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For people who are near retirement or in retirement a daunting problem is replacing income. Gone for the foreseeable future are the 4-5% yields from CDs or U.S. Treasuries. The bond markets offer little assistance as they are in their last legs of a 30 year bull market, after a 50 year bear market. Given the projected slow growth (or worse) global economy one can hardly count on exceptional earnings growth. One of the only strategies for investors to get ready to replace income, stay ahead of inflation and capture growth is the "dividend growth strategy". In particular, my 4,5,8 dividend growth program. The numbers stand for:

  • 4% yield
  • 5% dividend growth
  • 8% earnings (or cash flow growth in the case of MLPs and REITs)

This strategy covers the 4 most critical objectives for investors in or nearing retirement. Income, income growth over inflation, capital appreciation, and the incentive not to time the market. Let's take these points one by one:

Income

The 4% yield is 350 basis points over the risk free return from a 12 month Treasury bill, a historically high premium. For Retirement Accounts 4% is also is also the magic withdrawal number. Assuming that a retirement account is large enough, a stretch considering that less than half of people between 55- 64 years of age have a $100,000 balance or more in their 401k, If one is receiving a reasonably secure 4% plus from a diversified stock portfolio they can draw down on the dividends and have less need to hit principal by selling stocks, thus less incentive to over trade.

There are plenty of stocks yielding close to 4% which would allow us to construct a portfolio with a net yield of over 4%.

Dividend Growth

To construct a yield-based portfolio without equally focusing on those companies with a solid dividend growth history and the likelihood of increasing that distribution at a rate of 5% would be foolish. Inflation is a silent killer. Even with an inflation rate of 2%, it would not take too many years before there would be a forced scaling down of your lifestyle. One of our objectives for an investor near or in retirement is to have dividend income growth above the rate of inflation. There are plenty of companies with are likely to increase their dividend over 5%. Corporate cash levels are at record highs and a number of sectors such as MLPs and REITs are mandated to pay 90% of their free cash flow to investors.

There are two ways that dividends can increase, higher corporate earnings or increasing the payout ratio. In order to make this strategy as simple as possible I tend to discount the increasing of payout ratio for stocks paying 4% or more, just too unpredictable. The only exception is if a company announces that their policy on payout ratios has been changed in a material way and that is typically for companies paying lower than 3%. I want to make this a dividend growth strategy one which will minimize the opportunity which the customer has to make a mistake.

A true wild card would be if the Federal Government would have the foresight to have a "tax compromise" which would allow mature companies with considerable cash on their balance sheet, but off shore, to bring that cash on shore but not at the current prohibitive tax rates. This was done before and would bring billions back of dollars back in the United States. for mature companies who already pay dividends and could pay more. Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), Intel (NASDAQ:INTC), Apple (NASDAQ:AAPL) (though not a mature company) are just a few examples. Tie it onto a domestic job creation bill. Write your Congressman yesterday on this matter!

Earnings Growth

To state the obvious, no company can increase their distribution unless they have more cash to distribute. Therefore, the third leg of my dividend growth strategy is an 8% or more EPS growth. MLPs and REITs trade and their payments are based upon cash flow. With just a little bit of research focusing on REITs, MLPs and Fortune 500 companies with a global business you should be able to put together a diversified portfolio. Here are a few names.

Atlas Pipeline (APL, 7.2% yield)

DCP Pipelines (DPM, 6.8% yield)

Eli Lilly (LLY, 4.0% yield)

Colony Financial (CLNY, 7.1% yield)

Bristol Meyers (BMY, 4.3% yield)

Kimco (KIM, 4.3% yield)

McDonald's (MCD, 3.5% yield), ok not 4% but as part of a dividend growth portfolio a great name to have

LinnCo (LNCO, 7.7% yield)

I also question anyone's ability to time the market. Thus putting together a portfolio and only selling when there are news events which would change the company's fundamental ability to grow earnings at the 8% rate and the dividend at 5% puts time on your side, as you are collecting a 4% yield while you wait, again trying to make the account replicate a pension plan. Indeed a disciplined investor would be less inclined to sell during a general market decline and will be more likely to buy on dips, thus strategically increasing your cash flow. The overwhelming data on how many investors liquidated their equity positions at the markets lows in the first quarter of 2009 (and never came back) make the dividend growth strategy critical to preventing investors from selling and ruining any chance of retiring.

To conclude, investors need to look past the headlines and focus exclusively on your goals while not playing the market. Have a plan that you feel comfortable with and one you can live with through the ups and downs of the markets. Have a disciplined, relatively easy to follow strategy to make their retirement funds resemble a defined contribution pension plan, one that you can draw income while not being forced to sell stocks. Obviously people need to save money to have a significant pool of capital to employ their strategy, but if done, the beauty of this strategy is that there are many different ways to customize this strategy and achieve your returns and simplified your life.

Source: Replacing Income: The 4, 5, 8 Dividend Growth Program