An Open Letter To My Kids - Prepare For Your Future Now

by: Eddie Herring

Dear J, A, & A: Do you remember our dinner table discussions, when we would have our family discussions, talk over issues of the day such as what happened at school, politics, issues of faith and values, family and friends, things going on in the world and all the other stuff? I think a good portion of your foundation and character was built during those family "roundtable" discussions. You participated in them, we laughed, we fussed, we agreed and disagreed, but we all learned from them. If I could add one more thing to those discussions though, it would be this. I wish we had discussed more with you about financial matters, or more specifically, preparing for your future retirement. So that is the purpose of this letter to you now.

You're all working now, and two of you have employer retirement programs you can participate in and one of you doesn't. We haven't discussed it specifically but I believe your current retirement programs are defined benefit pension plans. In all honesty I expect the defined benefit plan will probably go the way of the 8 track tape player and at some point yours will probably change to a 401K program or something similar. You'll probably be required to take more responsibility for it than in the past. That is not necessarily a bad thing. I'm sure there will be lots of debates and ill feelings over it, but that's the day and age we live in. Many pension plans handled by states are underfunded and are struggling to survive, and a number are raising the retirement age. You can expect more to do so in the future.

Don't depend on social security being there for you either. You are all at least 38 years or more from reaching the age to draw full retirement from social security. It's changed in my lifetime and will probably change again in yours. Let me give you this one piece of fatherly advice. Don't put your financial future in the hands of government bureaucrats any more than absolutely required by law. If social security is still there when you retire, great, and if not, then you will be prepared. Taking charge of your own financial future can, with proper attention and management, allow you to retire well before full retirement age.

You're currently busy with life and as you start having children (need I mention your Mother is growing impatient for grandchildren?) and getting involved with their interests, your free time will inevitably decline. Because of that time factor, or a lack of interest, or even believing they lack the ability to do it themselves, many people turn their investing over to financial professionals. There is nothing wrong with that if that is your decision but there is a cost for it. Good financial advisors earn and are worth their pay, but they're also not easily found.

My suggestion is to handle it yourself. I recommend a method called dividend growth investing, or DGI. With DGI you invest in quality companies that pay a reliably growing dividend that you reinvest in your account until such time you begin distributions. With proper understanding you will select investments that you will plan to hold for the next 40+ years and let them work for you. And it will not take as much of your time as you might think. With that said, let me get down to some specific retirement points to consider in doing this.

The Points

Live frugally now so that you don't have to live frugally as you get older. The less debt you have the more you can invest for the future. Automate your contributions so that you don't see them in your normal paycheck. Payroll deduction works great with contributions and it's easier to live without it if you don't see it.

If you are able to participate in a 401K and your employer matches a portion of your contributions I suggest you contribute enough to get the maximum match available.

In addition to your 401K open a Roth individual retirement account. Contributions are after tax money but they accrue tax free within the account and distributions are tax free. For your age group 2013 annual contributions are limited to $5,500 provided your modified adjusted gross income is less than $178,000 if married filing jointly, $112,000 if single. As a gift your Mother and I will provide funds for each account initially with an amount sufficient to get started since the IRS allows a gift tax exclusion of up to $14,000 or $28,000 for married couples for 2013. After that contributions will be up to you. And open a Roth for both yourself and your spouse. If you're married filing jointly the IRS allows the contributions to the Roth to be from the joint income. That's not true for the traditional IRA though, that income has to come from the account holder.

I also suggest you open up a taxable investment account. With this one you can contribute as much and as often as you wish, and you can withdraw at any time. You'll need to consider taxes in managing it but it will have more flexibility than the Roth IRA account.

Next develop a plan for all the accounts. This plan should include the amounts you'll contribute along with goals for 10, 20, 30 and 40 years out. The plan will define the type of investments you will make. I earlier recommended dividend growth investments. By receiving dividends you can have those reinvested for you and then those reinvested dividends will also pay dividends. As you know this is called compounding. Here is a chart illustrating compound interest and simple interest over time.

Chart 1

From 1926 to 2009 the stock market returned 9.8% per year. So if you start with $5,500 and contribute $5,500 annually, with a portfolio average 3% dividend yield and reinvesting those dividends, and the portfolio returns 9.8%, in 35 years your balance will be $3,267,172.40 (calculator used here). Here is a chart showing your portfolio compounding:

Chart 2
(Click to enlarge)

As you start progress may appear slow but as you can see over time the results really take off. If you're concerned about the amount you need to be saving towards retirement you can also use this calculator to get another understanding.

Before you decide what companies you want to invest in be sure to stick to this important rule: Don't invest in any company that you don't understand how it makes money and how it will keep making money in the future. I'll say it again. If you don't understand it, don't invest in it. Starting out I recommend you keep it simple and only invest in companies easily understood. This will eliminate companies with more complex operating structures such as mREITs, BDCs, and MLPs. Later as you gain knowledge you can expand in to these types of companies if you desire.

The Methodology

You will want to diversify your portfolio into multiple companies to reduce your risk. Starting out with limited funds will slow that down so you'll accomplish that over several years. I mentioned easily understood companies so here are my recommendations for your first easily understood companies:

  • The Coca Cola Company (NYSE:KO)
  • McDonalds (NYSE:MCD)
  • Johnson & Johnson (NYSE:JNJ)
  • Procter & Gamble (NYSE:PG)
  • Wal-Mart (NYSE:WMT)
  • Chevron (NYSE:CVX)
  • General Mills (NYSE:GIS)
  • Walgreen (WAG)
  • Kimberly-Clark (NYSE:KMB)
  • Exxon-Mobil (NYSE:XOM)

All of these companies have something in common. They are all "buy more" companies. What do I mean by that? They all provide products that people either want or need and they go buy more when they run out of them. If people want or need more toothpaste, drugs, food, toilet paper, gas, oil, or detergent these companies provide them. People might put off new software, automobile, or phones but they won't gas, household essentials, and food.

I'll explain this concept with a personal story. In the 80's I was in a well known department store shopping for a suit/sport coat. This was around the mid 1980's when the Miami Vice TV series had popularized a style for guys to wear the light colored flashy sport coats. But I was looking at the classic conservative black/blue/gray coats. While I was there a young man came in looking for the "Miami Vice" type colors and left irritated because the store didn't carry them. After he left the manager came over and what he said has stuck with me all these years. He said "what that guy doesn't understand is that I can get in those jackets and sell a few and then the fad or style changes and we're stuck with a surplus. But the coats you're looking at I can sell every day, every week, all year long and they don't go out of style." I've never forgotten that and he was right because those same types of suits are still selling. Now the point is not to invest in coats but in companies that manufacture products that don't go out of style, products that will be selling every day for years. In other words, for your core holdings invest in the "buy more" companies.

Before buying a company make sure it is financially stable. At a minimum look at growth rates for sales, net income, earnings per share, free cash flow, dividends, and also look at the dividend payout ratio, net profit margin, return on equity, debt, and credit rating. There are other metrics to review also and as you learn to do due diligence for your investments you will become more familiar with the others. But sales, net income, EPS, and free cash flow tell you if the company is continually making money and how much cash they have left over to pay the dividends, if the dividends are growing fast enough to keep up with or exceed inflation, and the dividend payout ratio indicates how much money is being used to pay the dividend. A high net profit margin means the company is making more money on what it sells. Return on Equity tells you how well management is using the earnings it generates, debt and credit ratings can tell you how sound the company is considered. But remember this, cash is king. The company is worth the cash it's generating today and will generate in the future. Look at those 10 buy-more companies in the table below.

(Click to enlarge)

Notice how low Wal-Mart and Walgreen's net profit margins are. They have to sell a lot of products in order to generate the cash flow they do. Then look at KO and MCD. They also sell a ton of product but have higher profit margins. And companies like JNJ or XOM are growing their dividends, generating a return on equity of over 25%, and have very low debt to equity as well as AAA credit ratings. Those are excellent companies to own.

Buy when these companies are at a price where they're not "over-priced." That means they are selling at a fair value or at a discount to their actual worth. There are many ways to calculate fair value so I'll suggest a way to make it easy. Subscribe to Fast Graphs and use their charts. It'll save you a ton of time and it's not expensive. To illustrate here's a chart on McDonalds:

(Click to enlarge)

The black price line is above the orange earnings line which indicates it's overvalued although not by a significant amount. It's also under the blue P/E line which based on its historical PE is cheaper than normal. Compare it to this chart of GIS.

(Click to enlarge)

You can see the price line is above both the orange earnings line as well as slightly above the blue PE line which indicates GIS is a little over-valued. Then look at this chart of XOM.

(Click to enlarge)

You can see that XOM is under-valued at its current price point which means if it meets your criteria you've determined are important to you, i.e. your due diligence requirements, then you might consider it as a buying opportunity. When you can buy one that is under-valued such as this one then you are buying with a margin of safety which will reduce your risk. And managing your risk is of utmost importance.

After you purchase the price will often decline further. Don't worry because you will rarely buy at the exact bottom of a price decline and the price you bought at will go up and down. As J.P. Morgan, the financier who was instrumental in starting both General Electric and U.S. Steel, when asked what the market was going to do, responded by saying "it will fluctuate." If you are buying these companies as long term investments then my advice is to ignore the price swings and focus on the company fundamentals and the income that the companies will be generating for your account. In other words be an investor not a trader. You're holding for the long term and as long as the company remains fundamentally sound, continues to generate cash and pay a growing dividend, you'll be okay.

So if you had bought these 10 companies I've suggested as starter companies how would you have done? Over the past 10 years a portfolio of these companies had a total return of 186.1%, averaging out to 18.6% per year including dividends. The S&P 500 during this same period was 97.1%. The portfolio volatility of these companies was 10.1% which compares to the S&P 500 volatility of 14.7%. That time frame includes the great recession so buying and holding these would have been a smoother ride and more profitable venture than buying and holding the S&P SPDR ETF (NYSEARCA:SPY). And these 10 companies have economic moats or sustainable competitive advantages.

Obviously there are a lot more details to investing than what I've listed above. But it's not rocket science either. As you get started in this you will learn more and more. You'll probably develop your own preferences for selecting and evaluating the companies in which you want to invest and will broaden your horizons into other types of companies such as the REITs, MLPs, and BDCs I mentioned earlier. You may even decide to invest in companies that provide faster growth or companies that you know something about through your vocation, such as Nike (NYSE:NKE) or Under-Armour (NYSE:UA), that aren't traditional dividend growth companies. But the important thing is to get started. It might seem far off but it'll be 2050 before you realize it. Your Mom and I want the best future possible for you and our future grandchildren. So don't wait, prepare for your retirement starting now.

Disclosure: I am long CVX, GIS, JNJ, KMB, KO, MCD, PG, WAG, WMT. 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. I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.