Seeking Alpha
Portfolio strategy, ETF investing, dividend growth investing
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At one time or another, probably all of us have experienced one or more of the following: 1) a bond with a good coupon recalled or matured, and/or 2) a good yielding stock where the dividend is cut or suspended. In many of these cases, it was difficult or impossible to replace them with something that paid the same income. I know I have lived through many of these instances in utter frustration. There is a solution! Simply stated; sell the bugger; buy a lower yielding, high dividend growth stock with most of the money and use the remaining funds (to augment income) over the years it takes for the new stock to pay the original income through dividend growth. You are trading a small amount of 'principal' for temporary income. In most cases, this so-called 'principal' is unrealized capital gains, so there is no sin in realizing part of them.

An example clarifies the concept: An original holding is worth $10,000 paying 5% (before the cut), a dividend of $500/year. Sell this holding and buy a 3% yield stock with a dividend growth of 10% using 91% of the sale price ($9100). This new stock yields $273 ($9100 times 0.03) the first year and has a growing income of $300, $330, $363, $400, $440, $484 in the following 6 years. The yearly income deficit in these 7 years is $227, $200, $170, $137, $100, $60, $16 for a total of $910. That amount is covered by the $900 difference in the sell-buy transactions, principal that was converted to income. This principal could be invested in a general ETF, selling a few shares each year to augment income as needed. This scheme converts a higher yield holding with perhaps little or no growth to a high dividend growth stock, maintaining original income for a few years and thereafter growing at the new dividend growth rate, as shown in the graph below.

(click to enlarge)

The new dividend flow will be $500 along the green line to the intersection, then along the red line.

So what could go wrong? Well, the new stock dividend growth rate could decrease and/or the value of the ETF could decrease. But the reverse is also true. The choice is live with the original situation and eat the loss in income, or 'gamble' on better days. I believe that over a few year time period, odds are good that this scheme will pay off.

Buy \ Sell Yields

5%

6%

7%

8%

4% Buy Portion>

. Min. Div Growth>

. Max. Years>

Min. Figure of Merit>

0.96

5%

5 yrs

20

0.925

10%

5 yrs

40

0.89

15%

5 yrs

60

0.855

20%

5 yrs

80

3% Buy Portion>

. Min. Div Growth>

. Max. Years>

Min. Figure of Merit>

0.91

10%

6 yrs

30

0.868

15%

6 yrs

45

0.825

20%

6 yrs

60

0.785

25%

6 yrs

75

2% Buy Portion>

. Min. Div Growth>

. Max. Years>

Min. Figure of Merit>

0.825

15%

7 yrs

30

0.776

20%

7 yrs

40

0.73

25%

7 yrs

50

0.68

30%

7 yrs

60

The table above shows general interrelationships between these parameters. Yields for the original holding that determines income to be maintained is on the top row. Yields of the dividend growth stock to be purchased is in the left column. Figure of Merit [FOM] is a metric used to determine best combinations of yield and dividend growth. It is the product of these two parameters. One of my past articles discusses its derivation, while other articles address its usage. The example above was taken from second column, middle row data.

As a check on how difficult it would be to find candidates for the dividend growth stock, that segment of my portfolio has a FOM average of 54, with 10 having values greater than 70. Individual FOM values were calculated using the 8-year Composite Dividend Growth (described in prior articles) and the 2012 year end yield.

While it is possible to interpolate between cells (in the table) for a specific application, it is more practical to simplify the task by pre-setting some parameters. This becomes necessary because both the dividend growth stock and ETF usually have a relatively large value per share which makes the situation much more granular. What this means is that it will not be possible to maintain precisely the year-to-year income desired because the number of shares purchased for the stock and ETF must be whole numbers, not fractions.

In my case, I have decided to limit the maximum time for this process to be 4 years. I select a dividend growth stock so there is some assurance it will provide the desired income growth, enough over the minimum to achieve satisfactory results within 4 years. Really, the main task is to adjust the number of shares to be purchased for both the stock and ETF to provide (at least) the required income amount the first year, spreading remaining ETF shares over 4 years. I use iShares Russell 1000 Index (IWB) as the ETF. It has no commission cost in my Internet brokerage account. It represents the broad domestic stock market and has a 1.9% yield kicker. I use IWB exclusively for this purpose to avoid misusage.

Here is a real live example: Sell 200 shares SPDR Barclays High Yield Bond (JNK) for $40.90, net $8180, dividends $604/year. Buy 200 shares Williams Companies (WMB) at $33.97, net $6794, forward dividends $260/year. Note: start the process by determining an approximate buy portion from the table, then pick a buy stock with an appropriate price, dividend, dividend growth. In this example, the remaining cash is $1386, used to buy 17 shares of IWB at $81.05, net $1378. I split the 17 shares of IWB into a 4 year payoff: 6 shares ($486), 5 shares ($405), 4 shares ($324), 2 shares ($162). The dollar amounts assume no change in share price. That is not important, just the allocation of shares over the years. The 8 year Composite Dividend Growth for WMB is 20.5%. Yearly dividend flow for WMB is: $260, $313, $378, $455, $548, $660. It takes 5+ years for the dividend to exceed the $604 target. With annual sales of IWB shares, the total dividend flow is: ($260+486=$746), ($313+405=$718), ($378+324=$702), ($455+162=$617), ($548), ($660). There is a surplus in the first 4 years, a $56 deficit in year 5 and a surplus from there on. These transactions were executed on 7 Jan 2013 converting a 7.4% no growth yield to a 3.8% yield, dividend growth asset with no loss of income. The chart below depicts income flow for this example.

(click to enlarge)

OK, The dividend growth for WMB could decrease and the price of IWB could drop, but since I started this scheme in Nov 2012, my shares of IWB have increased almost 13% in value. I haven't sold any shares of IWB yet, so I can always change the allocation to better fit future yearly payouts. Using this scheme for several stocks in a portfolio provides an opportunity to smooth overall portfolio income flow.

This is my thirteenth SA article. I have no knowledge of the benefit they may have provided to others, but I do know they have helped me. Writing down ideas to be understood by others requires extra thought and care to provide a logical process. For example (a benefit to me), during the writing of this article it dawned on me that I could adapt this scheme to solve a problem I have been chewing over for some time. I own shares of CenturyLink (CTL). In mid February this year they announced a major dividend cut with a proposed stock buyback plan. The stock dropped from $41.69 to $32.27 in one day. It has since recovered about half that loss. Not knowing what to do, I did nothing. Adapting the scheme described here, I could sell a few shares of CTL and use the proceeds over the next 3 (say) years to maintain original dividend income, buying shares of IWB to be sold over that time period. This would effectively delay the dividend cut for 3 years giving me time to see how the company performs in the interim, at a minimum loss of capital. The stock price is now back up to about what I paid, so there is no capital gain/loss issue. My next article will be about linear dividend growth stocks which will be a good place to analyze the situation.

I am gradually coming to the conclusion that it might be a good idea to slice off profits from a portfolio in good years, invest these in a no-commission ETF to be utilized whenever there is need for additional funds, a rainy-day stash. I am using this concept in my ETF segment to help fill dividend cuts that occur in down markets, reported in a previous SA article. This current article describes a second application. Maybe a third general fund would be useful in those unpredictable circumstances called 'the real world'.

Source: Trade Down On Yield Without Losing Income

Additional disclosure: I am long CTL IWB WMB