The simplest way to generate passive income is through dividends. There are other avenues to generate passive income, such as investing in real estate, but normally these require a large initial capital and lot of work; also, most often investments are illiquid. Investing in dividend-growing stocks involves two basic steps:
- Identify companies with large moats that pay regular dividends and raise them year after year.
- Buy and hold the stock of such company's long term (10-20 years) and re-invest all dividends. Hold at least 20 stocks for diversification.
The first step is not too difficult. There are several websites that make this information available; one that I normally visit is "Dividend Champions" maintained by DRiP Investing (The list of US dividend champions is maintained by David Fish, a Seeking Alpha contributor). It maintains a list of companies who have paid and grown dividends consistently over a 25+ year period. Once you have identified a company, it is also important not to overpay. This is what I generally look for: If the current dividend yield of a company is in the range of its long-term average dividend rate (during the past 10-20 years), it should indicate a fair price. Say, for Coca-Cola (NYSE:KO), if the current dividend yield is 3.0%, and the long-term average dividend yield over the last 10 years has been 2.80%, then it may be an indication of fair price. On the flip side, if the current dividend was 2.5%, that would indicate an over-valued share price and it may be better to wait for a price correction. Another technique would be to initiate a small position and then regularly add extra money (say every month or every three to six months) to take advantage of dollar-cost averaging. You could also use the DRIP (Dividend Re-Investment Plan) facility provided by many companies to keep the trading costs at a minimum.
The second step usually proves to be more difficult for many people: To hold a stock (with dividends re-invested) for a long term lasting ten or twenty years. That's exactly what one needs to do without worrying about the daily gyrations in the stock market, as long as the fundamental story of the company remains intact, however. With dividends reinvested, it accumulates more shares that in turn earn more dividends and so on. In the first few years, you may not see much increase in the holding, but after a while the principles of compounding take hold, acting as a "snowball" effect.
An Example of Dividend Growth:
Let's assume that on January 4th, 1994, the first trading day of the year, you buy shares worth $2000 of Colgate Palmolive (CL; 37.14 shares @ $53.85 per share). Assuming you re-invest all dividends after purchase, but never put in an extra penny. Ten years later (January 2004), you will have 177 shares (after two splits and consistently growing dividend) worth $8387, paying you $170 in dividend income per year. Pretty nice return. Keep in mind that during these ten years, we had a raging bull market followed by a severe bear market from 2001-2003. Now, let's assume that you, being a patient investor, decide to continue holding the shares and re-investing all dividends for another ten years. Fast forward another ten years to January 2nd, 2014. After the great recession of 2008-09, and a recovering market since 2010, you would have 443 shares of Colgate worth $28,500 (share split in 2013 and dividends buying more shares). That is a darn good return. More importantly, the current dividend income you receive on these shares in 2014 is $603 per year, with your original investment being a mere $2000. You are now making a 30% yield on cost.
Let's add one more twist: You also added $500 to your Colgate holding on the first trading day of January every year. This means, starting January 1995, you invested an additional $10,000 over the next 20 years. With your total investment of $12,000 in January 2014, you would have 1032 shares of Colgate worth $62,214, earning you roughly $1404 of dividend income (on a yearly basis), nearly a twelve percent yield (income) on cost.
Colgate Palmolive is just one example amongst many good companies who pay consistently growing dividends year after year. Since, in the investing world, past returns are no guarantee of success in future, it is very important to diversify your capital into many companies. I like to allocate my capital between at least twenty or more companies. Also, I never like to invest more than three to four percent of my investible capital in any one company.
Growth stocks versus Dividend-stocks (Hare versus Turtle?):
There are a lot of folks who prefer to invest in growth stocks and there is nothing wrong with that. However, investing in growth stocks requires a lot of time researching the market and constantly keeping a tab on the companies you are invested in. For example, let's assume for a moment that you had the foresight to know in 2003 that Apple (NASDAQ:AAPL) as a company was going to do extremely well and so you invested in Apple, which was a growth stock back in 2003, and stayed invested until 2011. You would have made a great return. But that would also mean that you bought at the bottom and sold at the top. Some people may have that magic-touch, but most average investors who bought Apple at the right time still did not make much profit because chances are, they sold it too early making just a few hundred dollars. In the long term, those few hundred dollars don't count for too much. Also, in the process, you are constantly trading and as such paying a lot in trading commissions and taxes. It also means you are spending a lot of time researching and trading. Most folks cannot afford to spend that much time on a constant basis. Most importantly, you would miss the compounding effect.
Turtle Wins the Race:
On the other hand, investing in dividend-growing stocks can be left on auto-pilot once you have identified the right mix of companies. All you need is to review the companies you are invested-in once every six months, or quarterly at most, to make sure that nothing has changed drastically and that their dividend growth model is still intact. You may not see immediate, short-term results, but it will compound your dividend income over time. After ten years or so, compounding really goes into overdrive and the investment can actually start generating serious monthly income. It is quite feasible that you would never need to sell your dividend portfolio, but simply could live-off the income it generates. However, it requires that you hold the stocks through good times and bad, which is easier said than done.
Disclosure: I am long CL, KO, AAPL. 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.
Disclaimer: All projections have been worked out using online portfolio software. All calculations are approximate. This article is for information purposes only and in no way should be construed as recommendation to buy or sell any securities.