The Ultimate Goal of Dividend Growth Investing
Investing in dividend growth stocks has become a very popular strategy for those seeking a different way to reach financial independence. We don't want to follow the traditional method of withdrawing 4% of our investment portfolio to cover our expenses during retirement. Dividend growth investors don't want to have to sell their assets at all. Rather, the goal is to accumulate a portfolio of companies that pay out an annually increasing amount of dividend income. The idea is that this dividend income can be used to cover our living expenses so that we need not sell any of our stocks. Ultimately, this income stream from dividends will grow at a rate faster than inflation as the companies we have chosen to own will increase their dividend rates year after year.
Therefore, while there may be a few different goals of dividend growth investing, there is one ultimate goal which is income. Dividend growth investors want to create a growing stream of dividend income that will be able to cover all necessary expenses and will grow over the years as those expenses grow due to inflation.
Protecting Income Through Diversification
For those who have reached financial independence through dividend growth investing, the passive income stream of dividends is the most important thing to protect. There are a few things investors can do in order to try to increase the safety and reliability of our income stream. Investing in the most stable, solid blue chip companies with long histories of dividend growth will help. Doing the proper research and making sure the company and its dividend are strong and not at risk will also help. However, the amount of diversification an investor has can have the biggest impact on how safe their overall portfolio income remains.
Diversification is important to investors relying on dividend income to cover living expenses. The more diversified a portfolio is along with the more securities held provide a safety net should some companies owned be forced to cut or eliminate dividends.
To illustrate, I want to take a look at a hypothetical million dollar portfolio made up of 10 dividend growth stocks with equal weighting. See the table below of 10 randomly selected Dividend Champions. Let's assume an equal weighting of $100,000 invested in each security. For this demonstration I've used current dividend yields from April 26, 2013.
|Cincinnati Financial (NASDAQ:CINF)||3.39%||3,390|
|Leggett & Platt (NYSE:LEG)||3.56%||3,560|
|Air Products (NYSE:APD)||3.32%||3,320|
The owner of this hypothetical 10 stock portfolio would be expected to earn roughly $36,580 in dividend income this year. He is relying on this income to cover his expenses.
What would happen if 3 of the companies owned in this portfolio were forced to eliminate their dividends due to economic problems? Let's see the impact if the highest yielding, lowest yielding and a middle yielding company stop paying a dividend. These companies would be Altria, McDonald's and Cincinnati Financial.
If these 3 companies were to stop paying a dividend, the investor owning this portfolio would lose $11,600 of the income he is so reliant on. This would be a 31.72% decrease in income. This decrease is so large that most families would not be able to get along after. The investors livelihood will take a hit and he must sell these positions to try to find replacements for this income.
Now let's take a look at what it would have looked like had the investor spread his $1,000,000 out between 30 companies rather than just 10. Below is a random selection of 30 Dividend Champions. Let's assume the investor spread his money out evenly giving him $33,333 in each position.
|Leggett & Platt||3.56%||1,187|
|Johnson & Johnson (NYSE:JNJ)||3.10%||1,033|
|Emerson Electric (NYSE:EMR)||3.01%||1,003|
|Procter & Gamble (NYSE:PG)||3.12%||1,040|
|The Clorox Co. (NYSE:CLX)||2.95%||983|
|Genuine Parts Co (NYSE:GPC)||2.87%||957|
|Exxon Mobil (NYSE:XOM)||2.86%||953|
|Wal-Mart Stores (NYSE:WMT)||2.38%||793|
|Illinois Tool Works (NYSE:ITW)||2.36%||787|
|3M Co. (NYSE:MMM)||2.45%||817|
|Target Corp. (NYSE:TGT)||2.04%||680|
|United Bankshares (NASDAQ:UBSI)||4.97%||1,657|
|Consolidated Edison (NYSE:ED)||3.91%||1,303|
|Sonoco Products (NYSE:SON)||3.61%||1,203|
|Atmos Energy (NYSE:ATO)||3.20%||1,067|
|Nucor Corp. (NYSE:NUE)||3.44%||1,147|
The owner of this second portfolio has his income sources spread out amongst 30 companies. If the same 3 companies from the previous portfolio were forced to eliminate their dividends, this investor would lose $3,774 in annual income. This amounts to losing 11.89% of his income.
Comparing the two scenarios, we can see that the less diversified investor lost nearly one third of his income (31.72%) compared to the diversified investor only losing one tenth (11.89%). This shows that the dividend cuts do not nearly affect the diversified investor as much as they affect the investor who has his income coming from fewer sources.
Conclusion - Diversify to Protect Your Dividend Income
Since the income is considered the ultimate goal for dividend growth investors, it stands to reason that these investors should look to protect that dividend income stream as best they can. One of the best protections against loss of income is through diversification. The fewer companies an investor owns, the fewer income sources he has and the bigger decrease in overall income he will experience when a company is forced to cut its dividend.
It can be tedious trying to keep track of a large portfolio spread among many different companies. I would conclude that dividend growth investors should try to diversify their portfolio by purchasing between 25 to 35 companies. This amount of diversification should offer adequate protection against dividend cuts/eliminations while at the same time keeping the number of companies down to a reasonable number for monitoring purposes.
Disclosure: I am long MCD, WAG, AFL, WMT, KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.