Wednesday, June 8, 2011

Lifecycle of the dividend investor

Dividend stocks have traditionally been the investment vehicle for investors who are looking to generate a sustainable income stream from their capital. As a result they have a strong appeal amongst retired individuals for several reasons. In recent years however many investors have started to realize that these boring companies with predictable earnings and dividend streams tend to deliver strong total returns in addition to rewarding patient shareholders with regular dividend payments. The main reason behind this is that dividend stocks are typically not overpriced, and as a result offer more value for the investors dollars in comparison to high-flying but volatile growth stocks. With the implosion of the bubbles over the past decade, even younger investors are starting to realize that dividend investing could deliver strong total returns over time.

There are several stages which investors go through in their dividend investing endeavors. Most of these stages are governed by the individuals age, but some could be dictated by the investing experience of each investor.

The first stage could be broadly defined as the accumulation stage. Investors save money and put a certain amount towards dividend stocks. They reinvest dividends into additional shares and build their portfolio slowly over time. These investors are typically investing for growth, as they expect double digit yields on cost a few decades after making their purchases. Companies which appeal to such investors today include:

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised dividends for 48 years in a row and currently yields: 2.80% (analysis)

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), provides supplemental health and life insurance. The company has raised dividends for 28 years in a row and currently yields: 2.60% (analysis)

Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. The company has raised dividends for 38 years in a row and currently yields: 1.90%(analysis)

The Clorox Company (CLX) engages in the production, marketing, and sales of consumer products in the United States and internationally. The company operates through four segments: Cleaning, Lifestyle, Household, and International. The company has raised dividends for 34 years in a row and currently yields: 3.60% (analysis)

McCormick & Company Incorporated (MKC) engages in the manufacture, marketing, and distribution of flavor products and other specialty food products to the food industry worldwide. It operates in two segments, Consumer and Industrial. The company has raised dividends for 25 years in a row and currently yields: 2.30% (analysis)

Walgreen Co. (WAG), together with its subsidiaries, engages in the operation of a chain of drugstores in the United States. The company has raised dividends for 35 years in a row and currently yields: 1.60% (analysis)

The second stage is the distribution stage. Investors who have accumulated a diversified portfolio of income producing securities are living off the dividend stream in retirement. The dividend income is sufficient to cover annual expenses. As a result the dividend investor does not have to sell any stock in their portfolio. This lessens the risk that the retiree will outlive their assets as they would not have to sell stock to cover expenses during bear markets.
Companies which might appeal to such investors are typically the ones that yield more than the market.

Kinder Morgan Energy Partners, L.P. (KMP) owns and manages energy transportation and storage assets. The company has raised dividends for 15 years in a row and currently yields: 6.20% (analysis)

AT&T Inc. (T) , together with its subsidiaries, provides telecommunication services to consumers, businesses, and other service providers worldwide. The company has raised dividends for 27 years in a row and currently yields: 5.60% (analysis)

Consolidated Edison, Inc. (ED), through its subsidiaries, provides electric, gas, and steam utility services in the United States. The company has raised dividends for 37 years in a row and currently yields: 4.60% (analysis)

Universal Health Realty Income Trust (UHT) is a real estate investment trust (REIT) which invests in health care and human service related facilities. The company has raised dividends for 22 years in a row and currently yields: 5.80% (analysis)

The problem with the higher yielding approach is that it limits the choices for creating a diversified dividend portfolio to sectors such as Utilities, Master Limited Partnerships, Real Estate Investment Trusts and Telecom. Financials used to be a favorite sector for dividend investors, given their high dividend yields and long histories of dividend growth. The financial crisis of 2007-2009 made many investors reassess their portfolios and include other sectors in it.

Investing purely for dividend growth without taking into consideration current yields also has its own risks of course. It is extremely difficult to predict which company would be able to grow distributions at the same rate as it has done in the past. As a result low yielding dividend stocks which fail to raise distribution quickly enough could result in low yields on cost for a longer period than investors could tolerate. Low dividend stocks could also experience a higher volatility in their stock prices as well.

As a result, many investors are using a blended approach of high yield stocks with low dividend growth as well as lower yielding stocks with higher dividend growth. This way investors could position themselves to not only generate sufficient income today, but will also be able to grow that income over time in order to offset the eroding power of inflation.

Full Disclosure: Long all stocks mentioned above except BDX and T

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This article was included in Carnival of Personal Finance #313.

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