July looks as if it's off to a good start with earnings season just beginning. It seems as if volatility has, for the short run at least, subsided a bit as the market fully absorbs the fact that interest rates are on the rise. The first two parts of this series prompted many to fully consider the important question: Is it time to consider a new investment strategy? The series to date has resulted in over 440 reader comments, producing questions as well as spirited discussion. In case you missed them, Part One is available here and Part Two can be found here. I sense that while questions and concerns remain, many showed considerable interest in learning more about the investment strategy known as dividend growth investing. This time around, I thought I would try to clear up some of the confusion surrounding this strategy.
I believe that just because a portfolio is designed to produce retirement income from dividends it is not necessarily following a sound dividend growth investment strategy. I believe that in order to practice a true dividend growth investment strategy, the core of your equity investments must come from the lists of dividend Champions, Challengers, and Contenders (available here). Those that are have the unique qualifier of five or more years of sustained dividend growth.
Often I am sent lists of equities from folks who refer to themselves as dividend growth investors only to find that less than 40% of their equity portfolio comes from the stocks that qualify for this distinction. Many of the stocks on their list fail because they lack dividend consistency, while others lack consistent dividend growth. Consistency of dividend payment and dividend growth are the two things I believe are most important when assembling and maintaining a retirement income portfolio. Unfortunately, they are the two things most often lacking in dividend-based funds and ETFs.
When stocks lack this consistency, it means that often retired investors need to sell stock each month for the retirement income they need. In addition, without dividend growth in order to keep up with inflation, once again the retired investor is forced to sell stock. This repeated need to sell often results in having to "sell low." Most retirees share concerns about running out of money during retirement particularly should they encounter a prolonged severe bear market such as 2008. Without consistent and growing dividends during such periods of turmoil, it's easy once again to sell low this time out of fear since any loss in value suffered by your portfolio will directly affect your retirement income.
It's different with dividend growth investing where your core equities are members of the dividend Champions, Challengers, and Contenders -- or, as we like to call them, the CCCs. Your core holdings are among the strongest survivors of just such bear markets. While other companies cut dividends, they maintained and even grew theirs. I've heard from countless dividend growth investors who advise that while their principal may have declined during this turbulent period, their income never did. In fact, it grew at a rate greater than inflation. Instead of hearing stories of having to sell stock for needed income, instead I hear from those who instead re-invested a portion of their growing dividends back into these same stocks -- this time purchased at bargain prices.
I believe that to provide necessary income, retirees should consider assembling portfolios yielding between 4% and 5%. Don't chase yield or you're likely to be sorry. I know because early in 2011 that is just what I did. To read more my about my misadventures with high yield, click here.
Some readers have said: "Then you're saying I have to invest all my money in Johnson & Johnson and Coke." Absolutely not! If you don't have your copy of the dividend Champions, Challenger and Challengers, stop reading right now and download the latest copy of the Excel spreadsheet here. You'll find great companies in every sector. You'll find great mid-cap and small-cap representatives. You'll find great candidates from rental REITS to master limited partnerships each with the bonus and protection of a history of five years or more of sustained and growing dividends.
Readers often ask, "Can't I do this with a dividend ETF?" I'm afraid the answer to that question is currently "no." It's not what any of the existing ETFs are set up to do. One problem I see is that most only yield between 2.5% and 3.5%, while most retired investors favor the dividend growth strategy seek between 4% and 5% yield. The next problem is that most carry the same risk as the market. Two of the most popular -- Vanguard's VYM and WisdomTree's DHS -- both sustained losses in 2008 similar to the S&P 500, with -32.1% for VYM and -38.81% for DHS. I believe that one of the reasons that occurred is that each is weighted, with the top 10 listed stocks of each of these two examples making up between 33% and 42% of your total investment. In fact, the top stock for each is weighted at more than 6%. Most of the dividend growth investors who comment here prefer an equal weight in their holdings. That way, if a severe dividend cut occurs it has a smaller effect on your monthly income from dividends.
If you own dividend-oriented funds or ETFs, I ask that you do this: Start by recording the year-by-year 10-year performance histories of each fund or ETF. Next, pull up a complete list of holdings for each. Next, record the year-by-year performance history of each holding. Cross through those holdings with histories not to your liking. Now, highlight each one included on your list of dividend Champions, Challengers, and Contenders. Continue until you have identified 35 or more holdings. Now, record the 10-year performance histories of each holding. Assume your holdings have equal weight and compare their collective year-by-year performance with that of your fund or ETF. Share your results with the community by commenting. I'm sure you will find the exercise to be rewarding.
As I've said repeatedly, I don't believe anyone should buy a stock without reviewing its year-by-year performance history and its five-year history of dividend payments. Each can be done quickly on the Morningstar website. Just enter a stock ticker in the "quote" box located at the top of the Welcome Page. After clicking enter, click on the "performance" tab located on the grey bar. Next, click on "expanded view." You now have your performance history. For dividend history, just click on the tab "Dividends and Splits." A simple composition notebook is the easiest way to permanently record this information. I plan to back test a portfolio constructed in this manner and compare its performance to that of both VYM and DHS for the same period. It should be interesting.
You will recall that in Part One of this series, we discussed the importance of constructing customized watch lists from the over 400 dividend Champions, Challengers and Contenders. I built just such a watch list of those with yields of 2.75% or more and what I considered positive 10-year performance histories. Metrics important to dividend growth investors are summarized again in the chart below. Recognize the potential these stocks hold to provide safe and growing income in support of your retirement.
These stocks represent a collective yield of more than 4%. They enjoy dividend growth more than double inflation. They have estimated five-year capital growth of 7.6%. Finally, they have a collective beta of less than 0.70, meaning that over time they are 30% less likely to incur severe losses during extreme bear markets. These stocks like any you might consider deserve your own due diligence and should only be purchased when they are fairly valued.
Since publishing the first two parts of this series, many of you have asked how my personal portfolio stacked up against the select group above. Remember, the majority of my 52 holdings are part of the 132 highlighted above. My portfolio, if purchased today, has a combined dividend yield of 4.72%, 0.63% higher than the larger group of 132 represented above. In return for higher yield and income, I gave up 0.5% in projected five-year growth and 0.4% in five-year dividend growth. I consider the trade off to be worth it.
The beta for my portfolio checks out the same at 0.68. In addition, my portfolio has a combined chowder rule score of 15.8%, clearly surpassing the requirement that stocks have a combined yield and dividend growth rate of 8% to 12%.
That wraps up my thoughts for now as we continue this important conversation. As always, I look forward to your questions and comments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.