Monday, August 15, 2016

My own unique approach to investing for retirement

Last month, I discussed with you reasons to have your own unique investment strategy. I reached the following conclusion:

If you follow someone into a security, you are giving up control over the selection process. You may know when the other person purchased the security, but you do not know when they will sell it. You have no visibility as to why they bought the stock. This is dangerous, because you may be the last person to be notified when the stock is to be sold. You are also not learning anything, because chances are that the other person has not shared all of the relevant points with you. When you make investment decisions without any input on your own, you are like a blind person driving on a highway. The problem is that noone has your best interests at heart, than yourself. Actually, many people have an incentive to deceive you and sell you on to a product or service that will enrich them at your expense.

When you focus on others, you may be able to get lucky from time to time. But this is not a good foundation for your retirement investing.

I prefer to focus on dividends, because the data has proven that dividends always provide a positive and more stable portion of total returns. As a component of total returns, dividends are more dependable than capital gains. My analysis shows that the capital gains portion of returns are not reliable in the short-run. By short-run, I mean any period ranging from  5 to 10 to even 15 years. You may not know this, but I plan to retire one day and live off my nest egg. I have found that if I spend my dividend income in retirement, I will never run out of money. Since dividends are always positive, they rarely decline, and they grow faster than the rate of inflation over time, they are a perfect source of retirement income for me.

My goal is to live off dividends in retirement. Dividends are more stable than capital gains, they rarely go down in a diversified portfolio of dividend stocks, and they produce dependable cashflow deposited in my account at regular intervals of time. I have a high level of confidence into the amount and timing of dividend cash. As a retiree, I will have to get cash from the portfolio quite often. If I were to sell stocks to live off, I will be dependent on short-term stock price fluctuations. If share prices happen to be low when I need to sell them, I cannot afford to wait. Selling shares in retirement to live off is the opposite of dollar cost averaging. I view dollar cost averaging as a good thing - but the opposite not quite so much.

I have found that companies that manage to raise dividends for at least a certain number of years do so, because they have a business model that allows them to grow earnings, and generate a lot of excess cash flow. Most of these companies have some sort of a competitive advantage, which allows them to generate high returns on invested capital. This allows these companies to generate more money than they know what to do with it. The outcome of this uniquely successful business model is a a long string of regular dividend increases, while earnings are growing as well.

In my dividend strategy, I focus on companies that have managed to grow dividends for at least ten years. Some use a minimum requirement of 5 consecutive years of dividend growth, while others use a 25 year requirement of annual dividend growth. I use ten years, because this period covers two average economic cycles. With this parameter, my goal is to reduce the number of eligible companies for research, who may have managed to grow dividends by being at the right place at the right time, rather than because they are excellent businesses.

So far, we have seen that many companies that develop a long record of regular dividend increases do so, because they have a business with competitive advantages. Examples could include a monopoly such as a utility or a drug company; a lowest cost provider such as a retailer or a company with a strong brand that demands a premium pricing for its product or service, which consumers cannot easily switch out of.

Owning a quality company is not enough however. I try to make sure I do not overpay for companies I analyze. This is why I try to never pay more than 20 times earnings for a business, even if earnings grow faster than expected. This is because I want to have some margin of safety in case earnings growth stalls. I have witnessed how some companies can sell at insane valuation, like Coca-Cola (KO) in 1998 – 1999 or Wal-Mart (WMT) in 1999 – 2000. Today we have companies like Brown-Forman (BF.B) selling at high valuations. Despite the fact that the underlying businesses kept growing, shareholders didn’t reap much in terms of returns, because they massively overpaid for future growth. If a company you buy requires double-digit annual growth for five – ten years, at the time you purchase it, in order to justify its high price, you have a low margin of safety. If our messy world throws a wrench in the company’s expansion efforts, it is possible that you do not generate good dividend income and capital gains when you purchase a stock that is priced for perfection.

I also try to own a diversified portfolio of dividend growth stocks, representative of as many sectors that make sense. I focus on a bottom up approach, where I select individual companies that fit my stringent criteria first. I do not add stocks for the sake of having exposure to a certain sector. For example, certain sectors are cyclical, which is why it does not make a lot of sense to have too high of an allocation to them. Other sectors, such as technology, are not well represented in my portfolio, because of the risk of disruption ( and because historically, tech companies didn’t pay a dividend)

I usually screen the list of dividend champions and dividend achievers once per month. I then make sure I have analyzed the companies on the screen and I like their fundamental picture. I also make sure that I do not own too much in these attractively priced companies. As I get money to invest, I deploy them strategically into what I believe to be the best values at the moment.

You can see the results of my screen from July in the following posts:

Nine Attractively Valued Dividend Stocks to Consider

Four Attractively Valued Dividend Growth Stocks For Further Research

I have been doing dividend growth investing for almost 9 years now, and my dividend income is very close to covering my expenses. Of course, I am not going to boast victory yet. I keep trying to learn more and more about investing, and build upon my existing knowledge. One of those bits of wisdom is investing through tax-deferred accounts. I am inspired by Warren Buffett’s quote:
I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.

In recent years however, I have started to dedicate a larger portion of my portfolio to simple investing through my 401 (k). For someone in the accumulation phase, this is probably the best way to accumulate a nest egg. It all comes down to incentives of course. The 401 (k) offers me tax-deferral of dividends and capital gains for several decades, which speeds up the compounding process. In addition, I get a tax credit for every dollar I contribute to the 401 (k), which is equivalent to getting those shares at a 25% - 30% discount. Last but not least, I receive an employer match on dollars I contribute to this plan. Add to this the fact that these assets have a very high level of liability protection as well, and you can see why I like it so much. The main downside is that I cannot select my own investments there, but am limited to a few low cost index funds. Perhaps one day I will be able to select my own investments in my 401 (k). However, at this stage, it provides me with so much incentives over my taxable dividend portfolios, that it is hard to ignore them. For busy investors out there, one of the selling point of that 401 (k) is that you can really set it and forget it. This actually describes 80% -90% of people out there. For the rest of us, if you are willing to do some work, and have your own plan, a strategy of incorporating both methods could work well.

Full Disclosure: Long KO, WMT, BF.B

Relevant Articles:

The importance of having your own unique investment process
How to buy dividend paying stocks at a 25% discount
Living off dividends in 2016 – My New Goal
How to accumulate your nest egg

Popular Posts