Wednesday, June 26, 2013

Dividend Growth Investing is a Perfect Strategy for Young Investors

Imagine your perfect day. You wake up when you are rested, without the need of any alarm clocks. You then do some working out , followed by having a nice healthy breakfast. You then read at your leisure, have a lunch later in the day to beat the 11:30 – 1 pm crowds, and then review your brokerage accounts. You notice dividends from several companies are deposited today, and you decide to transfer them to your checking account. You check for any major items concerning your portfolio holdings, and spend a few hours researching a new dividend stock.

After that you get more time to concentrate on your activities, be it volunteering at the local homeless shelter, mentoring high school students, learning a new language or simply catching up on some good books. Later that day, you might decide to enjoy a few with your mates/gals. This dream is brought to you by dividend investing.

This is my retirement dream in a nutshell. The reason I started Dividend Growth Investor blog in 2008, is to write down ideas on how to make it happen. I believe that dividend growth investing works for all investors, regardless of their age. However, I do realize that older investors might have a preference for higher yielding stocks, while youngsters like myself can afford to build portfolios across the yield spectrum.

One of the most common misconceptions about dividend investing however is that it is not a good strategy for building your nest egg, and therefore it is not suitable for younger investors. Being a youngster myself, I (not surprisingly) disagree.

Younger investors are typically told to take a lot of risks early on, because they have time to recuperate those losses. I find this saying to be very dangerous for young investors. The problem is that taking risk is important, but it should not be mean gambling. Investors should only be taking on large risks when they have a strategy with positive expectancy of a positive return, while risk is minimized. If you invest in penny stocks, social media stocks, or if you bought dot-coms during the tech boom of the late 1990s, you took huge risks but you were likely making concentrated gambles. There is a cost to gambling, because losing your entire nest egg of $10,000 at the age of 24 means you will be poorer by $800,000 by age 70. This calculation assumes a 10% annual return for 46 years.

In contrast, with a typical dividend growth strategy, you get a slow and steady approach that will lead to a monthly passive income that will pay your expenses in retirement. Starting out early will be beneficial, because you would gain the necessary experience through trial and error, and find out the nuances that work out for you. This would make you successful, and ensure you maintain your success in investing. A big part of investment success is not losing too much in your investment career.

With this dividend strategy, we are focusing not on net worth per se, but on target annual dividend income. If your goal is to have a net worth of $1 million dollars, but you end up investing it in a relatively illiquid asset such as a personal residence, you might not be able to retire entirely on it. In some parts of the US, you might have to pay $20 - $30 thousand in annual property taxes plus paying for upkeep, maintenance etc. If instead you had a rental property generating $4,000 in monthly income or a portfolio of dividend stocks generating a similar amount, you might be set for life.

I believe that a new investor who does not have a lot of money today but who plans on accumulating their “financial nut” over the next years will be perfectly able to utilize dividend growth investing. With this strategy investors turbocharge the dividend income growth of their portfolios by putting money to work every month in stocks that regularly boost dividends, and then reinvesting those dividends selectively.

Since 2008, I have been on a mission to build up my portfolio income. Every month, I save an amount of money that I deposit in my brokerage account. I scan the market for investment opportunities all the time, followed by analyzing prospective investments. I identify dividend stocks for further analysis either by running my screening criteria against the dividend champions or contenders lists, by looking at weekly list of dividend increases as well as through interactions with other investors and the general method of my inquiry into business.

I do a complete stock analysis of each company I find interesting, in order to gauge whether the company in focus has any competitive advantages, pricing power and whether there are any catalysts for further expansion in revenues and profitability going forward. I focus on companies that can grow earnings over time, which will provide the fuel for future dividend increases. A rising earnings stream is also positively correlated with an increase in stock prices. You can have your cake and eat it too with dividend growth stocks.

My goal is to acquire the quality companies identified for purchase at attractive valuations. Entry price does matter to an extent, because a lower price provides a higher margin of safety in the investment and is equivalent to a higher dividend income. Of course, if you plan on holding stocks for 20 – 30 years however, it would not really matter whether you purchased Johnson & Johnson (JNJ) at $70/share or $75/share. If you overpay today however, it might mean that your returns in the first five years might be below average, until the growing earnings result in a valuation compression that would make the stock attractively valued today.

For my personal portfolio, I try to generate annual dividend growth in the 6-7% range on aggregate. My portfolios also yield approximately 3.50% – 4%. I achieve these aggregate figures by stacking three different types of dividend growth stocks, for maximum results. So far, I am able to cover approximately 50% of my expenses from my dividend income.

A few good picks include:

Coca-Cola (KO) engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. This dividend champion has increased distributions for 51 years in a row. Over the past five years, Coca-Cola grew distributions at a rate of 8.40%/year. Currently, the stock is trading above the 20 times earnings limit I have set for myself, but yields a very respectable 2.80%. Check my analysis of Coca-Cola.

Phillip Morris International (PM) manufactures and sells cigarettes and other tobacco products. The company has managed to grow distributions by 13.10%/year since the spin-off from parent Altria Group (MO) in 2008. I like the economics of the tobacco business, without the liability stemming from doing business in one country. PMI's revenues are generated outside the US, and therefore are not dependent on a single country's onerous laws on smoking. Currently, the stock is trading at 16.60 times earnings and yields 3.90%. Check my analysis of PMI.

Kinder Morgan Inc (KMI) is the general partner of Kinder Morgan Partners (KMP) and El Paso Pipeline Partners (EPB). It also owns limited partnership interests in KMP and EPB.  The most important asset is the incentive distribution rights structure, which provide for a 50% share of any future distirbutions growth over a certain threshold for KMP and EPB. Given the growth projections for energy assets in the US, and Kinder Morgan in particular, this stock can achieve high single digit dividend growth for at least the next five years. Currently it is yielding a very attractive 4.20%.

Procter & Gamble (PG) engages in the manufacture and sale of a range of branded consumer packaged goods. This dividend king has increased distributions for 57 years in a row. Over the past five years, Procter & Gamble has managed to boost distributions at a rate of 12.20%/year. Currently, the stock is trading at 17.20 times earnings and yields a very respectable 3.10%. Check my analysis of Procter & Gamble.

Let’s see how a portfolio stacks, where a young dividend investor puts $3000/month in 4% yielders that grow at 6%/year.

After five years with this approach, you would be earning $750 in monthly dividend income. Ten years after starting this strategy you will be earnings $2,000 in monthly dividend income. Fifteen years after beginning your dividend investment journey, you will be making almost $4,000 in monthly dividend income. This slow and steady approach is very boring, and it is not as exciting as tripling your money in Tesla (TSLA) in less than a month. However, more investors who focus on long-term wealth accumulation potential of dividend growth stocks will be better off than investors who gamble on the next big growth stock.

An investor with a vision will look beyond the 3%- 4% current yields today, but look at the potential for higher distributions over time. An investor that starts small at a young age, builds a diversified portfolio of income producing securities with growing distributions when valuations are right, reinvests these rising distributions into more stock and continuously adds to his portfolio, will achieve wealth at a relatively young age.

Full Disclosure: Long KMI, KO, PM, PG, JNJ, KMR

Relevant Articles:

Check Out the complete Archive of Articles
Dividend Stocks for Young Investors
My Dividend Retirement Plan
Dividend Growth Strategy for Retirement Income
Buy and hold dividend investing is not dead
- Carnival of Personal Finance #421

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