Roth IRA’s for Dividend Investors

Nothing is certain in this world except for death and taxes. For many dividend growth investors, this could be characterized as a feeling that they are being taxed to death. I am always on the lookout to legally minimize my investment taxes as much as possible. In fact there is an easy way to invest in dividend paying stocks without ever having to pay taxes on your investment.

The Roth IRA allows individuals who have earned income in a given year to contribute up to $6000 in after-tax dollars to their retirement account. There is a catch-up contribution of $1000 for individuals who are 50 years of age or older. While contributions to Roth IRA’s are not deductible on your tax returns, earnings and principal distributions are tax free once certain age and time requirements are met. 

Roth IRA’s allow for tax-free compounding of capital over time. This means that you will not pay taxes on dividends or capital gains on your investments that are placed in a Roth IRA.

The earned income includes compensation from salary, wages, commissions, bonuses and alimony. Income from interest, dividends, annuities or pensions does not count as earned income in the eyes of the IRS.

A non-working spouse can set-up a Spousal Roth IRA, even if they have no working income, as long as the other spouse has enough working income to contribute. For example, if one of the spouses earns $50,000/year, and the other one stays home, they can each contribute $6,000/year to their own Roth IRA's. If they are over the age of 50, the $1,000 catch-up contribution still applies.

The contribution limit for a Roth IRA is the same as the contribution limit for a regular IRA. However the amount that can be contributed to a Roth IRA is the amount remaining after subtracting any contribution made to a regular IRA. This means that if you contributed the maximum allowable amount to your regular IRA of $6000, you would not be able to contribute anything to a Roth IRA in that year.

There are no required minimum distribution rules for Roth IRAs. 

However, there are phase-out income limits for high earning taxpayers, which reduce the opportunity to use this tax advantaged investment account. A modified adjusted gross income (MAGI) of $214,000 for a couple filing jointly, or $144,000 for an individual makes you ineligible to contribute to a Roth IRA in 2022. The following table outlines the Roth IRA Contribution limits for 2022.

Source: Schwab

There are ways around it of course, using the "Backdoor IRA Conversion" Strategy.  Basically, it entails contributing to a Regular IRA, and immediately converting it to a Roth.

In order to avoid paying taxes on distributions from Roth IRA accounts, investors need to become acquainted with the qualified nontaxable distribution rules.

According to the IRS, qualified nontaxable distributions for Roth IRA’s are those made at least 5 years after the taxpayer’s first contribution to a Roth IRA and made:

1) After the taxpayer become 59.5 years old
2) To a beneficiary after the death of the taxpayer
3) Because the taxpayer becomes disabled
4) For a use of a first time homebuyer

The biggest benefits of a Roth IRA are the long-term tax free compounding of capital, the fact that qualified distributions are tax-free and the fact that there are no required minimum distributions. Another little known fact behind Roth IRA’s is that direct contributions may be withdrawn at any time. This makes them a perfect investment vehicle for investors who plan on retiring early and living off dividends before they reach typical retirement ages of 60 years.

I hold a portion of my assets in a Roth IRA. While the contribution limit is only $6,000, that is still a good start. For a married couple maxing out their Roth IRA's, you have $12,000 to invest. 

In today's commission free world and fractional shares, you can build a diversified portfolio fairly easily.

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Six Dividend Growth Stocks Rewarding Shareholders With a Raise

I review the list of dividend increases every week, as part of my monitoring process. It helps me evaluate existing holdings, and identify companies for further research.

In my review, I focus on companies that have raised dividends for at least a decade. That's a quality filter that screens out a lot of cyclical companies, and companies that may not have what it takes to compound capital for long periods of time. 

Next, I review the raise, along with any pertinent financial information. I like reading management's opinion about the raise, and compare it to financial history for more context. 

When I review companies in more detail, I look at trends in earnings per share and payout ratios, in order to determine if the company can continue delivering in the future.

Over the past week, there were several companies that raised dividends, and have a ten year track record of annualized dividend increases. The companies include:

Badger Meter, Inc. (BMI) manufactures and markets flow measurement, quality, control, and communication solutions in the United States, Asia, Canada, Europe, Mexico, the Middle East, and internationally. 

The company raised quarterly dividends by 12.50% to $0.225/share. This was the 30th consecutive year of dividend increases for this dividend champion. Over the past decade, the company has managed to grow dividends at an annualized rate of 9.70%.

Kenneth C. Bockhorst, Chairman, President and Chief Executive Officer, stated, “We remain committed to our long tradition of paying dividends to our shareholders as part of their total returns, and are incredibly proud of achieving 30 consecutive years of dividend increases. Dividends are a key element of our disciplined approach to capital allocation, and evidence of the confidence that Badger Meter has in the resilience of our earnings and cash flow.”

The stock is expensive at 43.78 times forward earnings however. Badger Meter yields 0.81%. Even at the June lows, the stock sold as low as 33 times forward earnings.

Broadridge Financial Solutions, Inc. (BR) provides investor communications and technology-driven solutions for the financial services industry worldwide.

The company raised its quarterly dividends by 13.30% to $0.725/share. This was the 16th consecutive year of annual dividend increases for this dividend achiever. Over the past decade, the company has managed to grow dividends at an annualized rate of 14.50%.

"Our results reflect continued execution of our long-term growth strategy, the ongoing digitization of financial services, and strong performance from our Itiviti acquisition.

"Broadridge's resilient business model is built to deliver growth through different economic cycles. Looking ahead, we expect continued growth in Fiscal 2023, with 6-9% organic recurring revenue growth, continued margin expansion, and 7-11% Adjusted EPS growth. Most importantly, we are well-positioned to deliver, again, on our three-year financial objectives, with recurring revenue and Adjusted EPS growth at or above the higher end of the range," Mr. Gokey added.

"Finally, I'm pleased to announce that our Board has approved a 13% increase in our annual dividend amount to $2.90 per share. Broadridge has now increased its dividend for 16 consecutive years, further underlining the strength and resiliency of our business and the durability of the trends driving our growth."

The stock sells for 26.35 times forward earnings and yields 1.58%. Even at the lows in June, the stock only went as low as 20.80 times forward earnings.

J&J Snack Foods Corp. (JJSF) manufactures, markets, and distributes nutritional snack foods and beverages to the food service and retail supermarket industries in the United States, Mexico, and Canada. It operates in three segments: Food Service, Retail Supermarkets, and Frozen Beverages.

The company hiked its quarterly dividend by 10.60% to $0.70/share. This is the 17th consecutive year of annual dividend increases for this dividend achiever. The company has managed to grow dividends at an annualized rate of 18% over the past decade.

The stock is expensive at 55.33 times forward earnings. The stock yields 1.61%. Even at the lows in May, the stock sold at 45 times forward earnings.

Nordson Corporation (NDSN) engineers, manufactures, and markets products and systems to dispense, apply, and control adhesives, coatings, polymers, sealants, biomaterials, and other fluids worldwide. It operates through two segments, Industrial Precision Solutions (IPS) and Advanced Technology Solutions (ATS).

The company hiked quarterly dividends by a massive 27.50% to $0.65/share. This increase represents Nordson’s 59th consecutive year of annual dividend increases. Over the past decade, this dividend king has managed to grow dividends at an annualized rate of 14.30%.

“Nordson has a proud history of returning a portion of its cash flow to our shareholders. This increase moves our annual dividend yield to slightly over one percent,” said Joseph Kelley, executive vice president and chief financial officer. “This increase reflects our confidence in our long-term profitable growth, which is driven by the continued execution of our Ascend strategy, designed to deliver top-tier growth with leading margins and returns.”

The stock sells for 25.62 times forward earnings and yields 1.07%. Even during the June lows, the stock only got as cheap as 21 times forward earnings.

ResMed Inc. (RMD) develops, manufactures, distributes, and markets medical devices and cloud-based software applications for the healthcare markets. The company operates in two segments, Sleep and Respiratory Care, and Software as a Service.

The company increased quarterly dividends by 4.80% to $0.44/share. This marks the 10th year of consecutive annual dividend increases for this newly minted dividend achiever. Over the past five years however, the company has raised dividends at an annualized rate of 4.94%. 

The stock is expensive at 42 times forward earnings. Even in May, it sold as cheaply as 33 times forward earnings, which is not cheap either. The dividend yield is 0.73%.

Westlake Corporation (WLK) manufactures and supplies petrochemicals, polymers, and building products worldwide. It operates through two segments, Performance and Essential Materials; and Housing and Infrastructure Products. 

The company hiked its quarterly dividends by 20% to $0.2975/share. This was the 18th year of consecutive annual dividend increases for this dividend achiever. Over the past decade, the company has managed to grow dividends at an annualized rate of 23.50%. The five year dividend growth is 8.80% annualized however.

The stock is selling at 21.74 times forward earnings. The new dividend yield is 1.15%.

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Stocks that leave the Dow tend to outperform after their exit from the average

Note: Article was originally posted in August 2020

The Dow Jones Industrials average is the oldest continuously updated stock index in the US. It was launched in 1896 by Charles Dow, who included 12 companies. The number of companies was later increased to 20 and finally in 1928 the number was increased to 30 companies.

It tracks the performance of 30 blue chip companies, which are representative of the US economy. Its holdings are selected by a five-member index committee at Standard & Poor’s/Dow Jones. This committee is basically comprised of the best stock pickers in the world, since they have managed to do better than most mutual fund managers and individual investors. They have done better than Buffett over the past 10 – 15 years as well.

The index made news in August 2020, when it was announced that it would drop three members of the index, following the stock split in Apple’s shares. Since the index is weighted by the share prices of its components, Apple’s stock split reduced it technology exposure.

As a result, the index committee is replacing Exxon Mobil (XOM), Pfizer (PFE) and Raytheon (RTX) with Salesforce.com (CRM), Honeywell International (HON) and Amgen (AMGN).

A lot of investors believe that indices such as Dow Jones do better over time, because of new members. In reality, the opposite has been the case.

I recently read a study that shows how the companies that have been deleted from the Dow Jones Industrials Index between 1929 and 2006 have actually done much better than the companies that were added to the index. The study is titled " The Real Dogs of the Dow"

This study reminded me of the study of the original 500 members of the S&P 500 from 1957. This study had found that if someone had only invested in the original 500 members of the S&P 500 from 1957, they would have done better than the index themselves. That's because the companies that were added did worse than the companies that were removed from the index. You may read more about this study and my analysis here.

This study also reminded me of the Corporate Leaders Trust, a mutual fund that was started in 1935 with a portfolio of blue chip stocks that stayed constant in time. This mutual fund did better than S&P 500 since the 1970s. You can read my review of the Corporate Leaders Trust here.

This is due to the principle of reversion to the mean. The reversion to the mean hypothesis states that companies taken out of the Dow may not be in as bad of a situation as expected. It also suggests that the companies that replace them may not be as great as their current record suggests.

As a result the stock of the deleted company may be too cheap, while the stock of the added companies may turn out to be too expensive. As a result, companies that were deleted from the Dow may deliver better results than companies that were added to the Dow.

This is somewhat counter-intuitive. But it makes sense. The companies that are likely to be deleted are the ones that have suffered for a while, and they are down on their fortunes. As a result, investor expectations are low, which means that these shares are low too, as they are priced for the end of the world. The nice thing about such companies is that if the world doesn’t end, and they do just a little bit better, they can reward their shareholders handsomely. That’s because you will likely experience an expansion in the P/E, at the same time earnings and dividends are rising too.

On the other hand, the companies that are recently added to the index tend to have done very well. They are promising companies of the future. As a result, they sell at premium valuations. However, if these companies fail to live up to their lofty expectations, their returns may suffer, because investors may be willing to pay a lower P/E multiple. If profits do not grow as expected as well, it is likely that investors would also suffer from that as well.

As I mentioned above, I found a study that analyzed the substitutions in the Dow Industrials Index between 1928 and 2005.  The results were in line with what my expectations would be based on my research on the Corporate Leaders Trust and the Performance of the Original Members of S&P 500.

Over this period, there were 50 additions and deletions. In 32 of 50 cases, the deleted stock did better than the added stock.

Figure 1 shows that, with the exception of the 1990s, the Deletion portfolio consistently outperformed the Addition portfolio over the 76-year period.

Figure 2 shows the ratio of the average deletion wealth to the average addition wealth each day over a ten-year horizon. The deleted stocks outpace the added stocks for approximately five years after the substitution date. Then their relative performance stabilizes

Table 4 summarizes the average levels of wealth for the Deletion and Addition stocks at 250- day intervals (approximately 1 year) over the five-year period following the substitution dates.

For example, the deleted stocks showed, on average, a 19.30% increase in value 250 trading days after the publication date, while the added stocks showed an average increase of only 3.37%. The differences in average wealth grow increasingly pronounced as the horizon lengthens.

The study had a fascinating conclusion.

A portfolio consisting of stocks removed from the Dow Jones Industrial Average has outperformed a portfolio containing the stocks that replaced them. This finding contradicts the efficient market hypothesis since changes in the composition of the Dow are widely reported and well known. Our explanation for this anomaly is the market’s insufficient appreciation of the statistical principle of regression to the mean, an error that has been previously identified in a variety of contexts and is no doubt present in a great many other contexts.

This is fascinating research, which spans a period of close to 80 years. The main point behind this research is reversion to the mean. Basically, a trend can only go so far, until it is reversed. It goes in both directions of course.

I went ahead and obtained a listing of all the additions and deletions for Dow Jones since 2004. I then compared the five-year performance for an investor who bought the deletions of the Dow and for an investor who bought the additions to the Dow. For companies that were bought out, I basically stopped the clock at the acquisition date.

I did not calculate anything past 2019, since the information is still new.

I present to you the data below. Again, please understand that I am one person who did this data analysis using free resources, such as dividendchannel.com. My data may be incomplete, or missing fields. I am not pulling it from an academic database, like all the other researchers.

Out of 14 substitutions, the deletions did better on only 4 occasions. The additions did better on 10 occasions. The total wealth for putting $10,000 in each deletion was $180,609 versus $227,540 for putting $10,000 in each of the additions.

The most interesting factor for me however was that since the research was published in 2005, I have found that the opposite has been the case.

In other words, the companies that were deleted did not do as well as the companies that were added to the list. Perhaps this is due to the way that things move faster these days in the globalized economy. The pace of change is faster, and the level of obsolescence is increasing as well. This just goes to show that success in investing is not going to be based on some simple formula that we can copy and paste and generate instant riches.

Another interesting piece of information relates to International Business Machines (IBM). The company was replaced by AT&T on March 14, 1939. I do not believe researchers were even able to find a reason behind the decision.

IBM did not get back into the index until June 29, 1979. At that point, the stock had increased in value by 562 times, which is incredible. AT&T stock had barely tripled over that 40-year period. You may read this excellent article on Dow Jones 22,000 point mistake.

Source: Global Financial Data

I am mentioning this part in order to show that a large portion of the 1939 – 1979 outperformance of deleted companies over the added companies could be attributed to this decision.

By the time IBM was added to the index, it stopped growing. Chrysler was removed because it was very close to going under in 1979. It would have gone bankrupt, had it not been for Lee Iacocca, and a $1.2 billion bailout by the US Government. The stock went as low as $2/share in 1979, before rebounding all the way up to $50/share before the 1987 stock market crash.

This information comes from the book " Beating the Dow".

In conclusion, based on this study, someone who bought the companies that were deleted from Dow Jones Industrials Average between 1928 and 2005 would have done better than Dow Jones Industrials Index. That's because the companies that were deleted ended up delivering a better performance than the companies that were added over this 77 year period. 

However, strategies and edges on Wall Street are not carved in stone. Things do change, either permanently or stay irrational for far longer than a follower of the strategy may remain solvent. 

For example, if you look at performance of US Stocks versus International, US Small versus Large Cap, and Value versus Growth, you can see that they are generally cyclical. Those cycles can last many decades however. These long cycles may fool market participants that they are seeing a trend. Check the charts on this article " Dividends Are The Investors' Friend"

It is also possible that the excellent results of this reversion to the mean strategy may have been due to a fluke in the 1939 removal of IBM, which turned out to be a very successful corporation. It was further compounded by the removal of Chrysler, which turned out to rebound. What happened in 1979 with Chrysler may have caused an investor to buy General Motors in 2009, believing that they would experience the same type of turnaround. However, if you bought General Motors in 2009, you lost your entire nest egg. Again, history does not repeat, it just rhymes. This is why you have to learn from history, but you also have to realize that the same thing happening twice over a span of 30 years may have a totally different outcome. 

Update: August 09, 2022

It looks like the three additions have not done as well as Dow Jones Industrials Average since August 31, 2020 (the date changes took place). 

It also looks like the three deletions did much better than Dow Jones Industrials Average since August 31, 2020:

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Twelve Companies Committed to Returning More Profits to Shareholders

Companies that grow dividends tend to have better financial health and produce sustained earnings and revenue growth. Dividends help identify well-managed companies; every dividend declaration represents a promise by management and a vote of confidence by the board of directors in the company's leadership. Companies that consistently raise their dividend payouts also raise the bar on their own performance expectations. These dividend increases show the longstanding commitment of returning capital to shareholders for these companies. These increases also provide evidence that companies are executing on their long-term business strategies.

Shares of dividend-paying companies possess built-in value that makes them generally more resilient in down markets, with solid appreciation potential during earnings-driven market upturns — with less price volatility.

I follow the list of dividend increases weekly as part of my dividend investing strategy. I try to approach investing from different points of view, in order to ensure that I can see emerging dividend success stories and monitor existing holdings.

Over the past week, there were several companies that raised their dividends to shareholders. I am listing below the ones which have managed to grow dividends over the past week and also have at least a ten year track record of annual dividend increases. The companies include:

This list is not a recommendation to buy or sell stocks. It is simply a list of companies that raised dividends last week. The companies listed have managed to grow dividends for at least ten years in a row.

The next step in the process would be to review trends in earnings per share, in order to determine if the dividend growth is on strong ground. Rising earnings per share provide the fuel behind future dividend increases.

This should be followed by reviewing the trends in dividend payout ratios, in order to check the health of dividend payments. A rising payout ratio over time shows that future dividend growth may be in jeopardy. There is a natural limit to dividends increasing if earnings are stagnant or if dividends grow faster than earnings.

Obtaining an understanding behind the company’s business is helpful, in order to determine how defensible the dividend will be during the next recession. Certain companies are more immune to any downside, while others follow very closely the rise and fall in the economic cycle.

Of course, valuation is important, but it is more art than science. P/E ratios are not created equal. A stock with a P/E of 10 may turn out to be more expensive than a stock with a P/E of 30, if the latter is growing earnings and the former isn’t. Plus, the low P/E stock may be in a cyclical industry whose earnings will decline during the next recession, increasing the odds of a dividend cut. The high P/E company may be in an industry where earnings are somewhat recession resistant, which means that the likelihood of dividend cuts during the next recession is lower.

For a sample analysis of Illinois Tool Works (ITW), check here.

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Dividend Stocks versus Dividend ETFs

Readers often ask me about my favorite dividend ETFs. I do tend to prefer to build my own portfolios consisting of individual dividend stocks, over buying dividend ETFs. However, I realize that not everyone is like me.

I have listed several reasons why I prefer selecting my own companies over using a dividend ETF:

1) Cost

Buying individual stocks in the US is commission free. It doesn’t cost me anything to buy stocks in individual companies like PepsiCo, Johnson & Johnson or Lockheed Martin. In addition, it doesn’t cost me anything to hold on to individual companies in my portfolio. In comparison, ETFs have an annual charge, which can range dramatically. Paying 0.40%/year does not seem like much, but if you hold a portfolio worth $100,000, that’s $400 that goes out of your pocket each year. Over time, these fees can add up.

2) Portfolio holdings

When I select individual companies for my portfolio, I can control which companies to add and what criteria to use for inclusion. I can vary the number of holdings to as low or as high number as I choose. I can decide which types of companies can be included, and which don’t stand a chance. I can also decide when to remove a company and what to do with the proceeds. 

With ETFs, you are basically letting someone else decide what to include. You have to trust that they will follow their process consistently.

3) Portfolio Weights

I can decide how to properly weight my portfolio holdings. If investing a lump-sum, I can decide to allocate money equally between the number of holdings I have. I believe in giving each company I own an equal chance of success.

Most ETFs weight their holdings based on factors that make building an ETF easy for the ETF provider, not necessarily the best method for investors. For example, most ETFs are based on a market capitalization basis, which assigns the highest portfolio value to larger companies. 

Very often you see ETFs that may have 100 or more individual holdings. When you dig further however, you see that half of the portfolio value is concentrated in 10 - 20 companies, while the rest are just filler.

4) Portfolio Turnover

I have more control over turnover than a dividend ETF. For example, I try to be as passive as possible, because turnover costs in terms of commissions, taxes, fees, and opportunity costs. I try to avoid selling, for as long as the dividend is not cut. I would have turnover, as companies split, merge, get acquired, and cut dividends. But I have found that selling for other reasons has been a mistake for me.

I also like knowing that I own certain businesses, when I design a portfolio. With ETFs, I cannot say that the businesses I own would still be in the portfolio. For example, the Schwab Dividend ETF had Microsoft (MSFT) in 2016, but doesn’t have it today in 2022. The company is a quality one, and has kept raising dividends in the past 5 years. I am not sure why it was deleted, but in my opinion, this is not a good move. Not just because it did so well, but because it was removed for no reason in my opinion.

That being said, there are reasons for using ETFs. Of course, for some investors, ETF’s may have appeal.

1) Time Factor

The main reason someone may like investing in a dividend ETF is because they do not want to select any of the companies themselves, and are fine to delegate this responsibility to someone else for a recurring annual fee. Some folks do not feel comfortable selecting well-known dividend growth stocks, which is fine. It’s better to let a more qualified party select companies for you, than to end up selecing the wrong companies in the process.

2) Instant Diversification

One advantage of ETFs is that you get instant diversification at the click of one button, albeit at the cost of a recurring annual fee that would increase in dollar amount as your investment accounts grow. I would argue that today I can generate this instant diversification by selecting companies one at a time, but I do understand the appeal of clicking just one button versus say 50.

3) Re-Balancing

The biggest advantage of ETFs is that they do not generate any capital gains to shareholders when they re-balance their portfolios. In other words, if an ETF decided to eliminate a certain company from its portfolio, and realizes a capital gain in the process, its shareholders do not get taxed on it. However, if there is a loss when an individual portfolio holding is disposed of, the ETF shareholders won’t be able to take the loss for tax purposes. This tax discussion only centers around the ETF portfolio holdings. If you sell the ETF at a gain, you will pay tax in a taxable account; if you sell an ETF at a loss, you will get a benefit.

Conclusion:

I have tried to summarize the pros and cons of selecting my own individual dividend stocks versus selecting a dividend ETF. I have discussed this topic a few times on the blog too. You may check out the "Relevant Articles" below for more information on my thought process.

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