Income Investors Take Note: Man Can't Live on Dividends Alone

Includes: CVY, DVY, FDL, FVD, PEY
by: Roger Nusbaum

One Seeking Alpha contributor I read is David Van Knapp who writes about dividend investing in the context of drawing income for retirement. David had a post yesterday that among other things asked for input about how RIAs approach dividends thinking that they are often ignored by advisors. I don't think that is true but either way below is the conversation David and I had in the comments of his post:

Me: I don't think RIAs ignore dividends in the manner you frame. In building a diversified portfolio there are likely to be quite a few companies with solid track records of dividend growth along with companies that pay no dividends.

For what it's worth, I target a yield for the overall portfolio, 3% is a good number for us. We own enough different names (usually 30-40) that dividends are hitting the account all the time--the month of May is a big month as a couple our foreign stocks are annual pays and pay that month--such that there is very rarely any need to sell something for the client to take their distribution.

Even a portfolio with a market equaling yield of 2-ish percent would only need modest gains to meet a reasonable withdrawal rate. In describing what we do it is not a story about dividend growth it is about diversification which INCLUDES dividend growers.

Please don't take this as a commercial but in terms of what RIAs do I would tweak the way you frame it as being the way to think of it.

David: Roger, Thanks for your comment. Your "FWIW" is invaluable. You do target an overall portfolio yield! You do recognize the trade-off of yield dollars for withdrawal dollars! That's great.

I think I know your answer to this, but I'll ask it anyway: Do you classify dividend stocks as a separate category of investment? If not a separate asset class, then at least as a separate category of stocks? If neither, then how do you target the 3% yield...or is that just a natural byproduct of the way you select investments? I guess another way of asking the same question would be, how do you "target" the 3% return? To me, "target" implies proactive strategies/actions to achieve it.

Me: Part of the process for me in building the portfolio is selecting what I think are the best exposures for each sector, country and theme. Some sectors, countries and themes lend themselves to being dividend centric and some not.

We've owned VALE and STO each for about six years (subject to shaving down and adding back in). In that time VALE is up 500%--for this name I don't really care about the dividend, I view the name as a great way to own Brazil, materials and volatility for the long term.

STO is up about 95% so the annually paid 4-5% dividend has been a much more important component to why we want the name.

In buying tech stocks, although several now have very good yields, it is not the primary consideration but it would be more important with utilities and telecom.

Energy and financials are examples where we want a mix of high yielders and what we hope will be fast growers.

Hope that makes sense.

David: It does make sense, Roger, and thanks for engaging in this discussion, you are about the only "pro" to share your thoughts. Let me rephrase what you said and see if I have it right. You look for the "best" exposures by sector, country, and theme. I take it that by "best" you mean the best prospects for capital gains in some cases, and total return in other cases. In the latter, dividends would play more of a role in your selection process. That's your selection process in a nutshell?

If so (and correct me if I am wrong), then the yield of the resulting portfolio sort of happens as a byproduct of the securities you select. Forgive me, I am having trouble correlating the "targeting" of 3% yield with a selection process that does not emphasize yield. Not trying to argue, I just want to understand.

When the time comes for your clients to live off their portfolios, I take it that the proportion of yield dollars as compared to withdrawal dollars is developed on a case-by-case basis? What's the maximum "safe" withdrawal rate that you recommend? Do you have clients that exceed that? What do you think of the Vanguard hybrid model described in the article?

Me: "Best" is a function of several things in terms of where we are in the cycle, trends emerging in each part of the market, or something becoming more attractive--we recently added Ecopetrol for many clients.

As far as targeting a yield. The portfolio was originally built in 2003, it had a certain yield. Along the way as changes have been made the yield goes up or down a little with each change made. If I wanted to have a noticeable change up in the portfolio's yield for some reason I could (examples only) swap SU for YPF and IYW for MXIM and add quite a few basis points to the yield. The few purchases we made early in 2009 would have had less regard for yield because the market had cut in half and some sort of snap back was plausible. Really this has become a matter of spreadsheet work.

As for living off portfolios, I blog about "whatever you got 4% (more realistically 1% per quarter)" without worrying about increasing it for inflation because if the portfolio is growing then you'd be taking 1% (or less) of a bigger pie every quarter. I would note that my role is portfolio manager and I have little to no client contact in this regard, my colleagues do that.

David: I do exactly the same thing: 1% per quarter. I know I make it sound sometimes as if I take dividends directly and spend them, but actually I mentally run them through my "cistern" to compute total spending allowance. What we are both using is model #2 from the Vanguard article. I like the method, because it does not mindlessly increase for inflation when your assets are contracting. Allowance decreases are at the margin and easy to tolerate. In actual execution, the dividend dollars make up most of the "withdrawal." I am not at the point yet where dividend dollars totally fund what we need for our retirement budget, although that goal is getting closer and closer as the dividends keep going up.