Monday, November 24, 2014

How to turbocharge dividend growth

Once an investment is made, and assuming no new money is put to work, there are four levers to help an investor reach dividend income goals:

1) Attractive entry price

The importance of the entry price cannot be overstated. Even the best company in the world is not worth overpaying for. It matters a lot that you can acquire those shares at low valuations, which ensures better entry yields. For example, if you bought Coca-Cola (KO) in 1999 at $23.50/share, you would have paid over 30 times earnings and received an initial yield of about 1.30%. Despite the fact that earnings and dividends increased rapidly, your yield on cost did not go that much higher than 5.20% although you did earn some capital gains in the subsequent 15 years. You would have been better served putting that money in REITs, oil companies or tobacco shares, which were cheap at the time and had better starting yields. Therefore, when you buy shares, it pays to always pick the ones with the cheapest valuations. Quality should never be sacrificed, but if you make a purchase at a cheap enough price, you can earn a decent return even if growth projections turn out to be poor. For example, I bought ED in 2008 – 2009 at really low valuations and entry of 6%. In hindsight, this was a mistake since the dividend was growing slower that inflation. But I still earned a high return despite that, and once I realized the mistake I sold and redeployed capital elsewhere.

2) Dividend growth

Dividend growth is the second important component in turbocharging the dividend income. A company that is cheap, and manages to grow dividends is a must to invest. Even if you spend your dividend income each year, your dividend income still increases. For example in 2004 Coca-Cola sold for 20-21 times earnings and yielded close to 2.50%. Since then the dividend income would have more than doubled by now, rising from 50 cents/share in 2004 to $1.22/share by 2014. Historically, dividends per share on US stocks have grown by 5%- 6%/year. This has beaten inflation, and ensured that the purchasing power of your passive income is maintained.

3) Dividend reinvestment

Another important component to grow income is the power of dividend reinvestment. Let’s assume a scenario where you have a company that yields 3% today, which manages to grow dividends by 7%/year and you spend all your dividend income. In this case, using the rule of 72, you will end up with double the dividend income in a decade. However, if you decided to reinvest those dividends into more shares yielding 3% and growing dividends by 7%/year, your dividend income will double in approximately seven years. It is important to treat reinvestment carefully however, and be mindful of valuations when doing so. In some cases, it might only be cost effective to automatically reinvest dividends, particularly if the position is only a few hundred dollars for example. In other cases however, it might be preferable to accumulate cash dividends for a month, and then put that amount to work in your best ideas at the time. This would work if you generate $600 - $800/month in dividend income.

4) Tax advantaged growth

Two things in life are certain – death and taxes. Investors who receive dividend income and are in the 25% tax bracket have to pay 15% tax on qualified dividend income. This reduces the amount of money one can feed their dividend machine. In order to reduce the effects of this obstacle, many dividend investors place their stocks in tax-advantaged accounts like Roth IRA’s. As a result, their dividends grow tax free, and therefore they could reinvest the whole amount into more dividend paying shares. If you are in the 15% tax bracket however, this means your qualified dividend income is essentially tax free.

The four points discussed above could be best illustrated by a small investment I made in Kinder Morgan Energy Management LLC (KMR) in 2009. This was one of the smartest investments I ever did, and hit the four points perfectly. I was bullish on the Kinder Morgan Partnership (KMP), which was a dividend achiever that offered sustainable current yield, and high distributions growth. I liked the prospect for high distributions growth and high current yields. However, I noticed that KMR was selling at a discount to KMP. KMR was equivalent to KMP in every single economics way, with the only exception being that it paid distributions in additional shares, and not in cash. Some investors disliked this idea, which explained why KMR was always cheaper by 5%-10%. In addition, since the distributions were payable in additional shares of KMR, this meant that IRS saw them as stock splits and considered them tax-free as long as the investor held on to shares. I thought of buying up KMR since I am in the accumulation phase, and then if the gap narrowed to sell and buy the limited partnership units and live off those distributions. For each dollar invested in August 2009, with distributions being reinvested tax-free at KMR that was selling at a massive discount, I ended up with approximately $2.80. Thus, an investment of $1000 back then would have turned into approximately $2800 today. Once the acquisition by Kinder Morgan Inc (KMI) is performed, and each of my shares of KMR is exchanged for 2.4849 shares of Kinder Morgan Inc, this small investment will result in an yield on cost of over 13% at the current rate of $1.76/share. At the $2/share annual dividend that is expected by Kinder Morgan Inc in 2015, that $1,000 investment in 2009 will generate close to $150 or a 15% yield on the amount invested. Not too shabby if you ask me.

As we all know however, Kinder Morgan Management LLC (KMR) is about to stop trading, since its shares will be exchanged for shares in Kinder Morgan Inc (KMI).

A recent example was the purchase of shares in several companies in tax-advantaged accounts such as Roth IRA and Sep IRA. I plan on maxing out the Roth IRA in 2015, and the SEP IRA, along with the 401 (k) and a newly started Health Savings Account. When you get the powers of compounding withing a tax-deferred vehicle, the results are truly spectacular.

Full Disclosure: Long KMR, KMI, KO,

Relevant Articles:

- Kinder Morgan to Merge Partnerships into One Company
Kinder Morgan Limited Partners Could Face Steep Tax Bills
Kinder Morgan Partners – One Company three ways to invest in it
How to buy Kinder Morgan at a discount
Two and a half purchases I made this week

5 comments:

  1. This is a really good article, could not agree more! One of my main tenet's of investing is "price matters". Does anyone want to buy a dividend stock that returns let's say 4% annually and have the share price be down by 10% or more, then wait years to recover the loss in share price, no. "The price you pay determines your rate of return" is what famed investor Benjamin Graham taught and what his student Warren Buffet lives by. After that comes valuation, earnings growth, dividend growth, deferring taxes and the power of compounding. Thanks for your post.

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  2. Great examples. I have been doing all of the above and I am seeing very nice dividend increases and dividends. TY

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  3. All good points. I would emphasize when your starting out it is important to just automatically reinvest those dividends. Like DGI said it may take a while before your pulling in enough monthly dividends to offset any trading fees.

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  4. DGI,
    My wife and I took tax advantaged to an extreme when we were younger and funded my 401k and our Roth IRAs with the funds in our after tax stock portfolio. It wasn't a whole lot at the time, but maximizing the tax deferred accounts, including some after tax savings in the 401k, have meant that all of our gains have had the taxes deferred for the last two decades.
    Thanks for another great article,
    KeithX

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  5. For me, the 4 levers are in order of importance. Entry price is the main one. Cheers!

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