What If You Can't Live Off The Dividends?

Includes: BDX, BP, CL, COP, DIS, GE, IBM, RDS.B, WMT
by: Tim McAleenan Jr.

Unless your goal is to die broke or something close to that effect, your end game is probably to reach a point where you can live off the organic income generated by your investments. In that situation, your primary focus is the safety of the dividend rather than the search for favorable fluctuations in stock-market pricing.

That's because you've done it. If you spend $70,000 each year and get $90,000 post-tax every 365 days just for staying alive, you've won. The money shows up in your checking account, and you get to spend your time doing what you want with your life while your checking account receives regular cash infusions that give you that flexibility as the result of being a business-owner with extensive enough assets to satisfy your lifestyle.

But what if life happens, and for whatever reasons, that isn't a possibility? What if you need the returns that the stock market has historically provided while simultaneously desiring to limit the potential effects of price declines because you will need to sell?

In this scenario, your income investing priorities shift. While someone living off of dividends makes decisions aimed at generating the greatest amount of future dividend income adjusted for risk, someone who cannot live off the dividends and needs to sell must choose to purchase companies with the greatest earnings per share growth at the highest quality possible.

The reasons why this becomes intelligent behavior for an investor that needs to sell is two-fold:

(1) The implication of having to sell means that you need capital appreciation. There's only two ways to get that. A P/E ratio can expand, or the overall profits can grow. The growth in retained earnings per share becomes critical because that drives the overall earnings per share growth (and, in turn, robust earnings per share growth is the most reliable way to count on the price of a stock to increase).

(2) The focus on quality is important for two reasons: first, when you know that the company possesses high quality, you are probably better able to predict the likelihood of getting that strong earnings per share increase. And secondly, the higher the earnings quality, the better your stock is likely to hold up during a recession because you will own the type of company that others seek out during a "flight to quality."

What are some dividend companies that are fertile ground for accomplishing this objective?

(1) Becton Dickinson (NYSE:BDX). Over the past five years, earnings per share have grown 9.5%. And over the past decade, they have grown 12.5%. But what is important is the style of how Becton Dickinson has grown-only two of the past ten years did not result in earnings per share increases. And even then, they were negligible (i.e. Becton Dickinson made $4.95 per share in 2009, and $4.94 in 2010).

(2) IBM (NYSE:IBM). The company's strong commitment to its buyback program ensures that earnings per share should increase on a reliable basis. People complain about IBM all day long, but at the end of the day, this is a company that has grown dividends per share and earnings per share every single year over the past decade. And it wasn't by trivial amounts either. The earnings per share have gone up 12.0% annually over the past decade, and 16.0% annually over the past five years. The dividend has gone up 18.0% annually over the past decade, and 21.0% annually over the past five years.

(3) Disney (NYSE:DIS). Disney is a useful stock for diversification purposes because there are not a whole lot of media companies occupying the blue-chip field of stocks. I don't usually write about Disney all that much because the dividend is low, is only paid out annually, and the company spends 4x as much on buybacks as it does as dividends. But the underlying business is excellent. Earnings per share have gone up 12.5% over the past decade, and 10.0% over the past five years. There was only one year in the past decade when earnings per share did not increase. Note: The share price of Disney gets pretty volatile for a blue-chip during a recession, because investors disregard the vast media empire that Disney has created and instead find themselves saying things like, "What middle class is left to visit Disneyland?"

(4) Wal-Mart (NYSE:WMT). This company does not get much love because most stock screeners show mediocre performance for Wal-Mart over the past decade. The problem with this kind of thinking is that it discounts the fact that Wal-Mart traded at 25-30x earnings ten years ago. If you ever want to handicap your chances of beating the S&P 500 over a long period of time, be sure to pay 30x earnings for a megacap company. The business performance of Wal-Mart, however, has been excellent. Earnings per share have increased 11.0% over the past decade, and 9.0% over the past five years. As for smoothness of performance, check this out: sales per share, book value per share, cash flow per share, earnings per share, and dividends per share have increased every year over the past decade. With Wal-Mart making a stronger commitment to its buyback program, this trend has a good shot of continuing over the medium-term.

(5) Colgate-Palmolive (NYSE:CL). One of my favorite things about this country is that you can get rich owning toothpaste and soap. Over most 20+ year periods, Colgate's returns have been north of 12%. Over the past decade and five years, respectively, the company has grown earnings per share by 10.0% and 9.5% (both of those figures would move up more than a percentage point if we moved our starting date back to 2002). The company is able to consistently grow profits because their toothpaste and soap gets shareholders 30% returns on equity. The business is so stable that Colgate was able to pay out dividends throughout the entirety of WWII. Not even Adolf Hitler managed to stop the American people from buying basic hygiene products. What more stability could you ask for?

Stylistically, the greatest question for the individual investor that has to sell stocks is determining whether high-yielding oil stocks like Conoco (NYSE:COP), BP (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.B) belong in the portfolio. On one hand, you're pretty much guaranteed 50% drops in share price every decade, because that is the nature of commodities investing. On the other hand, one thousand shares of Shell get you $3,600 in cash income each year, possibly reducing the need for you to liquidate your portfolio. Stocks with a reliable yield above 5% have a tendency to protect you like that.

There is one more consideration you need to take into account if you plan on selling stocks to meet your spending needs: you need to be prepared for stock prices to fall apart three or four times over the course of your life. The best way to prepare for the 1973-1974 and 2008-2009 periods is to try and set aside eighteen months of withdrawals as an emergency fund somewhere. During the most recent crisis, the important thing was to limit selling between the summer of 2008 and the summer of 2009. The "scare" prices that you hear bandied about refer to a very narrow period of time-when you hear someone reference General Electric (NYSE:GE) around $6 per share, that was a very short-term storm. It's not like General Electric hung out at $6-$8 per share for two years straight. The more flexibility you can have with your selling, the better off you'll be. A cash buffer is the best way to put yourself in a situation to execute a drawdown strategy successfully.

Disclosure: I am long COP, IBM, BP, GE, BDX. 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.