Showing posts with label dividend strategy. Show all posts
Showing posts with label dividend strategy. Show all posts

Monday, March 30, 2015

Comparing your results to S&P 500 could be dangerous for dividend investors

As a dividend growth investor, I tend to create diversified portfolios full of companies that regularly raise dividends. I try not to overpay for shares in these companies, when I put my money to work. Dividends are more stable than capital gains, which is what makes them ideal for those who want to live off their nest eggs. The end goal for me is to generate as much in dividends to pay for my regular expenses every month. I expect the forward dividend income generated in my taxable accounts to reach the dividend crossover point at some point around 2018. The stable nature of dividend income makes it easier provides much more confidence in projecting future dividend income at a certain point. On the other hand, I cannot tell you whether the value of the portfolio will be twice as much as today's or half as much.

However, I regularly receive some feedback from new readers, because they might have overheard about the importance of benchmarking against a common benchmark, such as the S&P 500. While I have tracked results versus S&P 500, I think that this is not a value added activity for my strategy and my goals. I believe that tracking my total return performance relative to S&P 500 is not going to add any actionable insights, that would help to me achieving my goals. My goals including reaching a certain target annual dividend income within a certain time period. Whether I do better or worse relative to some random benchmark is irrelevant to my long term goals and objectives.

I monitor the annual operating performance of the businesses I have invested in, as I review them at least once every 12 - 18 months. I also review press releases regarding quarterly results, dividend increases announcements, mergers and acquisitions. I track the organic dividend growth rate for my portfolio. I also track dividend income received, and try to understand whether growth came from organic dividend growth, dividend reinvestment and new cash contributions. As you can see, it doesn't matter for my goals and objectives, if over the next 5 - 10 - 15- 20 years the total return on my portfolio is better or worse than the S&P 500. Not only is relative performance versus a benchmark lacking actionable insights for me, but it could be downright dangerous for dividend investors like me.

The biggest danger in comparing my performance to that of the index, is reaching dangerous conclusions. For example, stock prices do not go up or down in a straight fashion. They move depending on a variety of factors, that few can predict in advance. Sometimes, even quality companies might be under appreciated by market participants, and their stock prices might stagnate for extended periods of time. At the same time stock prices can be increasing, as evidenced by stock indexes. However, if the fundamentals of the underlying businesses are doing well and improving, then holding on to those businesses might still make sense. This is because while their price is doing worse relative to the stock market index, they are getting more valuable, despite being underappreciated by the stock market. It might take the quoted price some time before investors realize this discrepancy and bid up the price. If I sold undervalued shares, to buy something that has done well in price, I would be selling low and buying high. I believe that this is not smart investment behavior. Please remember that the stock market is there to serve you, not to instruct you. The time to sell a business is when it no longer performs to expectations, not because the stock prices a group of other businesses have done better in the past 3 - 6 months.

For example, back in 1999 - 2000, many shares of tobacco companies, financials, utilities and REITs were punished by investors who wanted new economy technology companies. The popular indexes such as S&P 500 and Dow Jones Industrial's Average added technology companies in 1999 - 2000. The performance of those companies was great for a while, as everyone gobbled up those shares in speculative frenzy. The old economy boring companies were not viewed as attractive enough. If a dividend investor had sold their tried and true investments because they underperformed for a short period of time, they would have made a terrible mistake.

If I am impatient however, I would feel like I am missing out by comparing my “slow moving” stocks to the index and chances are I would sell as a result of the exercise. This is usually at the same time that the index would likely start dragging its feet, while the shares of the former “slow mover” finally get appreciation by buyers. I see this happen again and again. This is why most individual investors never make any money in stocks – they go from one strategy to the next, chasing hot strategies and looking for something that magically works all the time. If they stick to a slow and steady strategy like dividend growth investing, they would do very well for themselves over time. This is because rising earnings per share, leads to rising dividends per share, which ultimately makes stock prices more valuable. Plus, the fact that most dividend investors are truly passive, they can compound their capital for decades investing in what they know. Studies have shown that the more passive the investor, the higher the chances for satisfactory long-term performance.

My goal should be to have a portfolio that produces slow and steady returns that I can live off of. If I get scared because my portfolio underperforms for a few years, and I end up switching at the worst possible time, I would likely never make any money investing in stocks. The real lesson here is to have a solid understanding behind my strategy, and then to have the patience to stick to it through thick and thin. If I sold my dividend portfolio holdings today and I invest everything in an S&P 500 fund, my dividend income will drop by 45 - 50%. This will be caused by the fact that I will have to pay capital gains taxes on unrealized capital gains and I will have to accept a lower current yield. This change would actually require me to spend more time working at a job that I might or might not enjoy. Since I am not a robot, I have a limited number of years on this earth that I can spend working, rather than enjoying life. In addition, index funds contain a lot of companies that do not pay dividends. And as we know, relying on capital gains works great during a bull market and prices move up. However, if prices are flat, as they were between 1929 - 1953 or 1966 - 1982 or 2000 - 2012, my portfolio will not last for long if it doesn't yield anything. Selling off stocks in your portfolio results in less stocks available over time. If prices do not grow fast enough, you will deplete your portfolio. Selling off chunks of my portfolio to live off is similar to cutting the tree branch you are sitting on. Why not just pick the fruit from the tree, and let it grow uninterrupted?

When someone tells me they are going to sell securities from their portfolio, they are essentially telling you that they blindly believe the stock market will only go up during their retirement. This flawed thinking ignores past history, and sequence of return risks in the portfolio distribution phase. It also resembles the flawed belief by some homeowners between 2000 - 2008 that they can tap equity from their appreciating homes and spend the proceeds. Treating your house like a piggy bank, and relying on increases in house prices to live off turned out to be a poor choice. Spending too much time comparing yourself to the Joneses, is another folly people do. To me, comparing total returns of my portfolio relative to that of someone else's is a perfect example of keeping up with the Joneses. This can only lead to folly behavior.

I am not a big fan of dividend funds or dividend ETF's either. Even dividend growth funds tend to do bizarre things such as keep companies that have cut dividends for almost an year, as was the case of Citigroup in 2008. Another bizarre thing I have seen is when some companies are not included, or others are taken out, as was the case of Altria (MO) being dropped from the S&P Dividend Aristocrats index in 2007. A third example includes my purchase of Higham Institution for Savings (HIFS) in 2010, which was not covered anywhere else except on the list provided by David Fish.  As you can see, indexing does not work for my goals and objectives. However, it could still work for anyone else. Because I am the only one who truly cares about reaching my own goals and objectives, I create my own portfolios by picking individual stocks.

To reiterate the biggest danger in comparing to index funds is that any under or over performance produces no actionable insight for my portfolio management. On the contrary, it can cause me to abandon my strategy at the worst time possible, simply because I “underperformed” the index. With dividend growth investing, I would likely at least match total returns of S&P 500 over long periods of time like 20 years for example. This could include variations in under or over performance over periods of time of varying lengths. However, just because I underperformed for 3 years, it doesn’t mean I would underperform for next 3 years. Because of reversion to the mean, the 3rd year of underperformance might mean that dividend stocks are cheaper than the stock market as a whole. Therefore, they could provide much better returns for the next few years, relative to a market index such as the S&P 500. As usual, past performance is not a predictor of future performance.

The real reason why everyone encourages individual investors to buy index funds in the first place is because some individual investors are horrible at making investment decisions. Not only are they terrible at investing, but they are overconfident and overtrade, fail to stick to a single strategy because they are afraid of missing out on the next big thing. The common fallacy among inexperienced investors is that you need to find the next Microsoft to make money in stocks. Unfortunately, few ever find the next Microsoft, but many lose a lot of money in the process. In fact, these investors would have been better off simply buying and holding on to the original Microsoft in the first place.

(The conclusion that individual investors are terrible at investing is based on data I have analyzed from DALBAR. While I am sure DALBAR is a reputable organization, I have learned to always take information with a grain salt and some healthy dose of skepticism. This is because the information is used by financial providers, advisers and mutual fund companies in order to get clients. Since Dalbar's clients are financial services companies, DALBAR has an incentive to show how bad individual investors do on their own.  If you prove to investors that they need help from the financial industry, they are more likely to come and earn money for your company. There is an incentive for DALBAR to not compare apples to apples, in order to make a case against individual investors. So, as Charlie Munger says, "Never ask a barber if you need a haircut" )

The truth is that if you build a diversified income producing portfolio with companies that are purchased at fair prices, and you do little activity every year, you stand a chance to do pretty well over time.

I reached these conclusions after studying the performance of the original 500 stocks in S&P 500 in 1957 versus index, as well as the ING Corporate Leaders fund for the past 50 years. Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index? Did you also know that S&P 500 frequently makes changes to its index methodology, which would have reduced past performance numbers?

In addition, if you study the history of the ING Corporate Leaders fund, you can gain a glimpse of the potential in a truly passive buy and hold portfolio. The trust was formed in 1935 with a list of 30 blue chip dividend paying stocks. Given the mergers, acquisitions, dividend eliminations, the list is now down to 22 companies. Over the past 50 years, the fund has managed to return 10.20%/year, versus 9.80% for the S&P 500. The trust sells when a company eliminates dividends or stock price falls below $1.

To summarize, it looks as if the only way to achieve my goals and objectives is by constructing portfolio myself, by purchasing companies with sustainable advantages at fair prices, and then holding passively for the long run. Being passive should be the goal, as selling is usually one of the biggest mistakes investors make. It is a mistake because few can just sit tight and enjoy the ride while ignoring the noise out there. Frequent churn could be costly. Cutting investment costs to the bone is also very very important. If you have a $1 million portfolio invested in index funds, you are likely paying $500 - $1000 every year. You can easily purchase stakes in 30 – 40 of the largest dividend paying blue chips listed in America, and just hold them for eternity. Some of those will fail in the next 40 - 50 years, others will merge or be acquired or spin off countless subsidiaries. A third group would likely still be around 40 – 50 years later, showering you and your descendants with more dividend income than you ever imagined in your wildest dreams.

Full Disclosure: Long MO, HIFS

Relevant Articles:

Dividends versus Homemade Dividends
Why I am a dividend growth investor?
Dividend Portfolios – concentrate or diversify?
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
How to be a successful dividend investor

Tuesday, March 24, 2015

Why Stock Charts Are Misleading for Dividend Investors?

As a dividend investor, I do not really look at stock price charts. The things I look for are trends in earnings and dividends, catalysts for further earnings growth, and whether the security is cheap relative to the other investment opportunities within my opportunity set. In other words, if I expect PepsiCo (PEP) to deliver the same growth as Johnson & Johnson (JNJ), but Johnson & Johnson is available at a cheaper valuation, I would buy Johnson & Johnson (JNJ). It won’t matter whether Johnson & Johnson is selling at a 52 week high, or 52 week low.

However, I know that for a lot of investors, they look at stock price charts for whatever reason. I believe that focusing only on stock price history is misleading, because it doesn’t show you everything you need to know about a security.

The missing link of course are dividends. One of the biggest lies told to investors is that stocks , as measured by S&P 500 or Dow Jones Industrial Average, went nowhere between 1929 – 1954 and 1966 - 1982. It might be true that stock prices were volatile but mostly flat, however dividends provided for a handsome return to those patiently reinvesting them through thick or thin.

For example, if let's look at the annual price performance of the S&P 500 between 1929 and 1954. The price in 1929 was 24.86 points, which was not reached again until some time in 1953. Based on looking at price alone, someone could incorrectly assume that stocks did not provide any returns to shareholders for a quarter of a century.

However, if you add in dividends, and reinvest them, you can see that someone who put money in 1929 broke even by sometime in 1937. This is a very interesting finding, because it shows that even during a period where unemployment was at 25%, industrial and agricultural production fell, GDP fell stocks in the US did well for the long-term shareholder who was not afraid.  In fact, during that 25 year period, the whole return on US equities came from reinvested dividends. Over that period from 1929 to 1953, a $1000 investment quadrupled in value.

Let's also look at the 1966 - 1982 period for US stock prices. Again, I used historical annual data for the S&P 500. You can see that between 1966 and 1982, the S&P 500 increased from $93.32 to $117.28. If you look at reinvested dividends however, you can see that a $1000 investment at the end of 1966 pretty much doubled in value during that period.

Dividends usually accounted for 40% of average annual total returns. They are always positive, and more stable than capital gains, which makes them as a reliable source of income in retirement. Interestingly enough, prior to 1994, the yield on US Stocks was averaging around 4%. Incidentally, a researcher found that it is “safe” to "withdraw" 4% of your portfolio in retirement. I say incidentally, because it is clear that this researcher inadvertently makes the case that the safe 4% average annual spending comes entirely from dividends and the high interest income that was prevalent at the times. For those in the accumulation stage, the thing to remember is that reinvested dividends have accounted for 97% of stock market gains since 1871.

The shortcoming of stock charts is also evident when looking at individual companies returns over time.  Another thing stock price charts miss is spin-offs. Altria (MO) is a prime example of this, if you look at historical charts on Yahoo Finance. To anyone who only looks at the chart, and ignores everything else, it looks like Altria has done pretty badly since 2007. In reality, the chart fails to account for the fact that Altria (MO) spin-off Kraft in 2007 and Phillip Morris International in 2008.

Those two spin-offs actually have confused a lot of institutions. For example, despite the fact that Altria had a record of consistently increasing dividends for over a quarter of a century, it was booted off the S&P Dividend Aristocrats index in 2007. Anyone who blindly followed the index, likely also sold their shares. In reality, Altria (MO) never cut dividends. Anyone who purchased Altria in early 2007, has been receiving growing annual dividends ever since. The only issue is that those dividends were generated from shares of Altria (MO), Phillip Morris International (PM) and Kraft Foods (KRFT) ( and later Mondelez (MDLZ) as well). This is why I am very skeptical about blindly following indexes - there could be lapses of judgment that stem from mechanical application of rules, without really giving much thought to the reality and facts involved.  This is also why I think it is important to analyze every company I own, or expect to own in detail. Luckily, when Abbott split in two in 2013, the mighty S&P Dividend Aristocrats committee decided to keep both Abbott (ABT) and Abbvie (ABBV) in the index. Either way, I focus on the dividend champions index, which is the most complete list of US dividend growth stocks I know of.

The spin-off situation at Altria also confused a lot of "chartists" that appear on CNBC. You might want to check this article - it blatantly ignores the fact that the split from 2007 and 2008 ever happened.

To summarize, stock price charts only show one part of return that investors would have received. However, without taking into accounts dividends, and the power of dividend reinvestment, you cannot understand what the total returns on an investment really are. It pays to research every investment in detail, before putting hard earned money to work there. In addition, it pays to own investments that regularly shower their investors with cash, in order to reduce the risk of outliving money in retirement. As we was above, stock prices can remain flat for extended periods of time - anywhere from 16 to 25 years. If you only rely of capital gains to bail you out, you might be in for some nasty surprises if you happen to invest during one of those periods. An investor who expects to live off the dividend stream generated from their portfolio can afford to ignore stock price fluctuations, and enjoy the retirement that they have worked so hard to achieve. An investor who wants to sell of portions of their portfolio will be in real trouble if that portfolio doesn't pay dividends and share prices fail to increase.

Full Disclosure:

Relevant Articles:

Altria Group (MO): A Smoking Hot Dividend Champion
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
S&P 8000 – The power of reinvested dividends in action
Dow 370,000
The case for dividend investing in retirement

Monday, March 23, 2015

The Perfect Dividend Portfolio

A few years ago, when I was starting my website, I featured research from Jeremy Siegel on the performance of the original companies in the S&P 500 index between 1957 and 2003. You can find the link in my article titled The Ultimate Passive Investment Strategy. Prof Siegel describes how an investment in the original 500 companies in the S&P 500 would have fared over that 46 year period. My favorite part was about the Total Descendants Portfolio, which assumed a total passive approach, where an investor reinvests dividends, holds on to shares of spin-offs, doesn’t do any rebalancing.

The lessons are very eye opening:

1) Having a totally passive approach has worked great for long-term investors

This is because spin-offs were held, transaction costs and taxes were minimized. It was quite interesting to learn how a totally passive investment ended up outperforming the S&P 500 over that 46 year period.

It is also interesting that only 30 companies failed outright, while 92 were merged and 74 were taken private.

2) The best performers were consumer staples and pharmaceutical companies.

The reason behind this strong performance is because many consumer staples and pharma companies have moats, reinforced by strong brands used regularly by consumers, customer loyalty and pricing power. The combination of competitive advantages, pricing power, brand loyalty which have resulted in above average returns for investors

3) Valuation is important

The most interesting thing is that investors in the so called slow growth companies for which investors have low expectations tend to outperform glamorous companies in new and exciting industries. This is because their valuation is usually low, and because investors in hot industries tend to bid up the valuations in pursuit of growth to the point of low expected returns. If you overpay for future growth, you might not earn a satisfactory return on investment even if your expectations are eventually met.

4) S&P 500 of today is not a passive index

Over the past six – seven years that I have been focusing on dividend growth stocks, I am hearing more and more people talking about index funds like some sort of a magic panacea for all investors. The truth is that S&P 500 is an actively managed portfolio, with frequent turnover, where new companies are frequently added when their valuations are often pretty steep. In addition, index funds have to sell due to adjustments due to buybacks, spin-offs, float adjustments, and other reorganizations. When a new company is added, investors bid up the price before it is added to the index as well, which also causes worse performance. Furthermore, the rules of the index get changes too often and investors who are passive by nature do not probably take the time to learn about them. Needless to say, if you are a terrible investor who makes poor choices, you will not be saved by index investing because it is the lack of education and emotional strength to hold on when things are tough. Plus, if the investor has to select this international index or that other index they heard about on the internet, they are essentially still picking stocks. Only this time the process of picking securities has a fancy named as it is called asset allocation. I have done better than the S&P 500 index since 2007. Of course, if I were a true indexer, I would have also had to own international indexes, which have not done too well. So I have done much better than most indexers out there.  And my goal is not even to beat some index either.

However, if I were a busy professional with a family, and no free time or desire to learn about investments, I would invest only in index funds in my 401k/IRA. That describes most individuals out there (roughly 80% - 90%). Therefore, chances are these people are not reading my site. This situation also doesn't describe most of the people reading this site either.

5) Some Industries are built to last

Many investors are afraid of missing the next hot industry. As a result they chase those new industries, because they believe that they would make their big break in investing this way. They seem to forget that just because an industry makes people’s lives better, that doesn’t guarantee profits for investors. As a result, everyone piles in, pays high prices, but doesn’t make high returns. At the end of the day, the slow growth, boring stocks keep producing consistent results to their long-term investors. The important thing, as we mentioned before, is to avoid overpaying.

6) Some companies are built to last

After reading the research again, and also reading about the Corporate Leaders Fund, I am convinced that investing in blue chip dividend stocks for the long term is the best strategy for my portfolio. It is true that investing in 500 stocks today, and doing nothing, could result in a much different portfolio due to mergers and acquisitions, spin-offs, a few failures. However, from the 500 companies from 1957, there were not that many complete failures. This could change in the future, but nevertheless confirms my belief that doing nothing with a portfolio could actually produce the best results in the long-term. For example, one of my biggest mistakes has been selling a company and thinking that I can do better with something else. In 9 out of 10 such circumstances, I would have been better off I had been busy working instead and not fiddle with the portfolio. A portfolio is like a bar of soap - the more you fiddle with it, the smaller it gets.

7) The most important lesson is to be a long-term investor

The best lesson is that success in investing lies down to choosing an investment at an attractive valuation, building a diversified portfolio of those investments, holding through thick and thin, and only reinvesting dividends selectively. The S&P 500 index which constantly added new companies, was very active and failed to do better than a totally passive index. Investors who believe they can outguess the direction of companies and choose to frequently churn portfolios end up doing pretty bad in the future. That’s why it is important to sit on my portfolio for the long term, and do almost nothing. Time in the market is more important than timing the market. Time in the market is important, because it allows your capital to compound quietly. It is important to keep your winners, and not succumb to rebalancing or too much in other activity. It is quite possible that a few of your companies will end up going more than 1000%, which is why selling early because no one went broke booking a small profit is a foolish mistake to make.

Relevant Articles:

Buying Quality Companies at a Reasonable Price is Important
The ultimate passive investment strategy
Should dividend investors invest in index funds?
Dividend Investing Knowledge Accumulates Like Compound Interest
How to never run out of money in retirement

Wednesday, March 11, 2015

Dividend Investors: Avoid Living in the Past

One of the reasons why some have ventured towards the world of dividend growth investing, is due to the marvelous success stories of the past. If you or someone in your family had put a mere $1000 in Coca-Cola (KO), Procter & Gamble (PG) or a Johnson & Johnson (JNJ) thirty years ago, your stake would be worth a lot, and you would likely be earning double digit yields on cost.

Such examples illustrate the true power of dividend growth investing as a strategy that can provide investors with a rising stream of passive income that is directly tied to the fundamental success of the businesses you are investing in. These examples are very inspiring, and show that a patient dividend investor can do pretty well for themselves if they select companies with the following characteristics:

1) A company with competitive advantages, pricing power and a growing market for its products/services
2) A company that generates so much extra cash, and has such a high return on equity, that it ends up increasing dividends for at least a decade
3) A company that is attractively valued at the time of purchase

If you are a serious dividend investor, I would strongly encourage you to study the history of all the greatest dividend growth stocks. This is in order to learn about the factors that had made these companies successful enough, so that they could afford to increase dividends for 40 – 50 years in a row. The knowledge should accumulate over time, and hopefully help you to spot those existing champions that can keep rewarding you with higher dividends or those emerging dividend achievers that can afford to raise distributions for several decades in the future.

However, there are no guarantees that the past performance will continue. The thing is that the world changes, and evolves over time. The destructive forces of capitalism continuously attack any moat out there, in pursuit of gaining market share and more profits. Technological innovations, changes in competitive nature and consumer habits can alter the business model of the company with the best defended moat of today. As a result, dividend investors should not be blinded and emotionally attached to each individual stock in their portfolio.

A few fallen angels from the list of dividend kings include Winn-Dixie and Masco (MAS). Other fallen dividend growth stocks include Bank of America (BAC) and Wachovia (WB).

While I am a buy and hold forever type of an investor, I realize that I would have turnover in my portfolio. As a result, I have several fail-safe mechanisms, whose goal is to protect me from getting too emotionally attached to a single stock, and failing to see that its business is never going to recover.

My fail safe mechanisms are:

1) Maintaining a diversified dividend portfolio, consisting of at least 40 – 50 individual companies
2) Focus on companies that have raised dividends for at least 10 years in a row
3) Selling a dividend stock after it cuts dividends
4) Reinvesting dividends selectively in other quality companies at fair prices
5) Purchasing companies that have increased earnings and which are not overvalued

In addition, next time you analyze a great company like Coca-Cola (KO), it is important to try and look past the dividend growth history. In other words, do not simply look at the dividend history, and assume the good times would continue indefinitely, without doing any additional research on the company. If the company manages to increase dividends for another 50 years, that is great. However, try to be realistic, and determine if there are growth catalysts that can allow it to keep earning more and paying more in dividends to you. Merely projecting past dividend growth, without doing any due diligence about where future raises could potentially come from, could prove to be costly for your dividend retirement.

In the case of Coca-Cola (KO), the company has hundreds of brands that it sells around the world. In addition, it has a very strong distribution network, and pricing power on its strong brands. The increasing in number of people around the world who can afford the refreshing products the company is offering, will most likely bode well for sales and profits over the next 15 – 20 years.

That being said, even for a great company like Coca-Cola (KO), you should avoid paying more than 20 times earnings at a time. Even for an outstanding company, you need to have a margin of safety by purchasing only when prices are fairly valued. If you overpay for a quality company, and something changes dramatically in a few years, you would lose far more compared to a scenario where you bought at lower prices.

On the other hand however, you should also avoid focusing too much on minutiae, and losing focus on the big picture as well. The worst mistakes I have made involved selling companies because they got a little overvalued, getting impatient because growth slowed down temporarily, and usually purchasing something inferior in the process. There are always reasons not to buy a stock, but unfortunately it would take many years, before you can realistically determine their validity. If you do start with companies that have a proven track record of growing dividends, but then study each company in detail for growth catalysts and fair entry valuations before you buy, you should do well in a diversified portfolio held patiently for the long run.

This is why dividend investing is more art than science. You essentially look for companies that have grown dividends in the past, but need to do your own due diligence in evaluating whether the good times can continue for a couple of decade.

The ultimate goal for you is to generate more dividends from your portfolio every year for the next 20 - 30 years after you retire. In order to achieve your goal, you need to avoid being emotionally attached to the stocks you hold, and be realistic about their position. History doesn’t repeat, but it rhymes.

Full Disclosure: Long KO, PG, JNJ

Relevant Articles:

Five Metrics of Successful Dividend Companies
Why Sustainable Dividends Matter
How to be a successful dividend investor
Dividend Growth Stocks – The best kept secret on Wall Street
Emotionless Dividend Investing

Tuesday, March 10, 2015

Turbocharge Income Growth with Dividend Reinvestment

Many of you are aware of the power of compounding. When you invest in a company that manages to grow dividends every year, and you are able to reinvest those dividends as well, you are turbocharging the growth of your dividend income. If you put in that potent combination in a tax-advantaged account such as a Roth IRA, and you have essentially planted a seed that will generate tax-free income for many years to come.

I usually reinvest dividends automatically only in my tax-deferred accounts such as IRA’s. I always reinvest dividends automatically in tax-deferred accounts, because I am limited in the amount and timing of contributions, and I cannot easily move money from one account to another. I recently reviewed two separate investments I made in Roth IRA on two separate occasions in the past.

The first investment I did in a Roth IRA was in 2009, when I purchased shares of Abbott Laboratories (ABT). After 6 years of reinvesting dividends, I ended up with shares of ABBV and ABT, which are generating approximately 8.90% on the amount I put to work initially. I was able to achieve this merely by checking the button to “reinvest dividends”. I liked the company Abbott between 2008 and 2012 ( prior to its split). I am still holding on to both shares, and I still reinvest those dividends in the Roth IRA.

The second stock investment I did in a Roth IRA was in 2011, when I purchased shares of Phillip Morris International (PM). I also chose to reinvest dividends automatically. After three years, the company managed to increase quarterly dividends from 77 cents/share to $1/share. My yield was 4.70% at time of purchase, and it has subsequently increased. If I add in the power of reinvested dividends, my yield on cost increased to 6.90%.

In a few more years, those two single investments will be generating a double-digit yield on cost, that will be growing even if I start withdrawing those dividends. The lesson learned is that those dividend seeds need to be planted as soon as possible. After that, they need to be let unattended, in order to let them grow into mighty oaks in the future. Do not be discouraged if you are not starting out with a lot of money – afterall some of the best dividend investors turned small amounts into huge endowments for their favorite charities.

I do believe that dividend reinvestment is important, whether you reinvest dividends selectively or automatically. However, I usually do not automatically reinvest dividends. I basically accumulate the dividends from all the stocks I own, add in the cash deposits for a given month, and then decide to put that money to work in a few attractively priced dividend growth stocks. I do this selective dividend reinvestment, because I want to avoid situations where I mindlessly reinvest dividends into a company whose share price is ridiculously overpriced. This was the case with Coca-Cola (KO) and Wal-Mart (WMT) between the late 1990s and early 2000s. If you reinvest dividends in overpriced securities, no matter how great the companies are, you are shortchanging your income and capital growth for years.

I also reinvest dividends selectively, in order to diversify my portfolio, and make it easier to do my recordkeeping. If I started with 100 shares of Realty Income (O) in 2008, and I put the dividends to buy shares in a new company each year, I would be sitting on 100 shares of Realty Income today, as well as shares in 6 – 7 other enterprises. Thus, I would have not only successfully reinvested dividends, but also improved my portfolio from a diversification standpoint. The downside however is that even if I reinvested those original Realty Income dividends into companies that are better values than Realty Income, there is no guarantee that those other companies will do better than a truly passive reinvestment in the original shares that produced the income.

With automatic dividend reinvestment, it is easy to see that putting 100 shares of Realty Income in your Roth IRA in May 2008 for $25.80/share has resulted in 146.2 shares throwing off $331.60 per year. This is equivalent to an yield of 12.85% over the cost in 2008. With the method I employ in my taxable accounts, you cannot do that calculation so easily. However, it is easy to see when total dividend income keeps increasing above the organic rate of growth, even when no new deposits are added to the account.

Full Disclosure: ABT, ABBV, PM, WMT, KO, O,

Relevant Articles:

The importance of investing for retirement as early as possible
Yield on Cost Matters
How to Generate an 11% Yield on Cost in 6 Years
Roth IRA’s for Dividend Investors
Investors Should Look for Organic Dividend Growth

Wednesday, March 4, 2015

Dividend Investing Knowledge Accumulates Like Compound Interest

Dividend investing is highly scalable. This means that the knowledge of how to screen for, analyze companies, and build dividend portfolios is relevant whether someone has to put $10,000 or put $10 million in stocks today. I am also not paying any management fees to someone who simply assembles a portfolio of a random number of companies, but charges me money each year for the privilege of holding several hundred well-known blue chip stocks.

I believe that my effort in gaining knowledge about businesses, which I have accumulated over the past 1.5 - 2 decades has been a good foundation that will pay dividends for hopefully 3 - 4 more decades in the future. Learning about business, stocks, asset classes, valuation, economics, and continuously acquiring company or investing specific information will pay dividends for decades down the road. I believe that the ideas I obtain from different sources, tend to build on existing knowledge, which will again pay dividends for years. This is why I believe that knowledge accumulates like compound interest over time.

Dividend investing works for me, because it is very easy to construct a portfolio that generates a certain amount of income, and match that to my expenses. My goal is to live off my portfolio during bull and bear markets or recessions and economic recoveries. That goal is much easier to accomplish when I live off dividend income. This is because if I relied on traditional asset depletion strategies like the four percent rule, I would risk selling off the stocks or funds in my portfolio during a protracted bear market or flat period for stock prices. This could increase the risk of running out of money, since I will be selling low, and reducing the amount of assets I own. This to me sounds contrary to common sense. I would much rather accumulate cash producing assets,spend the cash they generate, and keep the assets. The asset producing assets for me are dividend growth stocks, but if you don’t know about stocks, you can do it with farmland, real estate in college towns, etc

With dividend investing, I have high certainty on the amount and timing of dividend income I can expect each month, quarter and year. This makes living off my portfolio a breeze, and would be similar to the cycle of regular paychecks one is accustomed to in their workplace. I want to generate cash every month or quarter to live off of, and not have to worry whether the market is up or down, so that I don’t sell my assets at low prices.

I like learning about businesses, learning about companies, and expanding my horizons. I believe in life-long learning. I also know that the knowledge I gain from researching investments has given me the knowledge to stand out from other candidates whenever I have been looking for jobs in the past.

If you are not interested in learning about business, then index funds might be the best bet for you. If you don’t have time for managing investments, then index funds might be for you. However, I can only talk about what I do with my money, and not provide individual investment advice. I would never myself invest in anything, without researching it really well. Only then would I decide whether this investment fits my goals and objectives. If I had no knowledge of investing, I would never put money in mutual funds or index funds. It is very likely that I would not own any stocks. Period. This is because I might do the right thing for years by patiently putting money in funds, and then one day I might hear that the economy is bad and how everything is going down. For someone who has absolutely no knowledge of investments, and who has not done their homework, it would be very easy to panic, and sell at the worst time possible. If someone also doesn't know much about investing, they also risk falling prey to unscrupulous financial advisers who sell expensive products like annuities or loaded or high expense funds.

Someone who is told to buy index funds, but doesn't understand why to buy them, is actually done a disservice. There are no shortcuts to investing, and index investing is not a magic panacea. If you want to live off a portfolio, and the stock market is flat for 16 years, index funds would not save someone’s nest egg after 16 years. In 2008 – 2010, many investors I spoke to were telling how bad stock index funds fared, since they had essentially generated very poor returns in the preceding decade. For someone who retired in 2000, they now have less than half of their money left and only a few years worth of expenses left. In my previous job, I had someone who retired in early 2013. He was not very optimistic about the fact that S&P 500 had reached record territory. The reason was that he had seen the stock market stay largely flat for the preceding 13 - 14 years. This is a lifetime, relative to the average amount of years we put working. This individual used to believe that stocks always go up and should deliver 9% - 10%/year. Unfortunately, the stock market proved that it is indeed a manic-depressive individual, whose goal is to confuse as many people as possible. That's why a strategy that relies on increasing of stock prices is not really taking into account the unpredictable nature of stock price fluctuations. As a dividend investor, one can ignore stock price fluctuations, since I am living entirely off the cash distributed from profitable enterprises, not by selling pieces of business that might go up or down in value.

Indexes are also teaching investors poor behavior such as ignoring valuation. Someone needs to learn about valuation before placing their hard earned money to work. In addition, if someone is a bad investor, they will find a way to lose money, even with the bullett-proof index funds. For example, investors in the Vanguard S&P 500 mutual fund have underperformed the S&P 500 index by 2.50%/year over the past 15 years. If you do not believe me, check this page from Morningstar.

I actually think that if everyone wants to be an indexer that could create a lot of inefficiencies, and could make indexing not as robust as it has historically been. It could also create opportunities for non-indexers. Of course, for those who have the ability to stick to a strategy for 20 - 25 years, it wouldn't really matter whether someone else picked 500 stocks for them, or whether they hand-picked 40 - 50 companies themselves. The caveat is that paying too much for future earning streams could result in much lower returns than in the past. The hand-crafted portfolio stands a better chance in the entry valuation camp.

ETFs are also notorious for their fluctuating distributions, much worse than those on S&P 500. This is because of frequent turnover, and building portfolios without trying to generate stable and growing distribution stream for shareholders. Rules of inclusions in different indexes are very arbitrary as well. For example, the S&P Dividend Aristocrats Index removed Altria (MO) in 2008, after the spin-off of Phillip Morris Internatinal (PM) and Kraft Foods (KRFT). This was a dumb move on their behalf, because Altria did not cut dividends. The dividend seemed lower, mostly because the company had split into three. But the original Altria Group shareholders enjoyed rising dividend income streams in the subsequent years. Unfortunately the S&P committee did a bad job in actually understanding the situation. Rather, they chose to mechanically remove a company whose board of directors had regularly increased distributions every year for close to 4 decades. And luckily for those like myself, who never sold Altria, those boards have kept raising dividends every year.

As you can see, you can learn from any strategy. For example, index investors naively believe that an index such as S&P 500 is "passive". This passive nature of indexing is the main selling point, since it has been documented by academics that individual investors as a group tend to do poorly particularly due to turnover. In reality, the S&P 500 index (which is the most popular vehicle for index investors) experiences turnover each year. According to research by Jeremy Siegel, this turnover has slightly reduced returns for investors. Thus, it pays to hold on to your companies as long as possible. This is why I have held on to Abbvie (ABBV), Abbott (ABT), Kraft (KRFT), Mondelez (MDLZ) etc. It is also one of the reasons why I hold on to companies that have kept dividends unchanged or those that experience temporary setbacks. In fact, when I analyze my results, and the results of other bloggers who publicly disclose their investments, I have noticed that selling is usually a bad idea in 80% of situations. Patience is the main edge I have against Wall Street.

At the end of the day, the goal is to create a portfolio that realistically matches someone’s needs. I say realistically, because if you need $40,000/year to live off for the next 30 years, but you only have $400,000 in your portfolio chances are that you are not ready to retire. However, if you need $12,000 - $16,000 in annual income, that has a high chance of at the very worst maintaining purchasing power over time, there is a high chance that a hand-built portfolio of dividend stocks could do the trick. It shouldn’t matter if you underperform index funds or not, as long as someone is achieving their goals.

In addition, for single people making less than $47,050/year or for Married people making less than $94,100/year, qualified dividend income is essentially tax-free at the Federal level, if that’s the only type of taxable income they earn. Hence, the argument against dividends that they are inefficient, and result in double taxation of income is not really valid for those individuals. Learning about taxation of dividends, and learning about taxation in general, has definitely made my life much easier, and has helped get my whole financial house in a much better order. I do believe that knowledge is power, that provides me with options in life. The more options I eventually have, the better the chances that I may be able to live it on my own terms. And that’s what financial freedom means to me.

Full Disclosure: Long PM, MO, KRFT, MDLZ, ABBV, ABT,

Relevant Articles:

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Wednesday, February 25, 2015

How to Convert a portfolio of index funds to dividend stocks?

In a previous article, I discussed various ways that investors can accumulate their nest egg. One strategy includes putting a portion in one or a few attractively valued dividend growth stocks every single month, and reinvesting dividends selectively. The other strategy involved investing in index funds, using tax advantaged accounts such as 401 (k) for example.

Traditional vehicles for saving such as index funds and target-date funds work well when you accumulate your nest egg, but could present a challenge if you try to live off them. Many retirees prefer to have a stable and growing source of income, which maintains purchasing power over time, and is not dependent on the manic-depressive swings in stock prices. Therefore, investing in dividend growth stocks is the ideal way to generate income from your nest egg in retirement, due to the stability of dividend income. Therefore, if someone were to accumulate their nest egg in other items such as index funds, but wanted to convert to dividend investing, there are two ways that they can achieve that.

The strategies outlined in this article also work for situations where you have a lump sum amount, and you are thinking of investing it.

The first strategy involves selling all funds in your portfolio, and using the proceeds immediately to create a diversified portfolio of quality dividend paying stocks.

This strategy is quick and easy to achieve, as it involves just a few steps. If you want to make the conversion all at once, and not have to worry about how to invest the amounts for months, this is likely the best deal for you. If you could find 20 – 30 quality dividend paying companies, which are also attractively valued, and your money is spread in several sectors, you could be done with this exercise in one day. After that the only thing to worry about would be to monitor the investments, decide what to do with dividend income, and enjoy life.

Back in early 2013, I converted an old 401 (k) into an IRA, and as a result was able to purchase shares in twenty dividend paying companies. It was somewhat challenging to find twenty dividend growth companies all at once that could be considered quality and attractively valued. Depending on the overall stock market environment, it could be very easy to find plenty of value opportunities or it could be very difficult. Between late 2008 and late 2011, it was relatively easy to find plenty of opportunities, and build a diversified portfolio with them. Starting in early 2013, it has gotten pretty tough to do so, especially if you want to avoid concentrating all your bets on several companies in a few sectors like energy for example.

The second strategy involves selling a portion of your funds every month for a period of at least 12 – 24 months, and then using the proceeds to acquire shares of attractively valued dividend paying stocks.

In my experience building dividend portfolios, it is much easier to build a diversified dividend portfolio slowly over time, rather than all at once. This is because different companies from different sectors of the economy are attractively valued at different times. For example, Walgreens (WBA) met my entry criteria between 2011 and early 2013. The stock wasn’t attractively priced again until a brief period in July - August 2013. Since then, it has been slightly overpriced.

In addition, if you buy a portfolio over time, you also want to avoid the pressure of finding 20- 30 attractively valued securities at the same time. If you get into the mentality of have to put my money in these stocks regardless of availability of quality companies at a fair price, you might be taking on a large risk to your portfolio. With the slow selling of index funds and replacing with dividend stocks, you stand a better chance of getting exposure to different sectors when they are undervalued, and thus having a higher opportunity for exposure to more quality companies to buy.

This strategy is also ideal if you want to convert your taxable 401 (k) into a tax-free Roth IRA. If you convert the whole 401 (k) into a Roth IRA in a single year, all of the amount in the 401 (k) would be considered taxable income, and would likely push your marginal tax rate to the highest levels. However, by slowly converting your 401 (k) into a Roth IRA over a period of a few years, you can make sure to avoid triggering higher taxable income brackets, which would mean paying less taxes on the conversion.

Full Disclosure: Long WBA

Relevant Articles:

How long does it take to manage a dividend portfolio?
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Monday, January 26, 2015

How to never run out of money in retirement

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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Check the Complete Article Archive
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Wednesday, January 21, 2015

Rising Earnings – The Source of Future Dividend Growth

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

How to invest a lump sum

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.

Relevant Articles:

Why Sustainable Dividends Matter
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