Friday, October 30, 2015

How to Increase Dividend Income

I expect that this year, I will be able to cover something like 60 - 80% of my targeted annual expenses from dividends alone. This means that my forward dividend income will cover 60% - 80% of my expenses. My forward dividend income is the amount of dividend income I will receive over the next year from investments I have today. It assumes no reinvestment of dividends and no new capital being added.

I believe that sometime around late 2018, my forward dividend income will be able to exceed my target monthly expenses and also have a neat little margin of safety as well. A margin of safety is important, because I want to have the luxury of never having to work for money again. A retirement where I have to spend time at a low paid part-time position does not seem appealing to me. This is why I believe generating a little more in dividend income than I need to is important, even if that means working an extra year.

As I get closer to the finish line, I am starting to get a lot of ideas on how to increase dividends faster. You might remember this post that I wrote over an year ago. I think it is time to re-visit the ideas, and add some more meat.


Before I get down to basics, I want to say again what I am looking for from my dividend portfolio. I expect to generate a stream of dividend income which grows above the rate of inflation. The majority of dividends from my portfolio should be coming from at least 50 – 60 individual dividend paying stocks. The portfolio should include as many industries that make sense. Each of those companies should be growing earnings to pay the rising dividend, and should have a payout ratio that is sustainable. I believe that a reasonable dividend yield in today’s world for US stocks is around 3%.

Now I will start getting down to basics. In order to increase dividend income, an investor can do several things:

1) Buy more stocks that pay dividends

The easiest way to increase dividend income is by buying more shares that pay dividends. For the past eight years, I have meticulously saved money and invested them in income producing assets such as dividend growth stocks. For example, I recently saved some money to be able to invest in VF Corp (VFC) and Target (TGT). The downside is that you need to be able to get capital to allocate. We all know that it takes time to save and invest enough each month, before this portfolio can generate enough dividend income to actually live off of. This process can easily take anywhere from ten to twenty years of saving a lot and investing every single month. Of course, once you are retired, you will not be earning much money. Therefore, your income will not be able to increase this way.

2) Reinvest dividend income into more dividend paying stocks

Another easy way to increase dividend income is by reinvesting dividends. A stock like Verizon (VZ) that pays a 5% dividend, where dividends are automatically reinvested, will produce more dividend income every single year to its shareholders. The problem of course is that if you need to live off income in retirement, you will not be able to grow dividends by much. Given the ten year dividend growth rate of 3.30%/year, this mostly keeps up with historical levels of inflation.

3) Sell existing holdings and purchase higher yielding ones

This is one thing that many investors have asked me about on the site. I am usually against this strategy, because it usually involves selling lower yielding companies today in order to buy a higher yielding company. If you sell an appreciated investment, you will end up paying steep capital gains taxes.The problem is that the lower yielding company can provide growth in dividends and sustainable dividends due to a lower payout ratio. Furthermore, those companies can provide you with a higher potential for capital gains. This is because lower yielding companies typically tend to grow earnings faster than normal.  The higher yielding companies in my view are usually riskier because they are flow-through entities (REITs, MLPs, BDCs), and as such pay almost all of their cashflows as distributions. This is all fine and dandy, until there is a recession, and many of those companies are pressured to cut distributions because of a temporary decreases in profits.

In other words, replacing lower yielding for higher yielding stocks is destined to change the risk profile of your portfolio ( hint: It will make it riskier because you will be holding companies which could crumble under similar circumstances such as rising interest rates or lack of cheap access to financing or change in favorable tax treatment of corporate structure). It is yield chasing, and I think that this is a dangerous situation to be in. In addition, when you sell all your lower yielding securities, your dividend income will no longer be able to grow by much.

4) Buy stocks that grow dividends over time

As evident by the title of the blog, I favor companies that grow dividends over time. This is because when I retire, I may not work for money again. As a result, I need companies that will grow dividends on their own, and will have the business models to support growing those dividends over time. This is why organic dividend growth is so important to me, and why I spend time researching companies in order to determine valuation, whether earnings have been growing, and whether the dividend payout is sustainable.  A prime example is Johnson & Johnson (JNJ), which has raised dividends for 53 years in a row, and will likely keep raising them for years to come.

There is of course a trade-off between yield and growth as I have mentioned before. I do tend to mix and match companies in the three different types of dividend companies. I also try to avoid purchasing companies that just raise dividends nominally for the sake of raising dividends. I want a decent yield today, and an adequate dividend growth in the future.

Obviously, a company that yields 2% better have a growth above 7%. At the same time I cannot expect double digit growth from a company yielding 5% - 6% - a 3% distribution growth to match rate of inflation should be satisfactory over time ( as long as it is supported by fundamentals of course).

5) A combination of all of the above

As usual, the best outcomes should not be a polarizing this or that, and nothing else. I have found that a solid mix of adding fresh capital monthly, reinvesting dividends selectively, and then passively holding for the long-term is the best situation to be in. I have also found that failing to take advantage of tax-deferred accounts such as a 401 (k) or a Roth IRA could prove to be costly down the road. It is much easier to compound your money when you get a hefty tax-break upfront, and tax-free compounding for decades. As I have mentioned before, I try to keep three different types of dividend growth stocks. My portfolio is like a symphony - each company in it has a role to play and together they make beautiful, income producing music.

What strategies have you employed to grow your income?

Thanks for reading!

Full Disclosure: Long VZ, JNJ, VFC, TGT

Relevant Articles:

Types of dividend growth stocks
How to increase your dividend income with these four companies
How to buy dividend paying stocks at a 25% discount
Taxable versus Tax-Deferred Accounts for Dividend Investors
Why I am a dividend growth investor?

27 comments:

  1. Finally sold BAX and BXLT this week to swap their puny 0.70% dividends for a utility paying over 4.5%. This increased my monthly income by $40. But I'm keeping Visa (V) and its 0.71% dividend due to its future dividend potential. Thankfully no taxes (yet) in an IRA.

    ReplyDelete
    Replies
    1. I always sell after a dividend cut – I did so with BXLT and BAX. I agree Visa has the potential to grow earnings/dividends/intrinsic value rapidly in the future.
      It is smart to hold equities in an IRA/Roth IRA

      Delete
  2. Thanks DGI , ì saw some investors using covered call option to increase yield , what do you think about that ?

    ReplyDelete
    Replies
    1. Hi Ahmed,
      I buy stocks to hold, and collect dividends, not to “rent them”. I also don’t like to limit my gains – selling covered calls for a tiny bit of premium accomplishes exactly that.

      Delete
  3. "This means that my forward dividend income will cover 60% - 80% of my expenses."

    Wow. Awesome. That's what investing means to me - cash flow from investments cover expenses. I'm a long ways away based on my burn rate but I hope to surpass $12k for 2016.

    Keep up the great work. Money that makes money, makes more money.

    Mark

    ReplyDelete
    Replies
    1. Hi Mark,

      Dividend income is more stable and more predictable than capital gains. It is so much easier to make retirement income projections based on dividend income alone.

      I agree that once that dividend snowball reaches $1,000 in monthly dividend income, there is no stopping it..

      Delete
  4. Thank you DGI for sharing your knowledge,

    I am in the early stage of dividend investing, currently generating around $5900 dividend per year. My goal is to get $25 000 per year dividend income to declare my financial independence day.

    I still have time (8 1/2 years left) in my goal. My strategy is dividend growth for now, not high yield.

    Cheers,
    FJ

    ReplyDelete
    Replies
    1. Hi FJ,

      It is impressive that you are earning $500/month in cash dividends. You are able to cover almost a quarter of expenses with dividend income alone. If you reinvest those growing dividends, I wouldn’t be surprised if your portfolio generates $12,000 in annual dividend income in 9 -10 years. And if you add money regularly to it, you will get closer to your goal in no time.

      I have found that I usually get burned when I reach for yield. This is why I focus on dividend growth

      Good luck on your finance journey!

      DGI

      Delete
  5. Selling existing holdings and purchasing higher yielding ones is probably the most underrated, as many dividend investors tend to "fall in love" with their holdings. I would recommend other investors to review their portfolio and each holding every 6 months and try to optimze according to the changed metrics.

    Dividend Freedom

    ReplyDelete
    Replies
    1. Hi Dividend Freedom,

      I agree that investors should not fall in love with a company, and should have an exit plan. However, I also know that frequently trading shares back and forth is usually a mistake that doesn’t add value.

      I agree that investors should review their holdings regularly. However, I disagree about the 6 month period – for a long term investor who will hold shares for many years, a period of 6 months is mostly noise. Perhaps doing so every year or so might be helpful. My job is to pick companies, and let managements do their work – I don’t want to micromanage them.

      I also disagree about selling a company to buy another in an effort to boost yield for the sake of boosting yield. Selling stock has been one of the biggest mistakes I have made – resulting in lost opportunity cost and more costs for taxes and brokerage fees.

      Thanks for stopping by and commenting!

      DGI

      Delete
  6. DGI...

    I agree with everything that you do to ingress you dividend income. One other thing I personally do is sell covered calls and cash secured puts to increase my income. I strongly believe in multiple streams of income Abe write about that on my site. I wish you the best and keep posting. I love your articles.
    Respectfully,
    Dennis McCain
    Dennismccain.weebly.com

    ReplyDelete
    Replies
    1. Hi Dennis,

      Thanks for stopping by. I do agree that having multiple streams of income is helpful.
      I am not a fan of selling covered calls, because the premium I receive is at the expense of future dividends and capital gains. I do not like to take all the risk of stock ownership, and limit my upside, while leaving all the downside wide open.

      I am a fan of selling puts however, particularly on stocks I like, and at effective prices that are lower than today’s.

      Best Regards,

      DGI

      Delete
  7. Great summary of ways to increase dividend income! I think the risk profile of a portfolio is an important factor to consider and I know I'm not giving enough attention to that aspect! I respect your stance on cutting a holding when the company cuts its dividend. Perhaps I should start leaning in that direction!

    ReplyDelete
    Replies
    1. Yep, risk profile and diversification are important. Having an exit plan is important.

      Thanks for stopping by and commenting!

      DGI

      Delete
  8. Covering 60-80% of your income with dividends will be awesome, great job! We're definitely doing all of the above except for #3.

    ReplyDelete
    Replies
    1. Thanks for stopping by and commenting Tawcan! How far along are you on your FI journey?

      Delete
  9. DGI,
    I am impressed at how cogent your writing has become in the last 3 years since I started reading your blog. I guess that I personally fall into category 5, all of the above. I wouldn't necessarily advocate that others buy and sell, but being retired allows me to watch for stock moves and take advantage of them a whole lot more than when I was at work. Since I haven't fully invested all of our funds yet, I don't have to sell to buy something else (although I am not philosophically opposed to the idea). To give an example, I bought VFC at $63 a week ago when the market overreacted to the earnings report. I have wanted to own shares for the longest time, but could never get in at a reasonable valuation before. Goal achieved!

    A couple of ideas for you to consider: ICE and UNH. Might not be your cup of tea, but I like the long term prospects for both companies and opened starter positions in them this week.
    Best wishes,
    Keith

    ReplyDelete
    Replies
    1. Just to update, I decided not to invest in ICE. I am concerned that a significant decline in the market will take this down with it. But I did open a position in UNH. I like healthcare in general and managed care was previously not a part of our portfolio. Value Line gives it a safety rating of 1 and it has an S&P credit rating of A, so I am comfortable that it is a strong entity.

      Delete
    2. Ahh, thanks for the kind words.

      I analyzed UNH a few months ago and bought a very very little there. The position could grow in the future.

      Thanks for stopping by. I am glad you are keeping busy in retirement. What percentage of your assets are in cash/fixed income today?

      Delete
  10. "I expect that this year, I will be able to cover something like 60 - 80% of my targeted annual expenses from dividends alone."
    Good article! Just curious, is your 60-80% after taxes?

    ReplyDelete
    Replies
    1. Hi Bernie,

      This is gross dividend income. Some of the income is in tax-deferred accounts. In the US, a single person earning $30K in annual dividends will not pay any taxes ( ~$70+K for a couple)

      DGI

      Delete
  11. Good job. My own dividends are almost there too. I am close to $2K a month, so it is enough for a bare existence living. Luckily the rentals are performing well too.

    ReplyDelete
    Replies
    1. You have done a great job accumulating a sizeable nest egg with stocks and rentals. And your retirement date is less than 8 months away! That must be exciting!

      Ownership of direct deal estate is one asset class I know nothing about ( which is somewhat mitigated by my exposure to REITs)

      Best Regards,

      DGI

      Delete
  12. Great post. I agree with not reaching for yield as I have also got burned doing that with common stocks. One method I've employed for a portion of my portfolio is buying preferred stocks in an IRA. Some payout 6-7% and are still pretty safe, now that it lower than common stock total returns but it serves as a cash substitute. I. The recent correction dividend growth stocks like JNJ and UTX which I added to fell precipitously, but most preferred stocks barely budged, so I sold off a portion of them to add to dividend growth stocks. When I have trouble finding good values for dividend Growth stocks I plan to add more to preferred stocks as a cash substitute without sacrificing a lot of return

    ReplyDelete
    Replies
    1. Thanks for stopping by and commenting. Most preferred stocks are in the financial sector, so you have to watch out for sector concentration risk. If interest rates go up, those fixed dividends could be seen as less valuable. The nice thing is that I believe those preferred dividends are taxed as qualified dividends ( though it probably doesn't matter to you in your IRA)

      Good luck in your investing journey!

      DGI

      Delete
  13. The selling of (overvalued) positions is perhaps one of the things I need to pay more attention to. With hindsight bias, holding on to my YUM shares as the P/E ballooned from the mid-20s to more than 45 over the span of the last year was a pretty stupid move on my part.

    ReplyDelete
    Replies
    1. Hindsight is always 20/20... I believe that time in the market is more important than timing the market

      Delete

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