Monday, January 13, 2020

Calculating Organic Dividend Growth

One of the goals behind my dividend growth portfolio is to buy shares in companies which grow dividends over time. Dividend growth protects purchasing power of retirement income, and in many cases is expected to grow above the growth in the consumer price index. I want dividend income to grow on its own, without having to add new funds, or reinvesting dividends. This concept referred to as organic dividend growth. This will be helpful when I live off dividend income in retirement.

For the purposes of this dividend portfolio newsletter you are reading, I want to generate a target monthly dividend income.

In my model, I have forecasted the following variables:

1) Initial dividend yield of 3%
2) Annualized Dividend Growth of 6%
3) Investing roughly $1.000/month
4) Reinvesting dividends strategically

The first variables will be dependent on market conditions and ability to identify quality companies at attractive valuations. It is possible that stock prices get even higher from here, which would make it very difficult to find quality companies with a 3% yield, on average. Alternatively, if security prices start decreasing, it would be very easy to find securities yielding over 3%.

The second variable is dependent on the companies executing on their plans. If we selected dividend growth stocks well, they would continue growing dividends by around 6%/year, or better. The rate of dividend growth is not going to be linear, and it would fluctuate somewhat. However, I expect it to grow over long periods of time at an annualized rate of 6%/year. This means that all else being equal, and without adding new money or reinvesting dividends, a 6% dividend growth rate would translate into dividends doubling every twelve years. If I manage to get a 7% annualized dividend growth, my organic dividend income will double every decade. At a 10% dividend growth, portfolio income will double every seven years.

Organic dividend growth is important, because we want dividend income to be growing in retirement, when dividend checks are spent paying for living expenses. Dividend growth keeps purchasing power of the dividend income intact, which helps us maintain a standard of living in retirement, when we are less likely to be able to add new money to the portfolios.

Reinvesting dividends also helps in growing the dividend income stream. However, it is dependent on the conditions available in step one. The investing of new money will grow our dividend income at a ratable pace, but the rate of growth will be dependent on points 1 and 2 above. Since I do not plan to sell, I won’t be replacing lower yielding securities with higher yielding securities, in order to boost income. Theoretically, I can grow dividend income by actively trading and selling my winners to add to the losers ( or to other higher yielding companies). I do not believe in active trading, and my experience has shown me that selling one company to buy another has usually been a mistake. I would have been better off not second guessing anything on average, and just sitting tightly.

This is the point where I want to mention that there is a trade-off between dividend yield and dividend growth.

On aggregate, there are three types of companies from a dividend yield/dividend growth trade-off perspective.

The first type includes companies that grow dividends at a slower pace, but offer higher dividend yields today.

The second type includes companies that grow dividends at a more moderate pace, but offer medium dividend yields today.

The third type includes companies that grow dividends at a faster rate, but offer smaller initial yields today.

These guidelines are pretty much based on common sense. If a company yields 1%, it makes sense that we would expect it to generate high dividend growth over time. Alternatively, a company like AT&T (T) with a close to 6% dividend yield today will not be able to double dividends every five years.

As usual, there are exceptions to these guidelines. But on aggregate, it is a useful way to categorize companies, when evaluating them. Since we own diversified portfolios, these guidelines are evident when we start stratifying portfolio components into groups.

I am stating this because the availability of dividend companies will vary from year to year. It is possible that if the stock market continues increasing in value, I may end up focusing on higher yielding but lower growing companies for a period of time, because that will be what is available to invest in. Alternatively, I may decide to focus on lower yielding companies with high dividend growth expectations, if I see those as attractively valued today. In all cases, I will review the financials, and determine if dividends are safe, before putting any money at risk.

The next question is how to calculate organic dividend growth. Just calculating the average rate of change for each portfolio holding is a simple and easy way. However, this way may ignore the fact that a dividend portfolio is usually not equally weighted.

Another possible method could be to compare actual dividend income growth from year to year, while ignoring the impact of investment contributions done during the year. This method may ignore the impact of dividend reinvestments as well. For example, a portfolio consisting of 1 share of Altria on December 31, 2017 would have generated an annual dividend income of $2.86/share in 2018. The same share would have generated an annual dividend income of $3.28/share in 2019. Obviously, this works best for comparing static positions that have been held for longer than one full calendar year.

The drawback to this method is that if Altria doesn’t announce any raises in 2020, it would still pay $3.36/share, which would translate into a growth of a little less than 3%, when no growth occurred really.

A third method could include looking at portfolio positions at year end, and determining what the forward dividend income would be during the year. In the case of Altria, at the end of 2017, you would have expected annual dividend income for 2018 to be at least $2.64/share. The quarterly dividend was 66 cents/share, multiplied times four.

By the end of 2018, the quarterly dividend is 80 cents/share, translating into expected dividend income of $3.20/share. By the end of 2019, the quarterly dividend is 84 cents/share, translating into expected dividend income of $3.36/share.

Obviously, organic dividend growth matters for retirees who plan to live off distributions in retirement. While there are multiple ways to calculate it, the end result is having income that grows at or above the rate of inflation, and maintains its purchasing power.

Relevant Articles:

Investors Should Look for Organic Dividend Growth
Types of dividend growth stocks
Investors Should Look for Organic Dividend Growth
Three stages of dividend growth
Dividend Growth Stocks Protect Investors from Inflation

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