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Long-term horizon, dividend growth investing
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As a younger investor, I want to invest my capital today to provide income in later years. I use a Roth IRA in particular so I can't touch the gains until I'm 59.5 years old at the earliest; I'm not even half way there. Yes, I could potentially access some of the contributions, but that will only happen when my emergency fund is depleted. I view my Roth as a kind of retirement black hole; I throw money in and hopefully I get more out in the future. A lot more, hopefully. The point is that money goes in and does not come out. Because it's an IRA, I am limited to $5,500 annually at the current level.

Now, we've all seen and probably toyed with the "4% Rule" for retirement. Most stories you run across that detail this rely on capital appreciation and selling off 4% + compounded inflation of your portfolio each year to fund your retirement. That never sat well with me for a few reasons, all of which have been discussed to no end, and I will not be contributing to that. Chances are, though, that you are here because you follow dividend investing ideas on Seeking Alpha, so you understand that dividend investing can yield a 4%-esque plan that will probably see you die wealthier than the day you retired. Personally, I plan to live forever, so let's investigate that part about getting wealthier starting the minute you retire.

The Simple Plan

Believe it or not, it is easy to retire this very minute and live a great life off of dividends! Just take $1,000,000 and dump it into dividend growth companies. You'll get $40,000 a year the first year and, with minimal maintenance, you'll get more and more money every year. That's great!

The Simple Plan, Take 2

Ok, so you may have seen the small problem in The Simple Plan, specifically that part about starting with $1,000,000. I don't have a million dollars laying around either. Most of the 4% Rule articles I find revolve around having a large amount of capital to invest or ultimately obtaining a large nest egg. Even the dividend growth versions tend to focus on turning capital directly into an income stream. I certainly want a direct income stream and not a portfolio to slowly sell in my retirement, but there's still the matter of getting there.

I follow David Crosetti who constructed "The Portfolio for Do It Yourselfers" which is a refreshing look at a real life portfolio he runs with his adult children. This is a well though out dividend growth approach, but the initial funds came from an inheritance. To the tune of $100,000. While the Crosetti family has my condolences and congratulations, even this portfolio may not be a realistic start for young investors. If we lop off a zero and make it a $10,000, portfolio then we're in the right ballpark.

The biggest problem that I see is for those of us investing in an IRA is the annual contribution limit. This year, IRAs have a contribution limit of $5,500, up from $5,000. Even a simple $10,000 portfolio requires two years worth of contributions. Sure, you could always plan your purchases and target positions that would mark an official "start" at the end of Year 2 when you have all $10,000 available, but that requires a lot of hindsight. I seriously doubt that any two year window would leave an investor with the same investment outlook and purchasing protocol. So when you are nearing the end of Year 2 in your $10,000 DIY Portfolio, you may not want the same assets and/or asset allocations that you planned for at the start of Year 1.

Can You Retire On $5,000 Invested Per Year?

I constructed a spreadsheet to assess different assumptions for retirement investing in my Roth IRA. Every retirement plan is based around a series of assumptions, some financial and some personal. My assumptions were as follows:

  • Beginning Balance: $0
  • Annual Contributions: $5,000
  • Beginning Share Price: $50
  • Beginning Dividend Yield: 4%
  • Duration of contributions: 30 years
  • Dividends always reinvested

These should be somewhat representative of any long term dividend growth IRA. Note that my initial annual contribution was $5,000, because at the time I opened my Roth, this was the limit. I will address potential contribution increases in the future.

I have not yet stated my dividend and share price growth assumptions. These started out as just another couple of assumptions; things I had no control over. However, they became quite thought provoking and the motivation for the article. Below I have charted the results at the end of 30 years of investments under the above assumptions at different rates of dividend and share price growth. The left hand, vertical side is dividend growth, and the top, horizontal side, is share price growth. Values are given in thousands:

(click to enlarge)Total Portfolio Value in 30 Years, Dividend Growth vs Price Growth

Before going any further, I would like to point out the area shaded in yellow ;these values are all below $1,000,000. Note that this is a 30 year projection that does not factor in inflation. What this means is that all dividend and price growth combinations in yellow will not grow to one million dollars in 30 years, and given a 4% Rule, they will not even yield $40,000/yr. Never mind the actual purchasing power of the amount yielded from extracting 4% annually.

This is a very sobering chart if you were to rely on capital appreciation for the entirety of your retirement portfolio. Of course, this is using the assumptions previously stated which include the $5,000 annual contribution limit. Exploring other changes beyond the dividend and share price growth rate are exercises for the reader.

If you've held on this long and haven't jumped straight to the comments section, I assume you are eagerly, or perhaps tentatively, awaiting dividend income chart. This following chart is in fact for the dividend income provided at the end of Year 30. All assumptions used in the previous example are retained and all values are given in thousands:

(click to enlarge)

Again, the yellow shaded area details all dividend and share price growth combinations that do not yield $40,000 a year. Before you ask, the one yellow cell that says "$40K" is an artifact of rounding. Again, these values do not factor in inflation, so the purchasing power of $40,000 at the end of these 30 year computations is much different than $40,000 today. Please note that the $40,000 threshold is not meant to be an especially significant retirement, but glance back at the first graph and look at how many of the combinations never attained $1,000,000. Given a 4% Rule approach, a $1,000,000 portfolio would yield $40,000/yr, so it provides a workable ratio for converting portfolio value to potential income under a tradition retirement approach.

Now, what jumps out to us is how poorly performing about half of these combinations are. In the first row, where dividend growth is 1% and share price growth is 7% or higher, we actually produce less in dividends than we contribute each year! Conversely, in the lower left hand corner of the graph, we see enormous income potential when dividend growth is high and share price growth is very low.

Again, consider that this is only from a $5,000 annual contribution for 30 years for a total of $150,000. In 19 of the combinations (19%) we see annual dividends more than $150,000. A 100% yield on cost. In 42 of the combinations (42%) we see over $50,000 in annual dividends, which would pay back our total investment in three years or less.

Review

From a pure portfolio total or annual dividend perspective, the best cases are found in the lower left hand corner of the charts. This translates to dividend growth being high and share price growth being low. The problem with that is obvious: dividends come from earnings, so earnings must grow to produce annual dividend increases. However, companies are all ultimately priced on expected future earnings. If share count remains the same, then earnings must grow to support dividend growth. In order for our best case scenarios from the charts to happen, the market at large has to continually misprice a given company. While it is possible to find undervalued companies on the market, the market will not undervalue them indefinitely. As I have already written, Coca-Cola (NYSE:KO) has an annual dividend growth rate of over 10% since 1970. The problem is that the market recognizes this as well as their potential earnings and continuously pays a premium for KO. The market isn't necessarily wrong, and KO continues to deliver, but for the portfolios explored in this article, that is not the most advantageous approach.

Summary

With respect to dividend paying companies, these charts support the idea that the most profitable portfolios, in terms of capital appreciation or dividend income, occur when dividend growth exceeds share price growth. This won't go on forever, because a company must earn more money to pay a higher dividend (buybacks excluded). Eventually the market catches on to their performance and fully values them or pays a premium share price.

In one of my previous articles, a user commented that they would never sell their KO position even if the share price grew by 1000% or some other arbitrary number (apparently you can go broke taking a profit in some worlds). If you rely on a dividend income stream to pay your bills today, then yes, profit taking doesn't make sense. You have an asset, or collection of assets, that fulfill all of your income needs. Great, you won the investing race. But if you still have 30 years to go before you rely on your dividends, then maybe profit taking is in your best interest. If share price growth is dominated by dividend growth, then you will actually have a substandard future dividend income stream.

With that in mind, perhaps buy and hold is not always the best approach in the Roth IRA scenario we have explored. Perhaps some vigilant value investing and profit taking is the best approach. At this time, I do not have any models to support that notion, but I will continue to explore it on my own and report back any findings.

Source: Is Dividend Growth Investing Crippling Your Dividend-Based Retirement?