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Dividend growth investing, retirement
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Summary

  • Realty Income's business model is similar to my own business model as a dividend growth investor.
  • Our central goal is the generation of an increasing stream of cash dividends.
  • We use similar methods to achieve our goals. Each step is described.

I was struck recently by a graphic that appeared in an article by Regarded Solutions about Realty Income (NYSE:O). The company's diagram illustrates how they go about generating reliable dividends and fostering dividend growth over time.

What struck me about the diagram (which comes from O's website) is that their business model is so similar to my own as a self-directed dividend growth investor. Like Realty Income, I also want to generate reliable dividends and foster their growth over time.

Let's start at the top and work clockwise around the diagram.

Discover

Realty Income searches for properties. I search for dividend growth stocks.

I use a broad definition of dividend growth. Some people exclude REITs or MLPs, because of their special structures. I do not exclude them. Some people exclude utilities on the basis that they grow too slowly. I don't.

I use exactly the same definition for dividend growth that David Fish uses for eligibility on his popular CCC document. CCC stands for Champions, Challengers, and Contenders. In compiling his invaluable research tool, David uses a simple requirement: Has the company increased its dividend payout X years in a row?

If X is equal to or greater than 5, the company makes it onto the document. It is hard to get simpler than that. Each C in CCC stands for the number of years of consecutive increases:

  • Champions have increased their payout for 25 or more years in a row.
  • Challengers have increased for 10 to 24 years in a row.
  • Contenders have increased for 5 to 9 years.

With few exceptions, I do not look beyond CCC to discover dividend growth companies. I no longer conduct independent searches through hundreds of companies to see if there is something David has missed. He rarely misses anything.

Analyze

Realty Income does not buy every property that comes to its attention, and I do not buy every CCC stock. I analyze the stocks to see how they fit my goals and whether one might improve my portfolio.

My principal goal is this:

The goal of my Dividend Growth Portfolio is to generate a steadily increasing stream of dividends paid by excellent, low-risk companies….I am more interested in the ability of this portfolio to produce income than its sheer size.

That quote is taken from my Constitution, which is the highest-level strategy document that guides my investing. Note how similar my goal is to Realty Income's, as explained in their Guidelines:

Operate a business that is designed to generate cash to pay a dividend over a prolonged period of time. Be conservative [and] committed to prudent growth… so that the income stream used to pay a dividend tends to be dependable. Maintain a long-term view and make operating decisions based on how they impact the ability to pay a dividend.

Realty Income runs their business according to those guidelines. I view my dividend growth investing as my own business, and I run it according to my Constitution. As a self-directed investor, I am both the CEO and CIO (Chief Investment officer) of my "company."

I divide my analysis of companies into two broad categories:

  • Company excellence
  • Stock valuation

When I am analyzing company excellence, I look for things like a great business model, sustainable competitive advantages, revenue and earnings growth, manageable debt, and the like.

As to the dividend, I try to find yields of more than 2.7%, dividend growth rates (DGR) of 4% per year or more, and of course an established record of annual dividend increases.

I score companies for their excellence. Higher-scoring companies rise to the top. Many readers here use the chowder rule to screen stocks. Chowder requires Yield + DGR to be equal to or greater than 12 for most stocks (some exceptions are made). Under my approach, theoretically a stock with Yield + DGR = 6.7 could qualify.

But such a stock would probably not rise to the top of my rankings, because of the grading system. In my Top 40 Dividend Growth Stocks for 2014, the Yield + DGR numbers range from 8.7 to 28.2, with a median of 14.4 and a mean of 16.7.

When I am analyzing stock valuation, I use tools like Morningstar's star ratings for stocks and FASTGraphs to identify companies that are selling for no more than a fair price, and hopefully for a bargain price.

Buy

For me, dividend growth investing is mostly about accumulating great dividend growth companies. I collect the dividends that they send me, and periodically I reinvest them to purchase even more shares. The result is a virtuous circle:

(click to enlarge)

In making purchase decisions, I look for high-rated companies that are well-valued and will improve my portfolio. Without overdoing it, I diversify, aiming for a well-rounded portfolio, just as Realty Income strives for diversification in its property holdings.

Diversification has been called the only free lunch in investing. The idea is explained clearly on Realty Income's website:

Diversification simply means spreading investment dollars across a number of different investment types, industries or companies with a goal of minimizing the losses that might occur when investing in a single type of investment, industry or company. This is similar to the idea of not putting all of your eggs in one basket.

Own

Realty Income's business model is not based on flipping properties for profit.

Similarly, not much of my business model is predicated on selling shares for a profit. I certainly do that under certain circumstances, but mostly I am interested in optimizing the income generation from shares that I own.

I view this process as amassing dividend rights, which are the rights that I get, as a part-owner of great companies, to receive the dividends that they distribute to shareholders from their profits.

Thus, I am an investor, meaning that my goal is to gradually build wealth over an extended period of time through buying, and mostly holding, dividend growth stocks. When I buy shares in any stock, my hoped-for holding period is forever, although of course things do not always work out that way.

Along the way, I expect to benefit from compounding, which on the income side occurs both through companies increasing their dividends and also through my reinvestment of them. Thus I am making money on money already made.

Many investors underestimate the power of compounding. Say that my average company increases its dividend 9% in a year. My total dividend income, however, may increase 12% over the previous year. How is this possible? Through compounding.

I use the incoming dividends to purchase more shares, either of a company that I already own or of a new company that I want to add to my collection. Those new shares generate dividends themselves, causing the income stream to rise at a faster rate than if I were not reinvesting the dividends.

Here is an illustration from my demonstration Dividend Growth Portfolio:

The blue line of actual dividends curves upwards towards the portfolio's 10-year goal. The increase in dividends each year is not linear, it accelerates. The 10-year goal line is based on a compound annual growth rate [CAGR] of 12.8%, even though I don't expect the average stock in the portfolio to maintain a DGR that high. The gap is made up through reinvesting and compounding.

Manage

Many investors use the term buy and hold to refer to the investment approach that I have been describing. However, to me, that does not describe what I do, because I am not that passive. I don't buy stocks and then forget about them.

As CEO and CIO of my investment business, I actively manage it. A better term would be buy and manage.

What do I manage? Every aspect of the business:

  • Strategies and goals
  • Tactics
  • Optimization of income
  • Deciding what to buy, hold, and sell
  • Reinvestment decisions
  • Risk
  • Mistake corrections

All of my guidelines are spelled out in the Constitution. For example, I have guidelines on when to consider selling a stock:

Investigate and seriously consider selling any stock for these reasons:

(1) It cuts, freezes, or suspends its dividend.
(2) It bubbles or becomes seriously overvalued.
(3) You receive news of significant changes impacting the company.
(4) It is going to be acquired.
(5) It announces plans to split itself or spin off a separate company.
(6) Its current yield rises above 9 percent or drops below 2.5 percent.
(7) It underperforms the market in total returns (price + dividends) for three
years running.
(8) Its size increases beyond 15 percent of the portfolio.

Note that these are guidelines, not rules. When Intel (NASDAQ:INTC) froze its dividend in 2013, I waited several months (to see if they would raise it) before selling my position. Some dividend growth investors have a hard-and-fast rule to sell immediately in such situations, while I "seriously consider" it.

The point I want to make about managing is that it is an activity that extends beyond buying and holding. My investment goal is clearly stated. Achieving that goal requires more than making good decisions about what stocks to purchase and then holding them forever. That is my aspirational holding period, but things don't always work out. Facts change, and as an active manager, that may cause me to change my opinions and to make new decisions.

Cash Dividends

In the center of Realty Income's diagram is their central goal: The production of cash dividends for their shareholders.

That is my central goal too. I want my business to produce cash dividends. When it does, I reinvest them as described earlier. At some point, I will live off of them, hopefully without needing to sell a share of anything to create the cash flow that my wife and I need.

Assuming that we reach that point, we will never outlive our money.

Source: Realty Income's Business Model Is Similar To Mine As A Dividend Growth Investor