at $77 - $78/share.
Full Disclosure: Long O, DLR, FDO, ABBV, ABT
- Do not become a victim of fear in your dividend investing
- Why most dividend investors never succeed
- Should you follow Warren Buffett’s latest moves?
- How to monitor your dividend investments
- Never Stop Learning and Improving
Tuesday, November 18, 2014
In a previous article, I discussed the idea of dividend investors holding non – dividend paying stocks. After I wrote the article a few weeks ago, I realized that I have received/am about to receive shares in two companies, after them being spun-off from their parents.
I receive one share in CDK Global (CDK) share for every 3 shares of Automatic Data Processing (ADP). Based on reading the dividend policy of this company, it is unclear whether they will be paying a dividend in the foreseeable future. Based on expected earnings of $1.37 - $1.39/share, the stock is selling for 26.30 - 26.70 times forward earnings, which is pricey. If we get high single digit earnings growth however over the next decade, it could be worth to hold on to this business.
I receive one share of Halyard Health (HYH) for every 8 shares of Kimberly-Clark (KMB). The company has stated that no dividends are expected to be paid. The company earned $154.6 million in 2013, and has approximately 46.5 million shares outstanding, which equates to approximately to an EPS of $3.30/share. Thus, the company is selling for approximately 11.50 times earnings, which is pretty cheap. While revenues have been stagnant for the past 3 years, net income has grown slightly. If they manage to streamline operations, repurchase stock or start growing income organically, shareholders could do pretty well by holding on. If they initiate a dividend and start growing it, I would have less reasons to not hold on to the company.
So I am trying to decide what to do. I basically have two options:
This sounds like a logical option for someone who calls themselves a dividend growth investor. If my goal is to earn more in dividend income from my portfolio, it would seem a waste of capital to hold shares in companies that do not pay dividends. I could essentially sell the shares, pay the capital gains taxes, and reinvest the proceeds in something that pays dividends. Since my goal is to earn more dividend income from my capital, I should not hold on to shares in companies which have mentioned that they won’t continue the legacy of regular dividend growth of their parent companies.
For some investors, having two extra companies in their portfolio would probably trigger a sale, because it would exceed a self-imposed number of companies they want to own. In addition, many index funds that held Automatic Data Processing (ADP) in their portfolios, were selling shares of CDK Global (CDK) merely because CDK was not a member of S&P 500, without questioning whether CDK is a good business to own.
I could also just sit tight and hold on to those shares. This is because stock spin-offs usually do really well, as the new company gets management whose sole focus is on managing it, rather than a division whose goals and needs are lost in a larger company. In addition, I have found through an analysis of the sales I have made that selling a company and buying another one usually results in poor results. This is because I pay capital gains taxes on the gains, which leaves me with less money to reinvest. In addition, I have reinvestment risk if I sold and bought something that doesn’t perform as well. The more time I spend reviewing investments, the more I realize that the biggest risk is not that a company goes to zero, but that I miss out on a potential for large gains.
I believe that I will simply hold on to those shares for the time being. In addition, despite the spin-offs of shares, my total dividend income will be unchanged since Automatic Data Processing (ADP) and Kimberly-Clark (KMB) are holding their dividends per share steady. Update: Actually ADP just increased their dividend by 2% to 49 cents/share, citing the high payout ratio as a reason for the slow increase. This dividend champion has grown dividends for 40 years in a row, and is targeting a dividend payout ratio of 55 - 60%.
The position in Halyard Health (HYH) is really small, since I received 1 share for every 8 shares of Kimberly-Clark (KMB). So the amount I received is roughly equivalent to the dividend from Kimberly-Clark (KMB) for 1 - 1.5 years. Based on my study of historical Kimberly-Clark spin-offs, it might pay off to sit tight, rather than lose capital to taxes and reinvestment risk.
There was a spin-off from Kimberly-Clark in 2005, called Neenah Paper (NP). The company was paying a quarterly dividend of 10 cents/share that was unchanged for about 6 years, until it started raising it to about 27 cents/share in 2014. Thus, if you held for 10 years, your dividend income would have increased by 170%, which is not bad at all. Either way, the investor in the company earned a total return of 7.50%/year since the spin-off. The investor in S&P 500 earned approximately 7.70%/year.
There was another spin-off from Kimberly-Clark in 1995, called Schweitzer-Mauduit International Inc (SWM), which made cigarette paper and related tobacco products. That company didn’t pay a dividend for the first 6 months after spin-off, and started at 7.50 cents/share every quarter in 1996. The dividend was held steady until 2012, after which it has been increasing to 36 cents/share every quarter. This goes to show that the most in profits is made by the patient investor, who holds on to their ownership through thick and thin, and doesn’t get scared away easily. Of course, waiting for a dividend increase for 16 years is a tough proposition. Either way, the investor in the company earned a total return of 10%/year the spin-off. The investor in S&P 500 earned approximately 8.40%/year.
The position in CDK Global is slightly larger, but not by much. A previous spin-off from ADP called Broadridge Financial Solutions (BR) has done pretty well, and has paid and increased dividends to shareholders since 2007. It paid a quarterly dividend of 6 cents/share in 2007, which increased to 27 cents/share by 2014. The company has done much better than an investment in S&P 500 since 2007, by providing a total return of 172% versus 67% for the stock index.
The more important thing is for those companies to be able to grow earnings per share. In addition, it is possible that they pay a dividend at some point in the future. After looking at the sales and earnings trends for the two companies over the past few years, I believe that those would be decent investments. I will wait for one or two years’ worth of performance as separate businesses, and see how promising they are as investments. At that stage I will decide whether it is worth holding on to those companies, based upon their business performance.
Update 11/20/2014: CDK (Name: CDK GLOBAL INC) announced a cash dividend with ex-dividend date of 2014-11-26 and payable date of 2014-12-29. The declared cash rate is USD 0.12.
Full Disclosure: Long KMB, ADP, CDK, HYH
- What is Dividend Growth Investing?
- Stock Spin-Offs – What Should Dividend Investors do?
- Warren Buffett is now working for me
- Types of dividend growth stocks
- Do not focus only on income for retirement planning
Wednesday, November 12, 2014
We live in a fast paced world, where we are constantly bombarded by information on something that makes us want to act quickly. Unfortunately, that is not the successful set of skills that you need as a dividend investor. The best dividend investors are those who buy a stock, and then let it quietly compound their income and capital over time. I know that many think they can do it, but in reality, few have the stamina to sit through extended periods of “temporary punishment”. Very often, investors give up on a company after an extended period of below average performance. After that happens, the things revert to the mean and the truly patient shareholders with a long-term vision are rewarded.
Those who got scared easily ended up with emotional scars for life and most probably failed to learn the lesson of what successful dividend investing is all about. The secret sauce is that one needs to select a company that fits their entry criteria, research it both qualitatively and quantitatively, and then let it compound their capital without really worrying too much about quarterly noise and even annual noise. You have to be patient, and not be scared by temporary periods of weak performance. Sometimes things look bleakest right after the tide turns positive. If you try to jump in and out of companies, you are very likely to incur so much in investment expenses, tax expenses and lost opportunity costs, that will result in a very poor investment record. The truly successful dividend investor knows they will have some losers, but that their winners will do so much better on average, that they would still generate an adequate portfolio return over a 20 – 30 year period. It is difficult to say whether a problem that everyone is talking about is a temporary or a long-term one that will result in the demise of the company. This is why I ignore most opinions out there, and keep holding and investing. It is tough to say if a weakness is a random item, or a beginning of a pattern until it is too late. I believe that no one can predict the future, which is why I try to ignore speculation which might or might not turn true. The dividend investor will have nerves of steel in their conviction, and hold on through thick and thin, despite the loud noise out there. The dividends they receive will be used to acquire more shares in the best values at the moment, or spent if they are in the distribution phase of their dividend investor lifecycle. Now, if the dividends are cut or eliminated, that itself signals that the reason the company was able to have a dividend growth streak is probably not valid after all. This is the situation when I sell right away, and ask questions later. Until then, I hold on.
We often hear the story of how someone could have put $1,000 in Johnson& Johnson (JNJ) in 1972, then let dividends compound for decades and ended up with a stake worth approximate $97,500. The reality is that in order to earn that handsome return, the investor would have had to sit through difficult periods that would have tested their conviction time and again. For example, it would have been difficult holding a stock through the 1972 – 1974 correction. It would have also been difficult to hold on to Johnson & Johnson through 1983, when the stock price finally exceeded the all-time-highs. It would have also been difficult to hold on to the stock during the Tylenol recalls in 1982, when you are bombarded by terrible news all the time. For me, it was difficult to hold on to shares of Johnson & Johnson in 2010, when I got bad news about recalls. It is difficult for most investors to hold on to a company where prices have gone nowhere for a decade. I got this response a lot when I first started my site and analyzed companies . As a dividend investor, it is rewarding to get paid for waiting, and receive a higher dividend check every year.
Nowadays, it is tough to hold on to shares of McDonald’s (MCD), as the popular opinion discussed how unhealthy the food is, how the minimum wage will rise to $15/hour, how the millennials are not going there etc. The reality is that same store sales have stagnated, and earnings per share growth has slowed down in the past couple of years. It is yet to be seen whether this is a real trend or just a temporary situation. In addition, McDonald’s is often compared to other chains that are relatively new and therefore have a lower base to grow from. And according to the WSJ, most millennials are still eating there, although the amount going to eat elsewhere is increasing from a smaller base slightly quicker. If you stop by your local McDonald’s, you see people waiting in line, going through the drive through, and eating their lunch in. The company is still unmatched in its scale of operations, and still manages to sell its products to millions of customers around the world. The globally recognizable brand name is still there, the premier locations are still there, and the innovation that resulted in the earnings growth that made 38 years of record dividends possible is still there. It is a given that blue chips stumble from time to time. This was true with McDonald’s in 2002 – 2004. It is true again with it in 2014. If you sold then ( in 2002 - 2004), you missed out on capital gains and dividends that were roughly several times more than the amount you had at risk. I like the fact that I am essentially paid for holding on to my McDonald’s shares, which are attractively valued today. I can and have used those dividends to acquire stakes in other dividend paying companies. This means that if I hold for 20 years, and the dividend increases by just 3% per year, I will likely receive as much money in dividends as I paid for the stock today. Plus, I would still have ownership of McDonald’s (MCD), the results of which can be pretty satisfactory without even considering the dividends. Of course, a 3% annual dividend growth in dividends sounds very low, and I only used it to illustrate the point that shares are offering a good return opportunity today. The lower the shares go, the better the opportunity in my opinion.
It might sound counterintuitive, but companies can provide very good returns to long-term shareholders even if their revenues stagnate. For example, investors in Sears in 1993 did slightly better than the S&P 500 benchmark over the next 20 years. This was due to unlocking value through spin-offs, regular dividend payments, share buybacks, cost cutting and asset sales. McDonald’s (MCD) has a lot of real estate, and a lot of restaurants it can refranchise, thus further increasing the amount of cash it could send the way of shareholders. Imagine how much more dividend income you can receive if McDonald’s spins off its real estate and converts it into a REIT? Even today, if an investor manages to buy the shares at close to a 3.50% - 4% yield, and then earnings and dividends only grow by 4.5% - 5%/year, they should earn a 9% total return. To give you some perspective, the lowest annual dividend growth by McDonald’s was by 4.50% - 5%/year in the late 1990s and early 2000’s. So I am describing again a very conservative scenario from a historical perspective. If that investor reinvests dividends automatically every quarter, their return will be further enhanced if the share price is depressed and thus they earn a higher yield on reinvestment than the above stated one.
Either way, I plan to hold on to my investment in McDonald’s, until management proves me wrong and cuts the dividend. If they freeze the dividend, I would no longer add money to the position (except for my IRA, where it makes sense to automatically reinvest them due to cost/benefit). Furthermore, my downside is protected because McDonald’s has a 2% weight in my diversified dividend portfolio. My largest 40 positions account for 90% of my dividend portfolio value. This helps me sleep well at night even in the highly unlikely scenario that I am wrong. The outcome of this investment will be visible in 2024-2034. Let’s circle back on this article then.
In conclusion, the important thing for investors is to have a strategy for stock selection, and stick to it through thick and thin, while ignoring noise. Investors should also have the patience to hold on to their position as part of a diversified portfolio, in order to let the power of compounding do its magic. Not all dividend investments will work out, but it is tough to say which ones will provide the blockbuster returns in the future. This is why it is a mistake to cut the opportunity for capital gains and dividends too quickly, and disposing of investments.
Full Disclosure: Long MCD, JNJ
- How to define risk in dividend paying stocks?
- Why would I not sell dividend stocks even after a 1000% gain?
- Dividends Offer an Instant Rebate on Your Purchase Price
- Dividend Investing Is Not As Risky As It Is Portrayed Out to Be
- How to become a successful dividend investor
Wednesday, October 29, 2014
There are four key attributes that need to be considered, in order to be successful at dividend investing. These ingredients include focusing on quality, earnings growth, entry price and sustainable distributions. In this article, I would focus in more detail behind each of these four items.
I believe in purchasing quality dividend paying companies. This means that I try to focus on companies with strong competitive advantages, strong brand names and/or wide moats. Companies like that offer a product or service which customers desire, and are willing to pay a price which would deliver a fair profit. In addition, companies which offer products which are perceived to have quality characteristics, which typically translates into repeated purchases of the goods or services. In addition, companies that offer a unique product or service are able to compete based upon the added value they bring to the marketplace, and avoid costly price wars with competitors. Furthermore, the company would be able to have pricing power and pass on costs to customers, which will be much less likely to switch to another product. I understand that quality lies in the eyes of the beholder, but through experience, dividend investors should be able to uncover quality dividend paying gems.
My strategy focuses on purchasing shares in companies which will grow dividends over time. In order to achieve that however in a sustainable manner, companies need to be able to grow earnings. Businesses that manage to grow earnings also tend to become more valuable over time. I also prefer to focus on earnings per share rather than total net income. Companies can grow earnings either by expanding in new markets, introducing new products, marketing existing products to new customers, acquiring competitors, cutting costs or raising prices. I like to read about companies which have specific earnings growth targets. Coca-Cola (KO) is anexample that immediately come to mind when I think about specific growth plans, as I outlined in an earlier article. I also like to see companies riding a long-term economic trend. Many of the companies I own in my portfolio for example will benefit from the increase in number of middle class customers in emerging markets such as China and India. Others like Eaton Vance (EV) or Ameriprise Financial (AMP) will benefit from the increased need for financial products that generate income in retirement by the millions of baby boomers that are expected to retire over the next two decades.
The price at which shares are acquired matters a great deal to investors. Even if an investor has identified the best dividend growth stock in the world, with the widest moat, and excellent prospects for earnings and dividend growth, they could still end up losing money for extended periods of time. The reason is that even the best dividend stocks are not worth owning at any price. If you overpay for your stocks, you might end up with losses or not gains to show for your efforts for extended periods of time, even if the underlying fundamentals improve according to your initial plan. In an earlier article I argued that this was one of the main reasons behind the so called “lost decade for stocks” in the US in the early 2000s. Companies such as Coca-Cola (KO) and Wal-Mart (WMT) were grossly overvalued in 2000, which is the primary reason why the stocks didn’t generate much in total returns over the next decade, despite the fact that earnings and dividend increased substantially during the period. I am not proposing that investors time the market and only invest when stocks are super cheap. Instead, I focus on screening the dividend growth lists for attractively valued companies on a regular basis, and then analyze in detail the companies that are spitted out by my screen before adding money to them.
The next key ingredient for successful dividend investing involves the sustainability of distributions. Investors who purchase dividend stocks for income should check whether the company is able to adequately support distributions from current earnings or cash flows for certain entities such as Master Limited Partnerships or Real Estate Investment Trusts. For most corporations, a dividend payout ratio below 60% is generally preferred. A higher ratio could jeopardize the dividend payment even if earnings dip temporarily. That being said, even if a company has a sustainable payout at the time of purchase, over time it could become unsustainable if it grow distributions faster than earnings or earnings decrease due to tectonic shifts in the business model. The best situation I like to observe is when earnings and dividends grow at similar rates. For new dividend payers I typically observe situations where dividend growth is higher than earnings growth up to a certain payout ratio, after which it closely trails growth in profitability.
While investors could argue that one cannot put success in a pre-packaged recipe for achieving it, I have found the four ingredients above to be essential for my income investing strategy.
Full Disclosure: I have a position in all companies listed above
- Seven Sleep Well at Night Dividend Stocks
- Three Questions That Every Dividend Investor Should Ask Themselves
- How to retire in 10 years with dividend stocks
- The work required to have an opinion
- Three Characteristics of Successful Dividend Investors
Wednesday, October 22, 2014
There is so much mental energy spent by investors, media and gurus spent on “guessing” the market top, market bottom, and whether we are in a bull or bear market, it is exhausting for me to watch. Frankly, in order to be successful in investing, one needs to keep it simple, and follow common sense principles. You do not need to successfully pick tops or bottoms in order to be successful, but have goals, and patiently hold quality companies for the long term that shower you with rising dividend income every year. If you have goals you want to achieve, you only need to develop a strategy to achieve it, and then stick to your plan through thick and thin.
Time in an investment is more important than perfect timing based on following fluctuations in the stock price. This is because if you hold a quality company purchased at a fair price, and then let the power of compounding do its magic over a long stretch of time, you will do really well. Those who are always looking to buy at the bottom or sell at the top end up missing out on the compounding of their income and capital. This is because noone can correctly buy at the top or sell at the bottom, except for a lucky accident once in their lifetime. At the end of the day, even a broken clock is right twice per day. Those who can tell you they can consistently do it, are either liars, are trying to get famous by being right once, or are trying to sell you an expensive investment service.
I did a quick experiment using Yahoo Finance historical data, where we have two investors buying shares of Johnson & Johnson (JNJ) between 1/1/1980 and 12/31/1989. The first investor has $1,200 to put to work each year, and manages to buy Johnson & Johnson shares at the lowest monthly close for each year. They reinvest dividends into more Johnson & Johnson shares with each payment from the company. This investor manages to get this lucky for 10 years in a row. They then stop adding new money, reinvest their dividends automatically into Johnson & Johnson stock and hold on to the end of September 2014. The first investor thus ends up with a stake worth roughly $1,011,000 million, which generates approximately $26,600 in annual dividend income.
The second investor simply puts $100 per month, every month between 1/1/1980 and 12/31/1989. They also reinvest those dividends in more Johnson & Johnson stock in the accumulation phase. After that, no new money is added, although dividends keep getting reinvested automatically. By September 2014, the second investor has a portfolio worth roughly $875,000, which generates approximately $23,000 in annual dividend income. As you can see, while the second investor ends up with a little lower final portfolio values and annual dividend incomes, their returns are much more realistic and achievable by ordinary investors. Again, the goal is to try and keep a simple plan to stick to. It is highly UNLIKELY that someone will be able to allocate money at the lowest point in a company for 10 years in a row. Most keep trying, and as a result end up missing the big moves. The important thing in the case of Johnson & Johnson was to buy the shares, and then patiently reinvest dividends for decades, and let the power of compounding do the heavy lifting for you.
This example is where you have an edge in investing, that noone else on Wall Street has - you can hold patiently to your passive portfolio of quality dividend paying stocks, and collect those rising dividends through thick and thin. You do not care about high frequency traders, irrelevant relative performance bench-marking against some index over a meaningless time frame of a month or an year. If you have patience, you are very likely to successfully fund your long-term goals.
My goal is to reach a certain level in dividend income by 2018 – 2019. In order to reach this goal, I know that I need to save a certain portion of my paycheck, and then invest it every month in quality dividend paying stocks. As those dividend paying companies pay me more in dividend income, I then reinvest that income into more dividend paying companies. Life is much easier when you create a positive loop.
You can see that my strategy is only dependent on finding enough quality dividend paying companies to invest in each month. Therefore, it does not matter whether we are in a bull market, bear market or sideways market. As a dividend investor, I am a stock picker, not a market timer or prognosticator anyways. I focus on individual businesses available at attractive prices, which can earn more over time and thus afford to increase my dividends regularly. The only difference that a bear market makes to me is that there are more companies that are attractively prices. Since my timeframe for holding those companies and living off those dividends is approximately forever, my success is determined on letting those dividends compound over time into a meaningful stream of income to live off forever.
The toughest part of my plan is patience. As Munger Says, the most difficult thing a person can do is sit alone and do nothing. Given the fact that I am constantly bombarded by useless chatter from the media about the economy, shares, the FED, the world etc, I feel inclined to do something when in reality no action on my part is needed. I believe that investors should tune everything out, and just stick to their plan. At least that’s what I am doing. I know that the odds for success are very high for the investor who buys stakes in quality blue chip dividend payers every single month, reinvests dividends selectively, and then patiently sits on those companies for the next 20 – 30 years.
For example, did you know that if you started investing in in blue chip companies at the start of the great depression in 1929, and you reinvested dividends you broke even within 6 years. You did pretty well if you held on for 30 years. Even if you bought shares right at the top in 1972, and held on for 30 years, you made a lot money as well. The lesson is very clear – keep holding to quality dividend paying companies through thick and thin, keep adding money to dividend portfolios every single month and keep reinvesting those dividends. If you are unwilling to hold through a company through a 50% correction in the stock price, you should not be investing in stocks. 50% corrections would not bother me, as I see them as opportunities, since my dollars buy more shares when prices are lower. I also try to invest in companies, where I would not be afraid to hold, even if the stock market was closed for a decade.
The lesson to long-term investors is clear; it doesn't matter whether we are in a bull market or bear market. The goal is to dollar cost average each month in quality dividend growth stocks selling at attractive valuations, reinvest dividends, and hold patiently for the next 20 – 30 years. I cannot emphasize quality factor, since the quality companies are more likely to survive a deep recession unscatered, and continue paying and growing dividends, even during the hardest of times. If you are already retired, then you shouldn’t really care about stock prices anyways – just withdraw those growing dividends and enjoy life. Dividends are more stable than capital gains, they are always positive, which makes them an ideal way of living off a nest egg.
Full Disclosure: Long JNJ
- Dividend Investors Will Make Money Even if the Stock Market Closed for Ten Years
- Let dividends do the heavy lifting for your retirement
- How to retire in 10 years with dividend stocks
- My Dividend Goals for 2014 and after
- Dividend Investors Should Ignore Price Fluctuations
Wednesday, October 1, 2014
One of the simplest truths about dividend growth investing is that not all companies you select will do as expected. Some will fail outright, while others will merely deliver some dividends which would barely match the rate of inflation. Based on studies I have performed, I have noticed that another small group of stocks will provide a large portion of returns in a dividend stock portfolio. You might not realize at the time of purchase, but the reality is that it is difficult to say in advance which company will do the best.
Even with those odds however, a dividend investor does not need to be right about all stock selections. In fact, even if they are correct for about 50% of the securities they pick, they should do fine as long as the dividend increases and capital gains from the winners offset the capital put to work in the “losers”. This of course is a very worst case scenario, since many of the “losers” will keep paying a slowly rising dividend, which could be spent or put to work into other dividend paying stocks. Therefore, I know that even by selecting my fair share of “losers”, I still have a very high chance of living off dividends. I follow a few principles to ensure I have the odds in my favor for a successful dividend investing.
This is why I stick to a few fundamental principles. The first principle is that I always strive to create a portfolio of dividend growth companies which are in one of the three types. The main goal is to be patient, and enjoy the ride. I view my portfolio like a a symphony. Each company in it has a role to play and together they make beautiful, income producing music. It is important to diversify risk with at least 30 – 40 securities, which will be purchased slowly and over time. Diversification helps when the proverbial bad apple takes a bite out of dividend income.
The second principle is to have patience. I have learned the hard way that once I purchase shares in a company I like and at a valuation I like, I should let it quietly do the compounding for me. I am a long-term investor, and my holding period is the next three decades. I am hopeful that my dividend portfolio will provide growing income for the next 30 years. This is why I need to view things in perspective, and think about longer term trends that span years, rather than get scared away from a single bad quarter or a single bad year. In the grand scheme of a 30 year investing time frame, one or two years are almost irrelevant data points. That doesn’t mean not to sell if there are any troubles brewing – it just means not to jump ship at the first “correction” or sign of “trouble”.
The third principle is being really selective about selling. After reviewing data about investor performance and psychology, I have come to believe that those who sell too quickly face reinvestment risk. Many investors tend to get a gain in a stock, see that the yield has gotten too low, and sell to get into a higher yielding security. As a result, they end up paying taxes, having less capital to invest, and in a large portion o the cases they end up with less in dividend income growth and capital gains than if they had patiently sat on their hands.
When you buy a stock, the worst think that can happen is that it can go to zero. The next thing that could happen is that you keep earning dividends, which reduce the amount you have at risk in the security, and then put those to work into more dividend paying stocks.
This is where the fourth principle lies in – hold on to your winners. The best case is that the company ends up performing like the next Wal-Mart (WMT), McDonald’s (MCD) or Coca-Cola (KO). You do not know at the time of purchase whether the company you picked will be profitable and paying more dividends in 30 years. You can make an educated guess, but the truth is you will not know which of your 40 stocks will be the best and which one will be the worst by 2044 – 2050. This is why I am trying to be as passive as possible, and reduce reinvestment risk as much as possible. I am often afraid that I will end up selling the next Coca-Cola (KO) to buy the next Jones Soda (JSDA), than missing out on the next Sigma-Aldrich (SIAL) because I stuck with Coke.
What I am trying to say is that with dividend stocks, your losses are limited, but your gains are unlimited and potentially much more than the amount you have at risk. This is why mistakes of omission, or the opportunity cost of not getting into a company prior to take off is a bigger problem than buying a bad stock. This is why I keep holding on to my winners, even if they end up delivering over 1000% profit.
Investors need to think probabilistically. In their portfolio of say 40 securities, there will be 10 which will likely do most of the heavy lifting for the next 30 – 40 years. If you sell those today, your portfolio will be mediocre. This is why it is also important to give companies a chance, provided you understand them well, they are available at a good price, and there are catalysts for future earnings growth. However, even for those who are average, it is helpful to understand that with each dividend check, the amount at risk in those securities is reduced. Therefore, even if in 2007 you had owned Bank of America for 20 years, you would have had received enough dividends to put in other dividend paying stocks that would almost cover for the capital you put to work initially
Full Disclosure: Long KO, WMT, MCD,
- Accumulating Dividend Stocks is a Long Term Process
- Dividend Stocks For Long Term Wealth Accumulation
- When to sell my dividend stocks?
- How to generate income from your nest egg
- Dividends Offer an Instant Rebate on Your Purchase Price.
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