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

Wednesday, April 1, 2015

Taxable versus Tax-Deferred Accounts for Dividend Investing

Dividend investing is a great strategy for accumulating income producing securities, which pay their owners cash on a regular basis. These cash distributions are viewed as taxable incomes in the eyes of the Internal Revenue Service (IRS). Depending on the taxpayers adjusted gross income, they could end up paying as much as 20% on the dividends they received. Compared to the top marginal rates on ordinary income such as salaries or bond interest however, dividend income has much lower tax rates. In retirement, qualified dividend income will not be subject to federal taxes for married couples earning $95,000/year (assuming no other sources of income). Unfortunately, it would take the average dividend investor years of accumulating assets, before they reach their dividend crossover point. This will result in them paying taxes throughout their accumulation phase. Many investors have the choice to shelter some or most of their investments in tax-sheltered accounts which could either postpone or eliminate the need to pay taxes on their investment incomes. By reducing or eliminating tax waste in the accumulation phase, dividend investors could reach the dividend crossover point much sooner than by doing it with taxable accounts alone.

There are several tax deferred account options for US investors who are still earning a paycheck. These include regular and Roth IRA’s in addition to 401 (k) plans. Each of these accounts has its pros and cons.

Traditional IRA’s provide investors with a tax benefit today, and allow them to compound their gains for years to come but have to take required minimum distributions at the age of 70 ½ years. Distributions are taxed as ordinary income. However there are strict eligibility rules that do not allow high income households to get the deductibility of contributions. Other negatives include the low contribution limit of just $5,500/year. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. The largest negative includes a 10% early distributions penalty that the IRA imposes if someone withdraws funds prior to the age of 59 ½ years. However, you can pretty much invest in almost anything with your IRA.

Roth IRA’s do not provide any tax benefit to investors today, but allow for tax free compounding of capital and tax free distributions from the account at the age of 59 ½ years. Direct contributions can be withdrawn tax-free at any time, although investors need to wait until they are 59 ½ years old, before they can withdraw gains from the account without a penalty. Investors cannot put more than $5,500/year in a Roth IRA, and there are strict income eligibility requirements to open an account as well. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. Another advantage of a Roth IRA is that there are no required minimum distributions requirements. With my Roth IRA’s, I can pretty much purchase any US Dividend Growth Stock I choose, and I like this flexibility. Tax payers are taking a gamble with Roth IRA’s however, as cash strapped Congress could decide to tax distributions in the future. Of course, it is also likely that tax rates on qualified dividend income will increase before Congress doing anything about limiting or taxing Roth IRA's for middle-class consumers.

The 401 (k) plan is the company sponsored defined contribution plan, that millions of Americans are eligible for. The annual contribution limit is $18,000/year for those under the age of 50. If you are over the age of 50, you can contribute up to $24,000/year to your 401 (k). The majority of 401 (k) plans allow participants to put pre-tax contributions today, and enjoy tax-free compounding of capital. They do have required minimum distributions starting at the age of 70 1/2 years old. This is when you will have to pay ordinary income taxes on any money you withdraw from the 401 (k). An increasing number of employers are now also offering Roth 401 (k) contributions, with the same limits as the traditional 401 (k). The nice thing is that contributions are after-tax, the money compounds tax-free, and there are no taxes to pay on investment earnings. The drawback of most 401 (k) plans for many investors is the limitation on the types of investments to choose. A good 401 (k) plan will offer low cost mutual funds to investors. A really good 401 (k) plan will also offer a Brokerage Link window, that would allow investors to pick their own investments. A really bad 401 (k) plan will include high-fee mutual funds with sales loads. If the fund you are purchasing charges an annual management fee of 1%/year, chances are this is part of the offering of a bad 401 (k) plan.

One disadvantage of both accounts (IRA and 401 (k)) is that you cannot deduct investment losses, or offset them against investment gains. In addition, foreign dividends are subject to witholding taxes at the point of origin despite the fact that they are in a tax-sheltered account. Unlike taxable accounts, investors cannot get a tax credit for these foreign tax withholdings. Dividends in tax-sheltered accounts of US investors which are derived from Canadian or UK companies are not subject to tax withholdings.

Despite popular beliefs however, Master Limited Partnerships can be held in tax deferred accounts, as the UBTI which scares investors off is mostly a non-event ( and has been in my few years as an MLP investor, although things might change). In the years that I have owned ONEOK Partners (OKS) and Enterprise Product Partners (EPD), I have never had positive UBTI.

In addition, investors need to choose whether to open a Roth or a Traditional IRA with their $5,500 in a given year, but cannot open both. Investors can still have an IRA and a 401(k) plan however. Given the lack of investment options in 401 (k) plans, they are of limited value to the self-directed dividend growth investor. 401 (k) plans are helpful as a tool to minimize taxes and get the company match, and buy a few index funds, which is why they work for mostly passive investors. The nice thing about 401(k) plans that I utilized in 2013 is that if you quit your job, you can rollover the money into an IRA. After that, you can pretty much invest in anything you want, including creating your own dividend stock portfolio.

In my investing portfolio, I keep most of my holdings in taxable accounts.The taxable accounts give me a lot of flexibility in my investments, and I can add or withdraw as much as I want at a moment’s notice. I do pay taxes on my investment income, but I also get to do tax loss harvesting on my investments.

I expect that by the end of 2015, I would have approximately 10 - 15% in tax-deferred accounts such as 401 (k), IRA, Roth IRA, SEP IRA and Health Savings Accounts (HSA). This is mostly because I used to believe that there are too many restrictions on withdrawing principle and accumulated gains from these tax-advantaged accounts. As a result, I used to contribute only the bare minimum to my 401 (k) in order to get the company match.  As I researched further, I realized that it is possible to withdraw money out of an IRA before the age of 59 and a half penalty free. With Roth IRA's, contributions can be withdrawn penalty-free at almost any time. With 401 (k) plans, investors can start withdrawals penalty free if they have separated from service, and they are 55 years of age or older. Or, just like with IRA's, investors can use Substantially Equal Period Payments (SEPP) and withdraw money to live off. The only catch is that if you start withdrawing money using SEPP, you need to continue doing it for the next 5 years or until you turn 59 1/2 years - whichever is longer.

The part I don't like about taxable accounts is that I was paying too much in taxes on salary and investment income. Taxes are the largest expense item on my personal income statement. Therefore, I have been maxing out all tax-deferred investment vehicles like crazy since early 2013 (luckily for some I was able to contribute for 2012 as well). I have saved tens of thousands of dollars in Federal and State taxes in the process. Prior to that epiphany, I had only contributed slightly more than the employer match I received. If I had to do it all over again, I would have been much smarter about the tax-efficiency of my investments. If my accumulation phase lasts for one decade, this means I would have to pay taxes on the money I want to invest in a taxable account, and then pay taxes on distributions I receive for that entire decade. It is little consolation that when I become FI, my dividend income will be tax-free. When you have too much waste in the accumulation phase of investing for retirement/FI, you end up with less money to invest, since you are paying so much in taxes.

Full Disclosure: None

Relevant Articles:

How to Retire Early With Tax-Advantaged Accounts
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
My Dividend Goals for 2015 and after
How to accumulate your nest egg

Wednesday, March 25, 2015

Dividend Stocks Provide Protection in Any Market

Dividends provide a positive return on investment in any market environment. Unlike capital gains, which can disappear in an instant unless the stock is sold, dividends represent a return which is realized by the investor and cannot be taken away from them. The dividend is always a positive return on investment, as evidenced by the cash deposited in investor’s brokerage account. It is also more stable than capital gains.

A cash dividend provides investors with a positive reinforcement during market declines. Bear markets as well as market volatility can make even the best investors worried about their nest eggs. Seeing the value of your portfolio fluctuate by the amount of a typical person’s annual salary every day, could be devastating to a retiree and make them question their judgment. Rash decisions such as selling your stocks, and purchasing bonds in order to limit the pain are thus much more likely especially if investors do not receive any dividends to soften the blow of stock price depreciation.

In order to reduce the psychological factors when dealing with adversity in dividend investing, there are several things that investors need to consider.

The first one is to have a strategy that fits the investor’s personality. Selecting dividend stocks provides both exposure to equities and a regular stream of income in the form of cash dividends. I can confidently predict the amount of dividend income I expect to receive in a given year - the same cannot be said about the price changes in the underlying value of my stock holdings.

The second one is that income investors should focus on analyzing companies they are purchasing in detail, and try to asses if they can continue growing. This would involve looking at ten year trends in earnings, dividends, revenues, returns on assets or equity, as well as reading a few annual reports and articles on the company in question. Having a solid understanding of the company’s business and how it generates cash flow will make it easier to stick to your guns if stock prices go down. You might even decide to add it to your portfolio if the valuation is right.

Sometimes however, no matter how well we understand the business, things outside of our control do happen. There could be change in the environment, business model or the economy, which could throw away even the best researched investment plans. In order to mitigate those risks, one needs to have a diversified portfolio of stocks. I am always amazed by the arrogance of investors who believe that a portfolio of 10 – 15 individual stocks is sufficient. They cite quotes by Buffett where he discusses how diversification is for the ignorant. I have looked at the portfolios of several traders/investors which have lost it all, and the common factor was lack of diversification. The risk that just one or two bad picks can permanently postpone your retirement is simply an unacceptable outcome in portfolio construction. Smart dividend growth investors would much rather have well-diversified portfolios with sleep well at night investments, than swing for the fences in a concentrated 10 – 15 stock portfolio. You are already retired ( or very close to that goal), so why would you even attempt to show how great of a money manager are you? It makes no sense to risk what you do need, in order to get something you might want to have but really don't need.

Another risk mitigating factor is having some firm exit rules. For example, I automatically sell an investment that cuts or eliminates dividends. I might sell at a loss, but this rule eliminates the risk of losing 100% of my investment value. While some companies increase several times after cutting dividends, others lose 95-100% of their value. If you lose 95% of your portfolio on bad investments for example, you would need to find an investment that goes up by 2000% simply to break even after that. Most investors who purchase these stocks are pure gamblers. The goal of my portfolio is to provide a dependable cash stream of dividends that grows over time, not to get rich quick overnight.

Stocks that pay dividends cushioned the losses for investors during the financial crisis. In fact, there were many companies which even boosted distributions to their shareholders:

Johnson & Johnson (JNJ), which researches and develops, manufactures, and sells various products in the health care field worldwide. It operates in three segments: Consumer, Pharmaceutical, and Medical Devices. The company paid quarterly dividend of 41.50 cents/share in 2007, raised it to 46 cents/share in 2008, and has continued increasing it all the way up to 70 cents/share in 2014. This dividend king has raised distributions for 52 years in a row. The company is attractively priced at 16.50 times forward earnings, and yields 2.70%. Check my analysis of Johnson & Johnson for more details.

Exxon Mobil Corporation (XOM), which explores for and produces crude oil and natural gas in the United States, Canada/South America, Europe, Africa, Asia, and Australia/Oceania. The company paid quarterly dividend of 35 cents/share in 2007, raised it to 40 cents/share in 2008, and has continued increasing it all the way up to 69 cents/share in 2014. This dividend champion has raised distributions for 32 years in a row. The company is overvalued at 22.40 times forward earnings, and yields 3.30%. Check my analysis of Exxon Mobil for more details.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. The company paid quarterly dividend of 37.50 cents/share in 2007, raised it to 42.50 cents/share in 2008, and has continued increasing it all the way up to 65.50 cents/share in 2014. This dividend champion has raised distributions for 43 years in a row. The company is slightly overvalued at 20.40 times forward earnings, and yields 2.70%. Check my analysis of PepsiCo for more details.

Altria Group, Inc. (MO), which manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. The company paid a quarterly dividends of 29 cents/share in 2008, which was raised to 32 cents/share later in the year, and has been increased all the way up to 52 cents/share by 2014.  This dividend champion has raised distributions for 45 years in a row. The company is attractively priced at 18.40 times forward earnings, and yields 4%. Check my analysis of Altria for more details on the company.

The reason why I do not track the dividend aristocrats list is because they kicked Altria out in 2008. The reason for kicking out Altria was dumb -  the company split itself in three parts, which reduced the dividend for the resulting legacy domestic US tobacco company. However, the investor in the original Altria did not really suffer in terms of total dividend income - rather they received shares in Altria, Phillip Morris International and Kraft, which together are paying much more in total dividend income than in 2007 or 2008. I am constantly surprised at the writers on Seeking Alpha who tout the dividend aristocrats index and pray that they are not really risking real money behind their work, since they obviously do not do thorough research to begin with. I have said it before, and I will say it again - the list of Dividend Champions maintained by David Fish is the most complete list of US dividend growth stocks available. The dividend aristocrats index is an incomplete list of dividend growth stocks at best.

Full Disclosure: Long all companies listed above

Related Articles:

Dividend Investing During the Financial Crisis
Where are the original Dividend Aristocrats now?
Historical changes of the S&P Dividend Aristocrats Index
The Dividend Investment Journey
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors

Wednesday, February 11, 2015

Will the dividend grow?

Dividend investing is more than just selecting the highest dividend stock and then forgetting about it. In fact, investors who simply choose dividend stocks based on yield only, without doing any additional analysis are taking too much risk. This risk could translate into full or partial loss of dividend income coupled with severe losses in principal. As a result, investors who plan on living off dividends for decades should take the time and learn about the business they are investing in. They should also try to purchase quality stocks at attractive valuations, and also hold a diversified portfolio with at least 30- 40 individual securities.

The diversified portfolio will reduce the risk to overall dividend income, should one or two components cut dividends. The detailed analysis of each company should determine whether the dividend is sustainable today, which should reduce the near-term risk of choosing a company that cuts dividends right after purchase.

The analysis of each company should include both quantitative and qualitative characteristics. Quantitative characteristics could include things like trends in earnings per share, dividends, stock prices, and returns on equity. Qualitative characteristics could include any piece of information related to the business that could help you understand the business and where it is going. Strong brands, strong competitive advantages, competitive landscape as well as whether products/services have enough appeal to gain some pricing power for the company are just a few items. In addition, any strategic plans will also add value to the analysis process.

After this analysis is complete, the investor should be able to determine whether the company will be able to deliver earnings growth in the future. After all, without sustainable earnings growth, there is a limit to the levels at which companies can boost dividends. Rising dividends will generate higher yields on cost for astute dividend investors who recognized the opportunity to purchase the right stock at the right times. There are several ways that companies manage to increase earnings:

A few ways companies can grow earnings includes:

- Increase Prices
- Cut Costs
- Sell more products
- Acquire other companies
- Create new products
- Sell or close unprofitable operations
- Share buybacks

Of course, as I have mentioned numerous times on this site, entry price does matter. Purchasing a good company at a fair price is important. I is rarely worth it to overpay even for the best dividend growth stock in the world. The attractive entry price provides the investor with another layer of protection, that limits losses, in the case things do not turn out as expected. In other words, if you have to purchase shares at 20 times earnings or 30 times earnings, it is always wiser to choose the cheaper company. This is particularly true if earnings projections are equivalent. The reason for that is in case dividend and earnings do not grow as expected, after the initial purchase.

The other important trait to have is patience. Sometimes, even the best companies in the world experience short-term turbulence. It is important to study each situation individually, and not succumb to feat and jump ship at the first time of trouble. Without patience, the dividend investor will jump from company to company, and from strategy to strategy, without really letting their capital compound over time. Remember, time in the market is more important than timing the market. Also remember that your portfolio is like a bar of soap - the more you touch it, the smaller it gets.

To put the lessons from this article in action, I have selected a few dividend paying companies, which I am reasonably certain will grow earnings and dividends at least in 2015 and 2016.

Johnson & Johnson (JNJ), is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The company earned $2.84/share in 2004, and grew profits to $5.70 by 2014. The company is expected to earn $6.21 in 2015 and $6.56 in 2016. This dividend king has raised dividends per share for 52 years in a row. The dividend increase announcement is usually in April of each year. I would expect the quarterly dividend to reach 75 - 76 cents/share in 2015. I would the further expect the quarterly dividend to reach 79 - 80 cents/share in 2016. This would be up from 70 cent/share today. I find the stock attractively valued at 16.30 times forward earnings and a yield of 2.80%. Check my analysis of Johnson & Johnson.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. The company earned $2.41/share in 2004, and grew profits to $4.59 by 2014. The company is expected to earn $4.75 in 2015 and $5.21 in 2016. This dividend champion has raised dividends per share for 42 years in a row. The dividend increase announcement is usually in May of each year. I would expect the quarterly dividend to reach approximately 70 cents/share in 2015. I would the further expect the quarterly dividend to reach roughly 78 cents/share in 2016. This would be up from 65.50 cent/share today. I find the stock slightly overvalued at 20.40 times forward earnings and yield of 2.70%. Check my analysis of PepsiCo.

Full Disclosure: Long JNJ and PEP

Relevant Articles

Rising Earnings – The Source of Future Dividend Growth
How to never run out of money in retirement
Margin of Safety in Dividends
Diversified Dividend Portfolios – Don’t forget about quality
How to read my stock analysis reports

Monday, January 5, 2015

How to reach your dividend income goals?

The goal of every dividend investor is to reach their dividend crossover point, which is the time when financial independence is attained. Many articles provide sources of inspiration touting the advantages of dividend stocks, while others show how to select the best dividend stocks at the best prices possible. Other articles focus on high yield, low yield, or a combination of all of them. Few articles however provide a concrete and actionable plan on how to utilize everything you know in order to reach your goals.

There are three key factors that can determine whether someone can retire with dividend paying stocks. In general, in order to be able to retire with dividend stocks, investors need to have a starting amount of capital to commit to the strategy. If they do not have a nest egg available, then the aspiring dividend investor would have to dedicate themselves to patiently building their portfolio of income producing securities, one stock at a time. This process takes time, and requires plenty of patience in order to build wealth. It also takes a lot of dedication to save money these days, rather than spend it on frivolous purchases such as new cars, big homes, expensive vacations or big screen TV’s.

Let’s look at a scenario where we have a dividend investor with zero assets, who commits to saving $1,000/month. This investor chooses to focus on dividend paying stocks yielding 4% at the time of purchase, which grow distributions at 6% annually. Our investor decides to reinvest distributions, in order to be able to compound distributions growth more rapidly.

After 10 years of saving and investing, our dedicated income investor is generating almost $2,000/quarter, which equates to $659/month in distributions. After 15 years, the monthly dividend income jumps to $1,325.

For the purposes of this example, I assumed that the investor purchases stocks which pay 4 cents/annual dividends and whose starting price is $1/share. I assume that dividends are going to increase by 6%/annually and that all future purchases will be invested in companies yielding 4% that offer a 6% dividend growth.

Now that we discussed saving money, and compounding at a given rates of return, we need to discuss how to actually invest the funds. In reality, it is difficult to predict the yield and dividend growth that new investments will generate even a few short years from now. However, having a disciplined approach where investments from approved lists are pre-screened using predetermined entry criteria is a very good start. Adapting to the current environment and keeping an open mind would be helpful as well, and keep you flexible.

In addition, it would be very helpful to focus entirely on researching companies, how they make their money, whether they can keep growing, who their competitors are and whether they have any strong competitive advantages. If you are able to invest in a few companies such as PepsiCo (PEP), Procter & Gamble (PG), Johnson & Johnson (JNJ) or Wal-Mart (WMT) over time, chances are that hitting your investment goals would be much closer. Worrying about interest rates, the general level of economic activity or unemployment in Brazil would be counter-productive. Instead, focus on factors that would help the companies you pick succeed and pay you higher dividends in the process.

In addition, in order to ensure that a sustainable stream of divided income flows to them every month, investors need to make sure that a diversified income portfolio is constructed over time. A diversified income portfolio should consist of at least 30 - 40 individual stocks, representative of as many sectors that make sense at the time. If in a given year 2 companies in a 30 stock portfolio completely eliminate distributions and go to zero, but the other 28% raise distributions by 7.10%, the amount of dividend income would be unchanged. The types of companies which fit the profile today include:

Eaton Vance Corp. (EV), through its subsidiaries, engages in the creation, marketing, and management of investment funds in the United States. This dividend champion has managed to boost distributions for 34 years in a row and has a ten year dividend growth rate of 15.10%/year. Currently, the stock is attractively valued at 15.70 times forward earnings and yields 2.40%. Check my analysis of Eaton Vance.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. This dividend champion has managed to boost distributions for 42 years in a row and has a ten year dividend growth rate of 13.70%/year. Currently, the stock is slightly overvalued at 20.90 times forward earnings and yields 2.70%. Check my analysis of PepsiCo.

Emerson Electric Co. (EMR) provides technology and engineering solutions to industrial, commercial, and consumer markets worldwide. This dividend king has managed to boost distributions for 58 years in a row and has a ten year dividend growth rate of 7.70%/year. Currently, the stock is attractively valued at 15.70 times forward earnings and yields 3.10%. Check my analysis of Emerson Electric.

ConocoPhillips (COP) explores for, develops, and produces crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids worldwide. This dividend achiever has managed to boost distributions for 14 years in a row and has a ten year dividend growth rate of 15.70%/year. Currently, the stock is attractively valued at 12.50 times forward earnings and yields 4.20%. Check my analysis of ConocoPhillips.

Chevron Corporation (CVX), through its subsidiaries, is engaged in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has managed to boost distributions for 27 years in a row and has a ten year dividend growth rate of 10.50%/year. Currently, the stock is attractively valued at 11.40 times forward earnings and yields 3.80%. 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. This dividend champion has managed to boost distributions for 32 years in a row and has a ten year dividend growth rate of 16.80%/year. Currently, the stock is attractively valued at 10 times forward earnings and yields 2.50%. Check my analysis of Aflac.

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 king has managed to boost distributions for 52 years in a row and has a ten year dividend growth rate of 10.80%/year. Currently, the stock is attractively valued at 17.70 times forward earnings and yields 2.60%. Check my analysis of Johnson & Johnson.

Full Disclosure: Long all companies listed above

Relevant Articles:

Diversified Dividend Portfolios – Don’t forget about quality
How to increase your dividend income
- Successful Dividend Investing Requires Patience
How to turbocharge dividend growth
My dividend crossover point

Monday, November 17, 2014

Should Dividend Investors own Non-Dividend Paying Stocks?

Dividend growth investing is the strategy I have been using for several years in order to reach my retirement goals. In order to be successful with a strategy and stick to it through thick and thin, investors need to understand its positives and limitations. One of the disadvantages of investing purely for dividends is missing out on spectacular price gains of hot new technology stocks. On the other hand, everyone can pick the best hot stock only after the fact. Most investors who look for the best growth stock are very often very wrong at the end. This is why I stick to the tried and true dividend champions and dividend achievers.

Apple (AAPL) is one of the best performing stocks over the past decade. The stock rose from a low of about $4/share in November 2004 to a high of about $100/share in 2012. If you look at any of the top performing stocks from ten years ago, one could notice that few of them even paid dividends, let alone maintained a streak of dividend increases. Opponents of dividend investing often use this fact as an argument against the merits of dividend investing. While as a dividend investor I am going to miss out on the next Apple, I also know that I am going to miss out on the next technology bubble, the next MCI Worldcom or the next company that will try to be the next Apple (or Google, Microsoft etc) but fail in the process. Most companies that are touted to be the "next something" end up failing, losing money for their investors and their worthless shares get delisted. Since those losers are not in the plain sight of ordinary investors, the lessons from their failures are soon forgotten by investors.

The world of technology changes very fast, which is why it is so difficult to maintain an economic moat that lasts for several decades. The companies that try to become the “next” Google, Apple or Microsoft often end up being nothing more than pipe dreams, which end up costing investors many dollars. In addition, the chances of selecting the best growth company over the next five years are really slim, unless you are a seasoned and well-connected Silicon Valley venture capitalist.

Looking at the best performing stocks over the past decade and then invalidating dividend investment altogether is not a very smart way of looking into things. This is because one is not comparing apples to apples. If instead we compared the results of dividend paying stocks to the results of non-dividend paying stocks, we could notice a stark contrast. Over the past years, dividend stock have consistently outperformed non dividend paying stocks.

The reasons behind this out-performance are somewhat counter-intuitive:

1) Dividend paying stocks are typically mature companies, which generate excess cash flows that they do not know what to do with. As a result, these companies return this excess cashflows to shareholders in the form of dividends. Some, like Procter & Gamble or Coca-Cola have increased dividends for over 50 years in a row each.

2) The boards of these dividend paying companies realize that companies cannot reinvest new money at the same rates of return. Investing new funds is important to maintain and grow the business, but unfortunately there are physical limitations to expanding business indefinitely and forever. Due to laws of diminishing returns, once you add in an extra dollar of investment that does not result in much profit, you should be better off doing something else with the money. In other words, if you are Starbucks (SBUX) and you already have four coffeehouses on a busy intersection, chances are the adding a fifth one is not going to result in a 20 – 25% automatic increase in total sales.

3) Because dividend companies are mature enterprises, their growth prospects are not going to be very high. As a result, these stocks are often trading at low price-earnings multiples. This allows investors to purchase these quality companies at a discount, and thus enjoy better compounding of capital. The companies which have very high earnings growth projections often sell at a premium price, which has high earnings growth already baked in to the stock price. The reason why Altria (MO) (which was called Phillip Morris back then) was the best performing stock between 1957 - 2003, was because it grew earnings and dividends while shares were always cheap, and thus shareholders were able to consistently reinvest dividends at low valuations. This turbocharges dividend income and capital growth.

4) While the growth prospects for mature dividend paying stocks are not as high as the prospects for a hot new IPO, they are more dependable. Many of these mature companies tend to deliver a small but consistent growth, which makes them clear winners over time. Many of these stodgy dividend champions tend to sell a similar type of a branded product or service that your parents or grandparents have used and which you and your children would likely use for decades to come. The consistent growth translates into consistent profitability, which coupled with the relative undervaluation when compared to the stock market makes investment a very good idea.

5) The dividends that these companies pay to shareholders represent a return on investment which is always positive. A company can see its stock price rise quickly to new highs or fall precipitously to all-time-lows, leaving investors with rapidly fluctuating capital gains or losses. At the same time however, income investors receiving a dividend would be essentially paid to hold on to the stock of their choice, and would be less likely to panic and sell at the worst time possible. The dividend payment, if sustainable, would thus be a factor that could keep the stock price from losing too much, since value oriented investors would step up and provide support behind the stock by purchasing it at attractive valuations.

6) The dividend payment provides a regular stream of income, which investors could use to either spend or invest in stocks that fit their entry criteria. Dividend reinvestment allows investors to compound their capital over time, through the systematic accumulation of undervalued assets over time using dividend income. This strategy has helped famous value investor Warren Buffett to accumulate a fortune worth over $60 billion. By focusing Berkshire Hathaway’s capital on income producing investments, and then reinvesting excess capital into other income producing assets, Buffett has transformed the sleepy textile company into a diversified conglomerate with a market capitalization of over $200 billion.

The article discusses dividend paying stocks and non-dividend paying stocks in general. While there could be dividend paying stocks which have failed, as well as non-dividend paying stocks which have been wildly successful, this does not change the overall conclusion that dividend paying stocks have historically done better than non-paying ones. The probability that your average blue chip dividend stock provides better returns is much higher than the probability of good returns by your average non-dividend paying stock. In order to further increase your chances of achieving your goals, one also needs to further screen out investments and evaluate the final list of candidates for inclusion one by one.

Full Disclosure: Long KO, PG, MO, PM,

Relevant Articles:

Another reason for companies to pay dividends
Why Dividend Growth Stocks Rock?
What is Dividend Growth Investing?
Should dividend investors hold non-dividend paying stocks?
The predictive value of rising dividends

Wednesday, October 15, 2014

Top Dividend Growth Stocks of the past decade

Dividend growth investing is sustainable when derived from consistent earnings growth. In its true form, successful dividend growth investing is characterized by instances where annual earnings and dividend growth are almost identical. In addition, companies that exhibit such traits tend to have their current yields being in the same range of 2% - 3% during prolonged periods of time. Ordinary yield chasing investors tend to ignore such companies, because they lack the patience or forward thinking to care for high future yields on cost or strong total returns. As a result, many of these companies offer low current yields, which tend to stay low for extended periods of time. The lucky investors who purchased such securities however are able to generate high yields on cost over time.

I selected the fifteen dividend champions which have achieved the highest ten year dividend growth rates:

Yrs Consecutive Div Increase
10 Year Annual Div Growth
P/E Ratio
Div Payout Ratio
Stock Analysis
Becton Dickinson & Co.
Computer Services Inc.

Donaldson Company

Helmerich & Payne Inc.

Lowe's Companies
McDonald's Corp.
MSA Safety Inc.

Nucor Corp.

Raven Industries

T. Rowe Price Group
Target Corp.
W.W. Grainger Inc.

Walgreen Company
Wal-Mart Stores Inc.

High dividend growth does not make companies automatic buys. Investors need to evaluate each company in detail, and understand where future growth will come from. A solid plan with concrete deliverables communicated from the company is just one instance of something that could propel solid dividend growth going forward. Other variables that could translate into high earnings and dividend growth include taking advantage of favorable demographic trends in healthcare, baby boomers needs for retirement saving, and the rise of the emerging markets middle class.

Investors should also take with a red flag companies whose dividend growth has been slowing down considerably in the past five years or less. Nucor (NUE) rode the boom in steel prices in the first half of the decade, only to reach a plateau at the onset of the financial crisis of 2007 – 2009. The dividend growth has been miniscule for the past five years.

Investors should also look into the valuation of each company, prior to investing. Purchasing even the best company in the world that is guaranteed to boost earnings and dividends for the next 10 years could still lead to losses, if investment is made at very high valuations. Investors in Wal-Mart Stores (WMT) in 1999 and Coca-Cola (KO) in 1998 can certainly attest to this fact.

However, a booming business can be rewarding eventually even for the most unlucky investors, provided they are true long-term investors. Great businesses like Wal-Mart and Coca-Cola are attractively priced today, and have managed to record better sales, profits and dividends since hitting all-time-highs at the end of the last millennium. If they can continue pushing forward, their investors will eventually make good profits.

Full Disclosure: Long WMT, KO, NUE, LOW, AFL, BDX, MCD, TGT, WAG

Relevant Articles:

The Tradeoff between Dividend Yield and Dividend Growth
Why Dividend Growth Stocks Rock?
Four Characteristics of The Best Dividend Growth Stocks
Living off dividends in retirement
Four Percent Rule for Dividend Investing in Retirement

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