Showing posts with label retirement. Show all posts
Showing posts with label retirement. Show all posts

Monday, November 9, 2015

Margin of Safety in Retirement Income: How to create a fool proof dividend machine for retirement

In a previous article titled, My Dividend Retirement Plan, I outlined the concept of the dividend crossover point. This happens when your dividend income exceeds expenses for the first time. The dream of every dividend investor is to achieve this point of financial independence. However, do not quit your day job yet. It might make more sense for income investors to postpone their retirement by a couple of years, simply to ensure an adequate margin of safety behind their dividend income.

In order to succeed, you need to layer your portfolio in a way that one black swan event is not going to derail your retirement plans. If you really want to fool-proof your plan, you should design your income strategy in a way that would allow you to retire, even if multiple torpedoes hit your portfolio. This is why I focus on building a diversified portfolio of dividend paying stocks, purchased at attractive valuations. I try to own at least 30 - 40 individual quality companies with competitive advantages, which are likely to increase earnings over time. In this article I am making assumptions that these qualitative factors are already accounted for.

In order to have a margin of safety in their dividend income, investors need to consistently generate an annual stream of distributions that exceeds their annual expenses by approximately 33% - 50%. This means that if your annual expenses are $30,000/year, your dividend income should be somewhere in the vicinity of $40,000 - $45,000 in order to have an adequate margin of safety. The factor is not set in stone, and could vary from as little as 1.20 times expenses all the way to two times expenses. This margin of safety is important, in order to protect investors against risks that they might have overlooked during the design stage of their dividend machine.

Wednesday, May 20, 2015

Front Loading Savings for a Successful Dividend Retirement

My favorite saying is that "The best time to plant a tree is 20 years ago. The second best time is today." This is why I am carefully planting each dollar seed into carefully chosen portfolio of quality dividend growth stocks available at attractive valuations. I then enjoy the increase in dividends per share from those companies, and further magnify the compounding process by reinvesting the dollars into more dividend paying companies. Thus, I am creating a positive loop, that keeps on delivering results for me.

The power of compounding is said to be one of the 8th wonders of the world. A dollar that compounds at 10%/year today turns into $1.61 in 5 years, $2.59 in 10 years and $17.45 in 30 years and $117.39 in 50 years.

This is why it is extremely important to start investing as early as possible, even if that happens during a time when you are not able to save too much due to low income. Focusing on the stream of dividend checks coming every month, quarter or year has also helped think a long-term business owner, rather than worry about meaningless stock price fluctuations.

Imagine that you started a job in 2003, and then saved 40% of your income every year. Your initial amounts invested look paltry, and the gains look pale compared to the amount you put to work. Many investors get discouraged at the initial steps, because the initial results are not visible.

Net Earnings
Portfolio Value
 $   36,000.00
 $  14,400.00
 $  21,600.00
 $         14,400.00
 $   37,080.00
 $  14,832.00
 $  22,248.00
 $         30,771.70
 $   38,192.40
 $  15,276.96
 $  22,915.44
 $         47,536.42
 $   39,338.17
 $  15,735.27
 $  23,602.90
 $         70,803.16
 $   40,518.32
 $  16,207.33
 $  24,310.99
 $         90,651.35
 $   41,733.87
 $  16,693.55
 $  25,040.32
 $         73,993.33
 $   42,985.88
 $  17,194.35
 $  25,791.53
 $      110,680.99
 $   44,275.46
 $  17,710.18
 $  26,565.28
 $      145,052.36
 $   45,603.72
 $  18,241.49
 $  27,362.23
 $      166,045.96
 $   46,971.83
 $  18,788.73
 $  28,183.10
 $      211,387.49
 $   48,380.99
 $  19,352.40
 $  29,028.59
 $      299,037.38
 $   49,832.42
 $  19,932.97
 $  29,899.45
 $      349,424.06

The table above assumes a net income of $36,000 per year after taxes, and annual raises of 3%/year. It also assumes 40% of income is invested in the S&P 500 index fund. It is easier to make the calculations using historical returns on S&P 500, as a proxy for returns on diversified stock portfolios as a whole. If the index funds are sold in 2014 and the money in is invested in dividend paying stocks however yielding 4%, they would generate $13,976 in annual dividend income.

However, after 10 years of saving as much as possible, and investing the proceeds, the power of compounding starts becoming extremely obvious. It is obvious that around that time the power of compounding starts doing the heavy lifting for your money. This is the point at which the amount of wealth and passive income starts increasing exponentially, without really much further fuel on your part (savings placed into investments). This is the point at which the invest gains start becoming noticeable and close to exceeding contributions. The knowledge gained from the first dividend investments I made, is easily applicable whether I manage a $10,000 or a $10 million portfolio. That’s why one should never despise the days of small beginnings. Even a few hundred dollars invested per month in quality securities for several years, can produce a handsome perpetual income machine.

This is essentially the reason why I have had an intense focus on saving as much as possible ever since I managed to get a decent amount of income in 2007. I decided that deferring gratification for a decade will provide much more benefits throughout my lifetime, than spending it foolishly on trophy cars, expensive vacations etc. Eight years into this experiment, I am able to see rapid increases in dividend income, net worth and ability to generate income. In a few more years, the amount of my passive dividend income will exceed my expenses. I am not saying this to brag however. I am saying this to prove that it is possible for an ordinary person to achieve financial independence if they have the ability to save a large portion of income, continuously look for ways to increase income and decrease expenses, invest money conservatively, and continuously trying to improve themselves.

I do not talk about anything else other than selecting dividend growth stocks. However, the investing part of my life is a subset of who I am. I am extremely frugal, drive a 15 year old car, and have tried to cut on big items like housing and taxes. I have also tried to earn more money at work by switching positions, getting professional certifications and expanding my education. Unfortunately, this has also resulted in increased responsibilities, and the requirement to work more than 40 hours per week.

By saving a lot however, I created a base of assets, that will produce an ever increasing stream of dividend income for decades into the future, which will pay for expenses, and ultimately go to causes and family members that deserve it. The dollars I save early in life, and invest prudently, will generate a lot of dividends and capital gains for me over my lifetime, because the power of compounding will do the heavy lifting for me. This is why investing early is important.

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investors
How to accumulate your nest egg
The importance of investing for retirement as early as possible
Let dividends do the heavy lifting for your retirement
Dividend Investing Is Not As Risky As It Is Portrayed

Monday, June 2, 2014

How to stay motivated on your road to financial independence

In my post related to my 2014 goals and objectives, I shared with readers my roadmap to financial independence by 2018. Currently, the goal is to have more than 2/3rds of expenses to be covered by dividends. I believe that a 100% coverage of expenses by dividends by 2018 is very doable, as long as existing companies I own manage to raise dividends by 6%-7%/year on average and I manage to reinvest distributions at 3%-4%. As I had mentioned earlier, most of my contributions are now going into tax-deferred accounts, in order to create a tax-free buffer for the excess dividend income I will be generating.

The road to financial independence is very exciting and liberating. I find it really liberating to check every quarter how much of my expenses is being covered by my dividend income. Ever since I converted to Dividend Growth Investing in late 2007 – early 2008, my dividend income has been increasing exponentially. This is a result of my plan to retire early.

So for the past 7 or so years, I have been focusing on several levers within my control, in order to achieve financial independence. The levers include saving a lot, finding ways to earn extra money, investing my hard earned money in the best values at the moment, and focusing my attention on researching companies and continuously increasing my knowledge about investing matters. The most difficult part of the journey however is the job situation, which has resulted in increased levels of stress for the past several years. The pay has been decent, but the increase in level of responsibilities has exceeded the level of income growth by a large factor. It is very difficult to keep producing and keeping up to those high expectations and stress, when you are also so close to the finish line. The problem is that the finish line is about 5 years down the road. ( 2014, 2015, 2016, 2017 and 2018). The one thing that I find difficult, is to endure the daily grind that leads to the dividend crossover point. I do not believe that it is healthy to sit in a cubicle for 60 hours on a slow week, while getting stressed out over impossible deadlines.

This means I still need to keep motivated enough, and work harder, before getting to the Promised Land. I find it tough to keep up with the daily grind, which is why I try to motivate myself to perform, because the daily grind is a major source of capital for my FI. I motivate myself by consistently trying to save a large portion every month, in order to put it to work, and have the asset base to generate more dividends. I motivate myself by searching for quality companies at bargain prices, and researching their business models in order to determine whether they can be sustainable engines of dividend growth for the foreseeable future. I also motivate myself by charting my dividend income over time, and visualizing the point in time when expenses will be more than covered by dividends by a nice factor of 1.3 - 1.5. I do want to do it the right way, and not quit in the middle of the journey. That’s why 2018 is the reasonable goal to have.

For me this is the point where my dividend income increases expenses, and technically I would never again have to work for money. That doesn’t mean I would do nothing, but would provide me with freedom of choice to pursue only projects and people I find interesting. I may still choose to work after that point, or do something else. However, having options in life is something that is extremely valuable.

The types of dividend growth stocks that will pay for my retirement, provide me with consistent raises include:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has managed to increase dividends for 6 years in a row, and currently sells for 17.10 times forward earnings and yields 4.30%. Check my analysis of PMI.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. This dividend champion has managed to increase dividends for 42 years in a row, and over the past decade has managed to boost them by 13.70%/year.  Currently, the stock is trading at 19.40 times forward earning and yields 3%. Check my analysis of PepsiCo.

Exxon Mobil Corporation (XOM) explores and produces for crude oil and natural gas. This dividend champion has managed to increase dividends for 32 years in a row, and over the past decade has managed to boost them by 9.60%/year.  Currently, the stock is trading at 13 times forward earning and yields 2.70%. Check my analysis of Exxon Mobil.

Johnson & Johnson (JNJ), together with its subsidiaries, is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. This dividend champion has managed to increase dividends for 52 years in a row, and over the past decade has managed to boost them by 10.80%/year.  Currently, the stock is trading at 17.30 times forward earning and yields 2.80%. Check my analysis of Johnson & Johnson.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. This dividend achiever has managed to increase dividends for 11 years in a row, and over the past decade has managed to boost them by 9.90%/year.  Currently, the stock is trading at 19.10 times forward earning and yields 3%. Check my analysis of General Mills.

There are several lessons however, which are applicable to everyone reading, even if you really enjoy your work and never want to retire. Things change, people change, companies change, which is why it is quite possible to really start hating what you do in the future, which might be unthinkable to you today. I am very lucky that I never had much in terms of debt, other than a credit card I pay off in full every month. I am also very lucky that I have had the frugal mentality to save as much as possible from my income, and also focus on increasing it over time. The problem of course is that reaching the goal takes time, which is the one commodity we can never buy back. On the bright side of course, once you reach the point of your goals, you would only have to deal with the rest of life’s challenges.

So how do you stay motivated on your road to financial independence?

Full Disclosure: Long PM, PEP, XOM, JNJ, GIS

Relevant Articles:

How to become a successful dividend investor
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
What is Dividend Growth Investing?
What are your dividend investing goals?

Wednesday, May 21, 2014

Generate a retirement paycheck with these dividend stocks

Investors spend a large portion of their working years accumulating a sizable nest egg, that will support them in retirement. Once they approach the age to retire however, investors are typically sold on asset depletion strategies such as the four percent rule, which rely on selling off assets in order to meet expenses. Selling off assets to pay for expenses in retirement is akin to cutting off apple trees for lumber, instead of harvesting the fruit and living off the income from it.

The issue with selling off assets is that there is a higher logical risk that once investors run out of assets to sell, they would have no other source of income other than their labor. Instead, dividend investors focus on generating income from their capital in the form of dividend or rent income that lasts in perpetuity. As a result income investors would be able to create their own retirement paychecks from the income generated by their investments. As a result, they would not be dependent on market volatility to generate the income in retirement they need.

In order to ensure that income lasts in perpetuity however, income investors need to consider the following factors, when creating their dividend portfolios:

1) Do not overpay for investments

Investors should avoid overpaying for stocks, since this could bring down their long-term returns. Investors in US stocks in early 2000s were willing to paying high multiples, given the rosy outlook for the economy and tech stocks. Even some quality companies such as Johnson & Johnson (JNJ), Wal-Mart (WMT) and Coca-Cola (KO) were selling at unsustainable valuations. The subsequent twelve years of flat returns served as a strong reinforcer to investors that overpaying even for quality dividend growth stocks could lead to sub-par returns. It makes sense that when you pay 40 - 50 times earnings and you lock in a current yield of 1% or less, you are not going to earn a lot in dividend income even if distributions double every 6 - 7 years.

2) Do not chase yield

Many novice investors tend to focus exclusively on dividend yield when choosing investments. As a result, they tend to ignore factors such as dividend sustainability as well as corporations ability to maintain and grow distributions over time. Many investors who focused on high paying bank stocks in 2007 – 2008 were burned in the process, as many financials had to cut distributions to shareholders in order to raise money and remain solvent.

3) Analyze the company in detail first

Investors should perform a detailed analysis of companies they plan on investing in, before they put their hard earned capital to work. By analyzing the company’s business model, and how it earns money, investors should be able to determine whether it can afford to grow earnings in the future. Over time, the potential for an increase in earnings will determine whether a company can afford to grow distributions or not. Most companies that have been able to raise distributions for decades tend to have strong brand recognition, which have allowed them to maintain purchasing power with customers, who are willing to pay a higher price in order to obtain the quality product or service.

4) Focus on companies whose culture has resulted in long dividend track records

In their quest for generating income off their portfolios, investors should focus on companies which have the ability and willingness to pay higher distributions. Companies that have managed to boost distributions for at least ten consecutive years, have achieved this by properly balancing the need to expand with the need to avoid diworseification by distributing excess cash flows to shareholders. Companies which generate so much in excess cash that they do not know what to do with it, after funding their business expansion plans, are very likely to keep paying and increasing distributions to loyal shareholders.

5) Diversify your dividend portfolio

Investors, who plan to generate a defensible income stream, should avoid putting all of their eggs in one basket. A portfolio consisting of at least 30 individual securities representative of as many sectors in the economy as possible, has a much better chance of ensuring that the dividend stream will continue uninterrupted for the long run. While currently it looks like a no brainer to focus on high-yielding master limited partnerships yielding 6%, past experience should note that overcommitting to a sector could be dangerous to your financial health. Investors who were overweight financial sector in 2007, suffered steep losses in the capital and dividend incomes, as the financial crisis of 2007 – 2009 exposed weak balance sheets and companies cut distributions.

Investors, who follow these five simple principles, will be able to not only generate a sustainable amount of income from their nest eggs, but also grow cash distributions to compensate for inflation. By living off income from their investments, these future retirees would be able to have a sustainable income stream that would be entirely dependent on the underlying investments financial performance rather than stock market gyrations.

Some examples of solid companies with strong competitive advantages and good long term prospects for earnings growth include:

McDonald’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has increased dividends for 38 years in a row and has a five year dividend growth rate of 13.90%/year. This dividend champion sells for 17.90 times forward earnings and yields 3.10%. Check my analysis of McDonald's.

Chevron Corporation (CVX), through its subsidiaries, is engaged in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has increased dividends for 26 years in a row and has a five year dividend growth rate of 9%/year. This dividend champion sells for 11.50 times forward earnings and yields 3.50%. Check my analysis of Chevron.

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance products.The company has increased dividends for 31 years in a row and has a five year dividend growth rate of 8.10%/year. This dividend champion sells for 9.90 times forward earnings and yields 2.40%. Check my analysis of Aflac.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. The company has increased dividends for 11 years in a row and has a five year dividend growth rate of 11.50%/year. This dividend achiever sells for 18.70 times forward earnings and yields 3%. Check my analysis of General Mills.

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. The company has increased dividends for 44 years in a row and has a five year dividend growth rate of 9.20%/year. This dividend champion sells for 15.80 times forward earnings and yields 4.70%. Check my analysis of Altria.

Full Disclosure: Long MCD, CVX, JNJ, WMT ,KO, AFL, GIS, MO

Relevant Articles:

The Four Percent Rule is Dependent on Dividend Yields
How to live off dividends in retirement
How to accumulate your nest egg
Dividend Investing – Science versus Intuition
How to define risk in dividend paying stocks?

Friday, March 28, 2014

Dividend Stocks for Consistent Cash Income

I was recently away from home for a two week period. During the time, I did not have the opportunity to check email or look at my dividend stock portfolio. The first thing I did after coming back was log on to my brokerage accounts. I noticed that everything had gone smoothly and I had more in cash than before. This should hardly come as a surprise to most readers – dividend investing is a low key, low activity process. It does not involve staring at a computer screen for 8 hours a day nor does my portfolio require tinkering every day, week or month. Most of the companies I tend to purchase are held as long term investments. Heck, even if I don't do anything with my dividend for a couple of years, I highly doubt my portfolio income will be affected.

I am mostly a buy and hold dividend investor. I tend to purchase companies, which have a quality product or service that is valued by customers, and which have been able to deliver dividend increases for at least one decade. Most of these companies, such as McDonald’s (MCD) or PepsiCo (PEP) tend to remain in the same lines of business for years, as they have the expertise and know-how to keep existing activities and also continuously improve in order to stay competitive. Even five or ten years from now, both companies would still be performing essentially the same things they are doing today. These strong brands are synonymous for quality and consistency of product/service, which is why consumers are willing to pay up. This translates into strong pricing power that enables companies to remain profitable, and pass on cost increases to customers, while retaining and even increasing profitability. Most such companies also tend to sell their products on a global scale, which ensures that they are not overly dependent on a single marketplace. Because these companies tend to have a stable, predictable business models, and because they have a diversified income streams coming from countries around the world, they tend to deliver dependable earnings and thus afford to pay dependable dividends to shareholders.

By owning companies with consistent earnings, I tend to generate consistent dividends every quarter. I typically let distributions accumulate in cash and do not automatically reinvest them. However, once amount f cash reaches $1,000, I tend to initiate or add to stock positions. I only tend to reinvest dividends in companies that are currently attractively valued, and whose prospects appear bullish. In other words, if my analysis indicates that a company has a decent chance of increasing earnings and dividends over time, and it is attractively priced at the moment, I would consider allocating any excess cash I have. This excess cash could be from dividends I received, and need to reinvest, or from new contributions. I do not automatically reinvest dividends, because I do not want to invest in companies which are overvalued at the moment, even if they have great long-term prospects. The frustrations of millions of US investors over the past decade, also referred to as the lost decade for US stocks, were primarily caused by excessive valuations in 2000. Even some solid companies such as Johnson & Johnson (JNJ) or Coca-Cola (KO) were overvalued in 1999 - 2000, which led to poor total returns over the next decade, despite the fact that their underlying businesses were growing.

The positive factor for owning quality dividend growth companies is that they tend to generate solid increases in dividend income, coupled with solid total returns. Another positive is the ability to compound income and total returns over time. Companies such as Johnson & Johnson (JNJ), Phillips Morris International (PM) and Casey’s (CASY) have been able to create strategies for increasing earnings, and then executing them. This has led to higher earnings and trickled down into higher distributions. As a result, investors who meticulously reinvested distributions at attractive valuations were rewarded by the amount of reinvestment plus the increase in distribution. As a result, they had effectively managed to turbo-charge their dividend compounding. The fact that earnings are growing, also makes the underlying businesses that dividend investors have put their hard earned money in, even more valuable. As other investors realize the extra value for the dividend paying company, they tends to deliver solid capital gains in the process as well. This icing on the cake also protects the purchasing value of the investment portfolio against inflation.

Full Disclosure: Long  MCD, PEP, KO, JNJ, CASY, PM

Relevant Articles:

Buy and Hold means Buy and Monitor
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Check the Complete Article Archive

Tuesday, March 25, 2014

Should dividend investors invest in index funds?

Index funds are perfect for most people who don’t want to bother about managing their finances and retirement. If your goal is to accumulate a certain amount of net worth in the future, and do not want to spend any time learning about investing, index funds could be your best solution. Therefore, index funds are great for 80% - 90% of the population out there, particularly if coupled with the tax advantages of 401 (k), Roth and Regular IRA’s etc. I own index funds in my 401 (K), because I cannot buy anything else there.

However, if your goal is to generate income in retirement, index funds might not be most optimal use of your resources. If your goal is to generate a positive stream of income that is not dependent on market fluctuations and grows faster than inflation (dividends), then index funds like the S&P 500 might not be for you. Dividend investing is probably practiced by less than five percent of the investing population, although it should be higher. Of course, do not take my word for that, as this percentage might be even lower than that. But this article is written for the dividend investor, who is willing to do some work, and not let their retirement in the hands of Wall Street.

With dividend growth investing, you put a portfolio of 30 - 40 equally weighted individual securities, from as many sectors that make sense, which are attractively valued at the moment. After screening for your entry criteria, you construct your portfolio, and sit on it, while receiving a rising stream of dividend income. You monitor your portfolio regularly, and only sell after a dividend cut or a crazy overvaluation. I have been doing this since 2008, and have experienced one cut in 2008, two in 2009, one in 2010 and none between 2011 and 2014. The proceeds from the sale of the stock which cut dividends is put to work in another company that fits your entry criteria. Typically, dividends are either spent or reinvested into more quality dividend paying stocks in the accumulation phase, in order to compound capital faster. The reason why relying on dividend income for retirement is superior to index investing is because dividends are more stable than capital gains, and are always positive. Therefore, if stock prices fall and stay down, the dividend payments will provide positive reinforcement to the investor, who would be motivated to keep holding and ignore market fluctuations. Otherwise, investors could panic during a market correction, and probably sell at the worst time possible. In fact, many investors do sell at the worst times possible. It is very difficult for the ordinary uninformed investor to see their portfolio being down 30% - 40% - 50%, and them losing several years worth of contributions in one bad year for stocks. Therefore, a lot of investors sell in order to stop the pain and stop their nest egg from dwindling down even further.

In addition, with dividend stocks, you are a buy and hold investor with a long-term view. You are not switching money from one company to another. Therefore, you are reducing reinvestment risk due to transactions, and have a much lower chance of generating lower returns that come out of frequent portfolio churning.

One reason against index funds, is that they include a lot of companies which do not pay ANY dividends. Therefore, the yields on index funds are very low, and not sufficient to live off of today. That’s why in order to live off this nest egg in retirement, you need to sell of a chunk of it every single year. This leaves you with a shrinking asset base, which is relying on continued growth in prices. Without the increase in stock prices, you are shrinking your asset base even further. If you retired at the end of 1999, you would have experienced stagnating stock prices, and as a result, you would have “eaten” more than half of your portfolio by now. I would not want to face the stress of eating into my capital when I retire. If I have $1,000,000, and I sell $40,000 worth of securities each year, I would be out of money in 25 years, assuming no inflation and no stock price growth. If the first five or ten years produce no increase in stock prices, then I face a high risk of running out of money. The last few years of living in such conditions would likely be horrible, as I would be counting every penny twice, and stressing over, while counting the days until I have to get a Wal-Mart job as a greeter out of necessity. The thing is that noone can tell you in advance whether the year you retire with index funds will be similar to 1972 or to 2000.

There are many flaws with index funds, particularly those on S&P 500, which make them poor choices for the enterprising dividend investor. The first is that there is a lot of turnover every single year, which is not good for wealth building. In fact, the turnover is approximately 3% – 5% per year on average. This means that every year anywhere between 15 and more than 25 companies are added and replaced by the benchmark, incurring fees for the investor. Buying and selling of stocks is the reason many investors underperform their benchmarks. For indexes like S&P 500, this frequency of asset turnover has lead to underperforming a purely passive portfolio of stocks. Did you know that the original 500 stocks of S&P 500 from 1957 outperformed the S&P 500 index by 1% point for 50 years? My previous article on the topic discusses research done to prove this.

The second flaw is that index funds are weighted based on float and market capitalization. This is to serve the mutual fund industry, not the investor. If you are a big shot mutual fund, and you want to raise 100 billion from investors, you cannot follow a passive strategy that requires you to put money equally between 500 companies, because for some the total amount of stock available to purchase might be less than $200 million. Therefore, some companies are ignored, at the expense of focusing on the biggest. In reality, the equal weighted S&P 500 has done better than the market cap weighted S&P 500 over the past decade.

The third flaw is that I do not know what criteria the index committee uses to include stocks in the S&P 500. Sometimes, they (just like any normal investor) follow the crowd into irrational exuberance and doing stupid things. For example, back in 1999, a lot of old economy stocks were thrown out of the index, and substituted for red hot technology stocks such as Yahoo! I would let you figure out for yourself how that worked out. The other sin of the S&P index committee is that it didn’t include Warren Buffett’s Berkshire Hathaway in the index until 2010. With my strategy, I can select the securities that fit my criteria, and live or die by their performance, as I am the one in charge of capital allocation in the family.

The fourth flaw with index investing that they are not a magic panacea for sure stock market profits. An investor who doesn’t know anything about investing, and is passively saving in index funds, can still lose money. They can lose money if they panic at the wrong times such as in 2008 – 2009 and sell everything. They can also lose money if they put money to work without taking valuation into account. The ordinary investor can find a way lose money even with idiot-proof index funds. In fact, according to Morningstar, most investors in the Vanguard 500 index fund have underperformed the index by 2% per year over the past 15 years. The investor also needs to focus on valuation at the time of investment. You should not just blindly put your money in the market to work, without taking valuation into account. For anyone who bought S&P 500 index funds in the late 1990s, they were simply chasing market returns. This was not a smart decision, and the subsequent decade of low returns proved that ignoring entry valuation at the time of investment is not a good strategy.

The other thing is that while index funds have rock bottom expenses, they could still add up over time. For example, if you have a portfolio worth $100,000, you will end up paying $100/year in management fees. If your portfolio is worth $500,000, you will be paying $500/year for life.

In contrast, if you built a portfolio of 40 individual dividend paying stocks, and paid a $5/commission for each trade, you would pay $200 in total. If you never sell, you would never have to incur commission expenses again. Therefore, with a $100K portfolio, you are better off cost wise in 2 years. For the larger portfolios you are better off in individually selected stocks on your own, rather than index funds. That is one of the reasons why people who have several million in equities always pick their own securities, rather than rely on index funds. Why pay someone else thousands of dollars in fees per year for passive investments, when you can simply create a portfolio of the largest blue chip stocks, and do nothing after that?

Over the past decade, more and more investors are beginning to embrace passive index investing strategies. I am just wondering to myself, what if everyone is in index funds one day? I wonder what the consequences and inefficiencies that could arise from this phenomenon of people believe you do not need to know what you own, as long as it is an index fund.

If at one point everyone is invested in index funds, this could create all sorts of inefficiencies in the market. For example, if a company asks shareholders to vote on certain issues that could be otherwise profitable, noone would vote, since conventional efficient market theory says all information is already priced into the stock. As a result, index fund managers might not even bother voting, as they won’t believe their vote counts. Next, since these fund managers might not vote, because they probably haven’t done any research to know enough about the companies they hold for investors in the first place. Therefore, corporate managers at those large companies would face few consequences from angry shareholders. I think that one of the reasons why CEO’s are earning such high compensations is because ownership is being delegated to mutual funds, and not individual shareholders. If Warren Buffett owned 30% of Berkshire Hathaway, and he let his son be the CEO, you could be 100% sure that he would fire Howard on the spot if he paid himself an exorbitant amount of compensation while not furthering shareholders’ interests. This is the reason why as dividend investors, it pays to have your interests aligned with management, especially when management has an ownership stake.

In conclusion, there are a few main ideas that enterprising dividend investors should take from this article.

The first idea is to buy and hold, and not engage in active trading. If you slowly built a portfolio of 30 blue chip stocks, from as many sectors that made sense, and you HELD ON, for several decades, you should do very well for yourself.

The second idea is also to educate yourself about money and investing AS MUCH AS POSSIBLE. The main idea is that you are the one responsible for your retirement future. You are the one whose retirement is at stake, and the only one who cares about succeeding. Therefore, you should be personally involved in the process, educate yourself and determine the best way to achieve your goals. Whether you end up buying dividend paying stocks, index funds, or daytrade internet stocks online, you are the person who will benefit or  lose from your actions. Therefore, do not outsource your retirement goals and dreams to a third party, whose only goal is to generate a commission or annual fees from you. Take your dream in your own hands, and get at it!

Full Disclosure: Long S&P 500 Mutual Fund

Relevant Articles:

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Monday, February 3, 2014

How to retire in 10 years with dividend stocks

The goal of every dividend investor is to generate a sufficient stream of passive dividend income, that would adequately cover their expenses. In order to achieve this goal however, investors need to select a strategy and fine-tune it over time to reflect current market conditions. In most of my articles I tend to focus on investing that would generate dividends for several decades to come. But how would someone who wants to retire in one decade afford to retire? Follow the guidelines in this article, and you might end up being one of the lucky ones who can afford to quit the rat race in a decade.

The first guideline is to contribute regularly to your dividend portfolio. This is important, because it allows our investor to dollar cost average their way over many years. This would provide them with the opportunity to build their portfolio brick by brick, without purchasing everything as a lump sum. Many articles on retirement focus on lump sum investing, which is not relevant to most future retirees.

The second guideline is to focus on dividend growth stocks, which are companies that regularly raise distributions. Since our dividend investor is likely to live off distributions for decades to come, they need to overcome the risk of inflation. As a result, they need to invest in stocks that can afford to regularly increase dividends, thus ensuring an inflation adjusted stream of income. Luckily, David Fish has the dividend champions list, which can be accessed from here. Investors can use this list as a starting point to identify dividend growth stocks, and apply their screening criteria.

The third guideline is to buy quality dividend stocks at attractive valuations. This is the step where the savings added to the brokerage account need to be invested. Investors should develop a set of standard screening criteria, in order to narrow down the list of dividend champions or achievers to a more manageable level. I typically look for companies yielding more than 2.50%, which have raised dividends for at least ten years in a row and trade at less than 20 times earnings. I then further avoid companies with high dividend payout ratios, depending on their industry and business form. After I do this, I research each stock in detail, in order to determine if it has what it takes to keep raising earnings and dividends over time. This is the most subjective part of the process. However, if you create a properly diversified portfolio of income stocks as outlined in the next step, you have a very good chance of success, even if you picked average companies.

The fourth rule is to focus on creating a diversified income portfolio, in order to reduce risk. In order to protect yourself, your goal is to have your income stream come from as many companies as possible. Leave the task of outperforming the market each year to the people who want to manage other people’s money or who are trying to sell you expensive newsletters. Your goal is to create an income stream that grows over time, which will support you in your retirement. As a result, in order to have a defensible income stream, you need to own at least 30 individual income stocks representative from as many industries as possible. Ideally, you would own three stocks from each of the ten sectors identified by Standard and Poor's, which comprise the S&P 500 index. In reality however, it might be difficult to achieve this strict diversification. However, since you are building your portfolio over a long period of time, you will likely be able to purchase quality stocks from different sectors, which would be priced right at different times over the next decade.

The fifth rule is to reinvest dividends selectively in these quality income stocks over the next decade. Until you reach your target dividend income, you need to use the power of dividend growth, new capital contributions and dividends received to plow back into your portfolio and turbocharge your dividend income. I typically avoid reinvesting dividends automatically. Instead, I wait for my dividends to accumulate, and then either add to an existing position, or initiate a new position in an attractively valued stock. While some might say I am missing out on compounding my income while waiting for my dividends to accumulate and buy a stock, I disagree. Re-investing dividends in an overvalued stock is a much worse offense than simply patiently accumulating cash in my book, and deploying it in the best values at the moment. This is another tool that will increase your odds of growing your dividend income stream faster.

Now that I outlined a list of few basic guidelines to follow, I will show how an individual can retire in ten years. Let’s assume that our individual manages to save $1,000/month for the next 120 months (10 years). The first month they only manage to save $1000. Let us also assume that our investor invests his or her hard earned money in dividend stocks yielding 4%, that grow distributions by 6%/year. Let's also assume that share prices grow by 6%/year as well (Such linear growth in share prices does not work in reality, but is only used for the model) If the distributions are paid monthly, and are reinvested back in stocks yielding 4% and growing distributions at 6%, our investor will generate approximately $659/month after 10 years. Now granted, they only saved $1000/month for ten years. However, if they saved $2,000/month instead, their dividend income will rise to $1,317/month in 10 years. If your dividend crossover point is around $1,300, then after ten years of meticulously saving and investing $2,000/month, you will be able to retire. The table below shows how investing $2,000/month in dividend paying stocks that yield 4% and grow dividends by 6%/year, can result in monthly incomes exceeding $1,300/month in 10 years, and $2,000/month in 13 years.

As you can see, the second column shows number of shares purchased with the $2000 savings every month, plus the amount of dividends received as well. After the first year, the $2000 buys less than 2000 shares, because the share price goes up in lockstep with the dividend growth.

This spreadsheet is a guideline on the forces that will help someone reach financial independence. Your dividend crossover point will be dependent the amount you can save, amounts you need, returns you can generate, and time to retirement. By carefully managing those variable, the retiree will be able to devise a proper plan that will help them accomplish their ultimate goals of attaining freedom over their time.

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Wednesday, January 15, 2014

My Dividend Goals for 2014 and after

With the end of 2013, many dividend investors are reviewing the year that passed, and are updating their 2014 goals. As I am reviewing results from my portfolio, I am trying to understand if I am on track to reach my goals.

The three inputs that will help me achieve my goals are organic dividends growth, reinvestment yield and new capital to invest. In my book, organic dividend growth is merely a result of corporations approving increases in distributions to shareholders. I strive for a 6% in annual dividend growth on average. Since I am in the accumulation phase of my dividend investing journey I am also reinvesting dividends into more income producing securities. I believe that if my portfolio keeps growing distributions by 6 – 7% per year, and I reinvest this cashflow back into more dividend paying stocks yielding 3- 4% today, I can essentially grow total dividend income by approximately 10% per year.

This of course assumes that I no longer put any new capital to work in dividend paying stocks. The biggest change I implemented in 2013 was to reduce the amount of contributions to my taxable accounts to the minimum. This was because I am starting to max out tax-deferred accounts such as 401 (k), Sep IRA and Roth IRA, in order to cut down on taxes today, and create a vehicle where I would generate dividend income that won’t be taxed for at least 30 – 40 years. When you put money in taxable accounts, you can withdraw dividends from one account and easily pool them into another account. Unfortunately, with tax-deferred accounts, the money generated in one account has to stay there. I am doing this, because my largest expense in my budget is taxes. This includes Federal, State and FICA taxes.

My taxable accounts would likely generate a sufficient stream of income to reach my dividend crossover point within five years. This would be as a result of organic dividend growth, dividend reinvestment and fresh additions of investable funds. I do believe that I need to be generating more in dividends than what my regular monthly expenses are, just to be on the safe side. Because I would be earning more than what my typical monthly expenses would be, I would be paying taxes on the buffer income I won't be using. Therefore, I have added the assets that would generate this dividend income buffer in tax-deferred accounts. I would have to jump through hoops in order to access these funds, which is why I would only tap them in the case of extreme circumstances. There is a high likelihood that these funds would not need to be used ever, but could provide a potential buffer in case I am wrong in my calculations. Plus, the money would compound tax-free for decades, before the tax person gets their share, if I do not need to use them.

Now that I provided some high-level background on the status of accounts, I am going to go over my goals for the next few years. As I had mentioned before, I plan on becoming FI by 2018. After looking at the numbers, it looks as if I am on track to reach this goal. I am currently able to cover approximately 60%-65% of expenses with dividend income. This is a slight improvement from 50% – 60% that I was able to cover in early 2013. Using a conservative 10% growth in total dividend income, I come up with the following calculations:

Expenses Covered by Dividends

The table shows percentage of monthly expenses that are covered by dividend income at year end. I have simply compounded the percentage of expenses covered by dividends by 10%/annum. It looks like I am on track right now to accomplish my goals. I prefer to discuss goals in terms of the longer-term goal, rather simply focus on isolated annual goals. I think that for 2014 I would strive for approximately 70% in dividend income coverage, but this is meaningless without understanding how this goal fits in the grand scheme of things.

The percentages in the table do not include dividends generated in tax-deferred accounts. I expect that most of my future contributions will be in tax-deferred accounts, which would hold the excess dividend income, that would be part of my safety net. Some portions of income will make their way to taxable accounts, which might increase the percentage of expenses covered by dividends. However, in order to be conservative in my assumptions, I am not going to change these estimates in the table above.

I am also not putting down exact dollar figures, because reasonable expenditures vary from individual to individual. For example, for a single individual living in the Midwest that owns their residence, they can probably get by on say $1,500/month. However, if you are a married couple that lives in New York City or San Francisco, you would likely need at least $4,000 - $5,000/month merely to get by. The goal of this article is not to debate whether a certain dollar figure is reasonable or not, but to discuss my thought process in getting to a reasonable goal within a reasonable time. After all, these are my numbers, and they make sense for me - your numbers are going to be much different.

Therefore, in order to get to a place, you need to determine what your goal is. Write it down, and then try to determine how to get to that goal. I figured out early that I would achieve my goal with my diversified portfolio of dividend growth stocks, which are companies that regularly boost distributions for shareholders. I then determined the monthly amount I plan to invest each month, and also determined reasonable assumptions about returns. Based on these assumptions, I then figured out the amount of time I would need in order to get there.

It is also important to have a plan B and even plan C in action, in case your assumptions don’t turn out as expected. The value of a job income cannot be overlooked. For example, a source of $100 in monthly income is equivalent to $30,000 - $40,000 invested at 3%- 4%. This should be something you enjoy however, and are passionate about. So if you enjoy doing taxes and learning how much others make – you might be a tax preparer between January and April every year. It is up to you to figure out what you can do. However, I am not going to tell how to spend your time in retirement, so I am going to end the discussion here.

One obstacle to my plans could include situations where I lose my primary job, and am unable to find another one after that. This could damage my ability to make future contributions, and would also prevent me from reinvesting distributions, as I would be using them for my day to day expenses. Another obstacle that could prevent me from achieving my goals include situations where I can find fewer securities that fit my entry criteria. After a relentless increase in 2013, it is getting to a point where quality dividend companies are tougher to find. I do not envy the dividend investor who is just about to start putting their hard earned money to work today.

However, all hope is not lost, as I do find quality at decent prices today. The types of companies that look priced fairly include:

McDonald’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. This dividend champion has increased dividends for 38 years in a row. Over the past five years, it has managed to raise them at a rate of 13.90%/year. Currently, the stock trades at a P/E of 17.30 and yields 3.40%. Check my analysis of McDonald'’s for more information.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. This dividend machine has increased dividends for 5 years in a row. Over the past five years, it has managed to increase quarterly dividends by 15.40%/year. Currently, the stock trades at a P/E of 15.70 and yields 4.60%. Check my analysis of Philip Morris International for more information.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has increased dividends for 26 years in a row. Over the past five years, it has managed to raise them at a rate of 9%/year. Currently, the stock trades at a P/E of 9.90 and yields 3.30%. Check my analysis of Chevron for more information.

Target Corporation (TGT) operates general merchandise stores in the United States. This dividend champion has increased dividends for 46 years in a row. Over the past five years, it has managed to raise them at a rate of 21.40%/year. Currently, the stock trades at a P/E of 16.70 and yields 2.70%. Check my analysis of Target for more information.

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide.This dividend champion has increased dividends for 39 years in a row. Over the past five years, it has managed to raise them at a rate of 14.20%/year. Currently, the stock trades at a P/E of 15 and yields 2.40%. Check my analysis of Wal-Mart for more information.

Full Disclosure: Long MCD, PM, CVX, TGT, WMT

Relevant Articles:

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