Wednesday, January 8, 2014

Achieve Financial Independence with Dividend Paying Stocks

My dividend retirement plan will be achieved at the time when my dividend income exceeds my monthly expenses. In a previous post I mentioned that I am close to covering approximately 50% of my expenses from my portfolio distributions. While achieving financial independence is important, maintaining and growing your dividend income  for several decades after that, is even more important.

In order to achieve and maintain financial independence, I generally try to follow several common sense principles.

1) I try to purchase quality dividend stocks at attractive valuations
2) I try to purchase quality dividend stocks which have sustainable distributions
3) I try to purchase quality companies that will grow earnings and dividends
4) I try to diversify my portfolio by holding at least 30 companies in as many industries as possible
5) I have an exit plan for each stock I purchase
6) I continuously study the lists of consistent dividend payers and analyze potential portfolio additions regularly
7) I analyze the companies I own at least once per year in a great detail

I define quality companies as those that have some sort of competitive advantages or wide-moats with strong pricing power. The companies typically have strong brand names, are market leaders in their niches, have patents or geographic monopoly in certain areas, or are the lowest cost provider of goods/services. Other characteristics of quality companies include high switching costs to move to a competitors.

I typically try to acquire such companies when they have achieved at least a decade of consistent dividend growth and trade for less than 20 times earnings. If their dividend yield is above 2.50% and they have a sustainable dividend payout, that makes me determined to study the company’s financials more in depth. I essentially try to determine whether the company would be able to achieve earnings growth over time, whether organically or through acquisitions. There are several companies in my portfolio such as Clorox (CLX), ONEOK Partners (OKS) and Coca-Cola (KO) which have outlined strategies to hit specific earnings targets within a defined period of time. Once I learn as much as possible about a company, and I have determined that it is a quality company that has a great chance of growing earnings and dividends and which is also attractively priced at the moment, I log on to my brokerage account and buy shares.

I would then hold on to these shares until one of these three events happens. The event that typically makes me want to sell stock has been dividend cuts or eliminations. I automatically sell after an event like that, and try to reinvest proceeds into another company that is attractively priced. This is where my continuous research of the list of dividend growth stocks comes in handy, because it enables me to have a list of 20 - 30 stocks at all times that could fit my criteria for inclusion in my portfolio. The average retirement could last for two – three decades. Over the course of this period, one could reasonably expect that the composition of their income portfolio would be different in year 31 in comparison with the portfolio composition in year one. If a company that I own is not in buy territory anymore, I do not sell its shares, but hold on to them. I would only consider selling if the company is severely overvalued and I have found similar prospects that would provide me with a better income growth over time. One such example was when I replaced most of my position in Con Edison (ED) with shares of ONEOK Partners (OKS).

I try to maintain a portfolio of at least 30 individual dividend paying stocks, which should be spread out between as many sectors that make sense. However, I would not add stocks in a dying sector such as newspapers or cyclical stocks such as General Motors (GM) or Ford (F) just for the sake of diversification. I now hold over 40 individual stocks in a material to my portfolio way. Each of those has varying portfolio weights, because some of the companies have been attractively priced early in my accumulation process, but have been overpriced ever since. As a result, I have allocated new funds and dividends generated by my portfolio into the best picks at the time funds were available. Contrary to popular belief, it does not take a lot of time to keep up with a dividend portfolio consisting of 40 -50 individual issues. This is because as a long-term investor, I purchase shares after doing a large amount of research behind each idea. As a result, I get to update my knowledge through my annual stock analysis of a stock. I gather data by looking at annual and quarterly reports, analysts’ reports and general news. As a long term investor, one notices that there are not a lot of things that materially change from year to year. For example, Wal-Mart (WMT) has been a retailer for over forty years, and McDonald’s (MCD) has been a fast-food company for many decades as well. It is true that each year these companies are facing different challenges ahead, but at their core they are very much unchanged. This is another reason why investors should spend a lot of time upfront educating themselves how a company generates money.

In addition, I also try to diversify, in order to decrease my reliance on the dividend stream from a few bad apples. In a concentrated portfolio of 10 securities which is equally weighted, a dividend elimination by one of the companies will lead to a 10% decrease in total dividend income. In a portfolio of 40 stocks, if one company eliminated distributions, it would result in only 2.50% decrease in dividend income. At the end of the day, even if the remaining stocks managed to grow dividends by 11%, my total dividend income would be unchanged. In the second portfolio, if the remaining companies managed to raise disitrbutions by at least 2.50% my total dividend income would be unchanged for the year. Given the fact that historical dividend growth has been around 5% per year, I believe that it is much safer to assume that 10% growth is too optimistic. As a result, I would much rather have my portfolio generate a stream of income coming from many stocks rather than few.

Full disclosure: Long all stocks mentioned above

Relevant Articles:

Dividend Investing Goals for 2013
My dividend crossover point
Dividend Paying Stocks for Retirement Income
How long does it take to manage a dividend portfolio?
Dividend Investors – Do not forget about total returns

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