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Summary

  • For rich retirees, dividend stocks might not be the best choice.
  • Standard portfolio structures don't take into account the long-term compounding potential of buy and hold stocks.
  • By focusing on immediate returns through interest payments and dividends, rich retirees lose one of their major advantages: they have the possibility to really invest for the long term.

The "problem"

A few weeks ago a friend of mine, who has sold out of a joint venture and is now retired, asked me how to invest his money. He has already collected several recommendations by bank consultants and investment professionals and while I believe that my Early Retiree Portfolio is suitable for average early retirees, his situation required some adjustments, which I will explain later on in this article.

He is married, his children don't need any support anymore, he owns a nice house, where the couple usually lives, has a quite expensive lifestyle and now wants to travel a lot. In figures: Besides the house, his now liquid net worth amounts to about $15 million and he wants to be sure that he can spend at least $200,000 each and every year for the rest of his life. He is now 53 years old. He doesn't want to rely on his pension, which anyway would be too little (compared to his requirements) and he still has to wait for it to become available. So basically he has to squeeze $200,000 (after taxes) out of $15 million every year and protect the purchasing power of this amount. That's the goal.

The consultants' recommendation

The average recommendation he received was to build a portfolio with approximately the following structure:

Asset class

Allocation (%)

Amount ($ m)

Projected yield (%)

Yield ($)

Gold

10

1.5

-0.3

-4,500

Treasuries, mix of several durations from short to long term

35

5.25

2.5

131,250

Corporate bonds, mix of several durations from mid to long term

20

3

3

90,000

Income stocks

35

5.25

7

367,500

TOTAL

100

15

3.9

584,250

The negative yield on gold refers to custody or similar fees. The yield on income stocks is intended as total return, of which my friend should receive about one third as dividends. Hence, he would receive current pre-tax income of $348,250, somewhat more than what he required in order to also cover taxes and fees. Some rebalancing would be necessary after a few years, as stocks, growing at 4-5%/year, should represent a larger part of the pie after a while.

There are a few details I want to highlight in this (rather common) portfolio project:

- Rebalancing requires to sell stocks and buy bonds and treasuries. This comes at the cost of fees and taxes on capital gains.

- Retained earnings and growth of the stock portion alone must compensate inflation for the whole portfolio, as all other asset classes won't grow together with inflation and their returns are spent every year. Hence, while this portfolio structure at first sight seems to be a very conservative choice, its long-term success in the end relies heavily on the stock selection. If $5.25 million in stocks don't manage to compensate inflation for $15 million, after a decade or so it will be even harder to preserve the purchasing power of his wealth. And of course my friend wants to leave his wealth to his family and not consume it.

- All in all, funds available at short notice would be only in the short-term treasuries portion, probably less than $1 million. The prices of all other asset classes fluctuate and might require to sell at a loss, if necessary.

- As I don't consider gold and corporate bonds to be risk-free assets, only about a third of the total portfolio would be allocated to risk-free assets.

My portfolio recommendation

As you have read the title of this article, it will be no surprise to you that I recommended to slash the dividend stock portion of the portfolio. Why that? Let me explain.

If dividend stocks were the perfect choice for rich people, Warren Buffett would be crazy to keep almost all of his wealth in a stock that doesn't pay one: Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). I have laid out in another article, why I believe that Berkshire is right to retain all earnings. Some of the reasons laid out in that article also apply to individual investors. In other words: If you don't need it, keep your money invested in productive assets and let compounding do its magic. Make sure that you don't need to sell, not even in worst case scenarios. Over long periods of time, stocks simply are the asset class that provides the highest returns and the best protection against inflation and other calamities, as businesses continually adjust to an ever changing world and look for ways to profit from new opportunities. Gold can't guarantee this result and neither can treasuries or corporate bonds.

What I recommended to my friend may seem outright crazy to some of you. Here is the allocation table:

Asset class

Allocation (%)

Amount ($ m)

Projected yield (%)

Yield ($)

Treasuries, short term

35

5.25

0.5

26,250

Cash

5

0.75

0

0

Stocks that don't pay dividends

60

9

8

720,000

TOTAL

100

15

4.98

746,250

(I slightly increased the projected yield on the stock portion from 7 to 8%, presuming that businesses can provide higher returns, if they reinvest the amount otherwise paid out as dividends. And, yes, of course it would be possible to squeeze more yield out of the cash/treasuries pile, but this is not necessary to prove my point.)

The reasoning behind this portfolio structure is very simple:

- Over the next 20 years, my friend will need about $5 million, presuming that inflation rates will average 3%/year.

- Over the same time, the $9 million invested in stocks, compounding at 8%, will have become $40 million, while the cash portion will have been consumed.

- In 2035, if inflation compounds at 3% until then, he would need $350,000 per year to cover his expenses.

- This amount would represent 0.88% of his wealth, while today the required $200,000 represents 1.33% of his wealth. Hence, his overall purchasing power will have increased.

- However, in order to have liquid funds, he will need to sell some stocks and pay taxes. Assuming that he will continue on the same path as before, by selling 25% of his stock holdings, he would realize about $7.4 million after taxes.

- This amount would cover his expenses for another 16 years up to the age of 89. At that time he would have about $90 million in stocks and expenses of $560,000 - or 0.62% of his wealth - meaning that his purchasing power would have increased once again.

- Besides very small amounts of taxes on interest income from his treasuries, he would not need to pay any other taxes except once after 20 and then again after another 16 years. No rebalancing, no fees, no hassle whatsoever.

- One major risk to this portfolio would be takeovers, or if one of the stocks my friend owns initiates a dividend. In these cases he would be forced to realize capital gains and pay taxes, or might need to rebalance his portfolio. Anyway, even in these cases, his portfolio would still be at least as tax efficient as the first one, recommended by his consultants. Very high inflation rates would probably do less damage to my portfolio than to the consultants' portfolio, considering the latter's high allocation to bonds and the lower likelihood of high rate compounding associated with income stocks.

Stock selection

Of course the most important problem to solve is the selection of the right stocks, which would be held forever. They should provide sufficient diversification among market sectors, currencies, geographies and be managed with a clear focus on compounding value for long-term shareholders.

Berkshire Hathaway: One obvious choice seems to be Berkshire Hathaway. It has a clear focus on compounding capital for shareholders, is highly diversified among market sectors and includes an impressive set of high-quality businesses. There also is some international diversification, mostly through the stocks in its investment portfolio. But will it be able to compound for 30-plus years without paying dividends? On the other hand, given its size, it is certain that it won't be acquired, forcing shareholders to realize capital gains. So, all in all, I would include it.

Markel (NYSE:MKL): Also called "Baby Berkshire," this company modeled after Warren Buffett's holding is managed by smart value investors. Book value per share has grown at a CAGR of over 10% during the past decade (the 20-year CAGR is 16%) and is likely to continue to grow by double-digits in the future. Markel has a market capitalization of $8.2 billion and owns a diversified set of businesses with exposure to insurance, manufacturing and healthcare among other sectors.

Loews (NYSE:L): another value investor run conglomerate. Loews pays a very small dividend and regularly returns excess capital to shareholders via massive stock repurchases. Here is an overview of the company's activities:

(click to enlarge)

Besides these rather easy choices that seem to have been created for our purposes, there are a few other companies that check most of the boxes required.

DirecTV (NASDAQ:DTV): This satellite TV provider enjoys very stable cash flows, which are mostly returned to shareholders via stock repurchases, as the company has little opportunity to invest retained earnings. It might be taken over, however, or might initiate a dividend. Bears say that web based TV will kill the company, while bulls (like myself) point to the great long-term potential of the Latin American markets, where DirecTV enjoys market leading positions and huge competitive advantages.

Another set includes companies that operate as consolidators in their markets and thus have a long path of growth ahead. (If they invest their retained earnings wisely.)

Jacobs Engineering (NYSE:JEC): I recently wrote an article on this company. Jacobs is one of the world's largest and most diverse providers of technical, professional and construction services. The company serves a great diversity of markets all over the world, has a very stable business model and invests its retained earnings to fuel growth through mostly small, niche, bolt-on acquisitions. It doesn't pay dividends, but might be taken over in the future, given its relatively small size.

World Fuel Services (NYSE:INT): This company also acts as a consolidator in its markets and over time has acquired a great number of smaller competitors, fuelling its own growth by investing smartly its retained earnings. It pays a very small dividend.

DaVita (NYSE:DVA): One of the largest dialysis providers worldwide. Its markets are growing, retained earnings can be invested at good rates of return into the expansion of its now global clinics network, fuelling growth with very little risks attached. It doesn't pay a dividend and occasionally buys back its own shares. Some investors believe that DaVita might be taken over by Berkshire Hathaway (although I don't think so).

Google (NASDAQ:GOOG): If you feel like investing in the rapidly changing world of technology, take a look at the web search monopolist. The company is unlikely to be taken over, doesn't pay dividends, at least until now, and would seem to be well positioned for a prosperous future (not only) thanks to the strong market position of its search engine.

Conclusion

My key point here is: By focusing on immediate returns through interest payments and dividends, rich retirees lose one of their major advantages, as they have the possibility to really invest for the long term and reap the benefits of internal, tax-efficient compounding. Unfortunately standard portfolio structures still prefer to possibly provide "low beta" through allocation to uncorrelated assets, even if in this specific case the investor doesn't need "low beta," nor would he have any advantage from it.

[Editor's Note: For another view, read Rich And Retired? Please Buy Dividend Stocks]

Source: Rich And Retired? Don't Buy Dividend Stocks

Additional disclosure: I may initiate a long position in JEC within the next 72 hours.