Now that we have the income argument out of the way, the next step is to go and look for the vehicle(s) that is going to generate income for us. One cant’t really look past dividend growth stocks as the vehicle as they are tried and tested and have been through the mill so to speak. Many long term investors merely buy some popular names in this category and hold onto them for life. For example companies such as McDonald’s (NYSE:MCD) and Coca Cola (NYSE:KO) have raised their dividends for decades which means investors who are long these names have received a pay rise every year since they started to invest in these stocks. Part of this set-up – I agree with. Long term dividend growth investing really gets compound interest working for you. In fact, dividend growth stocks with reasonable yields usually result in the investor doubling his income in eight years as long as all dividends were re-invested back into the respective stocks.
The benefit here is that quarterly dividends can be pumped back into the stock at lower prices which means the investor over time can average out the buying price. In the industry this is called “cost basis reduction” because every re-invested dividend brings down the original cost of the original shares over time. This improves one’s probability of success especially in an up-trending market. However the pretence with dividend growth investing is again predominantly investing for the future. Yes the investor could just live off the dividends and not touch the stock but in this day and age, I’m afraid (income-wise), that yield just won’t cut it for many investors looking for robust monthly income unless of course one is open to more risk.
For example a $100k portfolio made up of popular safe blue chips yields around 3 to 4% and the average yield goes up by 6 to 8% per year. So based off that original capital, the investor would collect around $3,500 a year and would receive a $250+ increase on his or her income after the first year. Those numbers are simply not going to cut it for many income investors. Our philosophy is slightly different in the sense that our portfolio will not have to hold stocks for life. In fact, I believe this is one of the downfalls of the dividend growth method. For the life of me, I do not understand why an investor does not sell a stock when it gets overvalued. When a stock is selling above its average earnings and sales multiples, the odds are high that upside movement in the stock (if any) from that point will be muted. Using dividend growth stocks as the vehicle is fine but the trick is not to get married with them.
Better to use them for income purposes like numbers on a page. Therefore as you read this, if you have any prejudices towards some stocks, I would invite you to get rid of them now. You do not need to hold a stock forever even if you absolutely love the returns it has produced over the past few decades. This is the lure of the “Dividend Aristocrats” which are a group of companies which have raised their dividends for 25 years+. However because of their track records, many of these companies sell at a premium which is why many of them (especially now with stocks at all time highs – 27-01-2017) are so expensive at present and should be avoided for income purposes. Past performance is not always an indication how the future will play out. Over the last 4 decades at least, the world has witnessed huge gains in many asset classes such as stocks, bonds and real estate. However the next few decades could be entirely difficult especially with government debt nowadays being much more elevated compared to previous times.
The reason why it is dangerous to get “attached “ or “married” to stocks is because of the mindset it fosters. For example if an investor times a stock purchase well and sees significant returns over time, it is very difficult for this particular investor to change strategies over time. It is something similar to going to Vegas and winning all around you on your first day. You believe you are a King and nothing can phase you due to you having something magical or different within your arsenal. You find out the hard way that it wasn’t your strategy at all but probably only luck that caused that big pay day on your first innings. Just remember this. Holding stocks indefinitely usually means that you are waiting for some reward in the future. Past performance is not always a guide to future returns. In fact if a stock has had a huge run-up over the past few decades, it probably is not a good long term hold at present as it has become over-valued. To comprehensively use the income strategies outlined in this book, there is going to be a level of active management involved. I’m not saying there isn’t a place for “stock pickers” who can choose undervalued companies, hold them for a while and then sell them for a profit. Yes there is but those strategies takes a person out of the “now” and hence focuses more on the future. If we have capital to invest, we want to make a return on that capital as quickly as possible – something similar to putting money into a bank account and earning interest.
In fact even within this bull run in equities for multiple decades now, stocks have still had under-performing periods. For example, look at the performance of stocks from the year 2000 over the first decade of this century. As the chart illustrates below, price in the index didn’t come back to original levels until 2013 – a full 13 years later! However throughout this period, one could have used many strategies to increase their income but there is very little one can do when a position remains underwater. Yes one can re-invest dividends until the respective position comes back into the black. However if equities suddenly entered a bear market, you would be left holding the bag and would have to wait potentially years for your position to come back into the black. We certainly do not want a situation like this so we protect ourselves by being highly diversified and by ensuring positions sizes are in line. No one position will ever make or break us which ensures we are always focused on income and not pie in the sky opportunities.
For example, if an income investor went all in with a popular dividend aristocrat such as Walmart (NYSE:WMT) in the year 2000, here is how the position would have played out over the 13 year duration. Walmart rose aggressively along with the stock market in the nineties but actually topped out just before the turn of the century. Let’s say for arguments sake that an investor bought $20,000 worth of stock on the 2nd of January in the year 2000. That capital sum would have turned into $23,664 in January 2013 if every dividend was invested back into the company. This turned out to be an annualized return of 1.3% – a return investors would not have been happy with.
I acknowledge that Walmart’s dividend growth rates have not been as robust as other dividend growth stocks but as the chart shows – this stock went nowhere for the best part of a decade. When this happens to an income portfolio, the investor in question is depending wholly on dividend growth rates to get the original investment back into the green. The take-away is this. Every time you pull the trigger on an investment, consider the following statement.
“When you do the right thing at the wrong time – you get pain”
Investing in a safe dividend aristocrat is never in a sense the wrong thing to do. However buying at the top of the market when the stock was over-valued definitely made it the “wrong time” to invest. Now you may counter and say that if the investment is for the long term – can one not ride the downturn out? I would answer yes but the kicker is that one’s returns will be dismal compared to original expectations. However what is even more important than that is that it is much more advantageous to have as little positions as possible underwater at any given time. Why? Because then the possibility of trading in and around them becomes non-existent and income suffers as a result. In fact, at any given time, investors need to accept that selling some positions (as long as a profit is made) will become the new age of investing. Remember we are focusing on the here and now. We want profits and income today. If a stock runs away from us and we see we could have made more. So be it. We move on, we search for our next vehicle. Rinse, wash, repeat..