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Dividend growth investing, retirement
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Background

My Dividend Growth Portfolio (DGP) is a public “demonstration” portfolio that I use to illustrate real-world application of principles and tactics in dividend-growth investing. The portfolio contains real money and actual stock holdings. It is part of my retirement cistern.

Articles about the DGP allow those interested to judge whether the principles and decisions make sense and work in the real world. See my four most recent articles in this series:

  • Dividend Growth Portfolio Review: Sherwin Williams Is Out (April 26, 2011)
  • The 5-Year Rule in Dividend Growth Investing (April 15, 2011)
  • Road Map for Managing a Dividend Growth Portfolio (February 23, 2011)
  • Watching Dividends Rise: Putting Together a Focused Dividend-Growth Portfolio (February 1, 2011)

Formation of Portfolio

I began the DGP—with its dividend-growth mission—in 2008. I converted it from a portfolio that actually began on April 1, 2002, when I funded it with $40,000. In the beginning, the portfolio had no particular strategy. I used it to experiment with small positions, test investing concepts, and the like.

In early 2008, I decided to convert the portfolio to the dividend-growth strategy. I did that in conjunction with writing my first Top 40 Dividend-Growth Stocks e-book. I wanted the portfolio to publicly demonstrate the opportunities and risks, the successes and failures, of a dividend-growth strategy. I had been studying and experimenting with that strategy for awhile, and I had become convinced that it was a viable approach for building a retirement portfolio. A unique characteristic of the strategy is that it has a built-in “withdrawal” methodology already in place when you retire. There is no need for a pre-retirement conversion (“glide path”) into “safer” fixed-income investments. The portfolio itself already spins out dividends, and if the portfolio is of sufficient size, there may be no withdrawals at all. You just stop re-investing dividends and start keeping them as spending money.

In hindsight, of course, buying stocks in early 2008 was bad market timing, as we were in the throes of a crash that would not bottom out until a year later. But I wanted to establish the portfolio in time for publication of the e-book, so I bought into the crash anyway. As it turns out, that may have made the portfolio even more effective in demonstrating the efficacy of the strategy.

Results I

Until now, I have always measured the DGP's results against the original 2002 investment of $40,000. But I have decided that I should re-boot the reporting to explicitly reflect the portfolio’s dividend-growth mission since 2008. So as of right now, I am converting my reporting to do that. (It may take a little while to change my website. July’s update, posted a few days ago, was based on the former method. You’re reading about the new method here for the first time.)

I made the final stock purchases to convert the portfolio to a full dividend-growth strategy in May, 2008. So from now on, I will report the DGP portfolio’s results as if it began on June 1, 2008. That makes the reporting a little awkward given the 7-month “first year” of the portfolio, but the reports will be more accurate, and they will reflect only the portfolio’s dividend-growth mission. Its former life is now gone.

The main focus of a dividend-growth portfolio is to be a “money machine” that creates streams of dividends that become ever-larger over time. That is the principal metric that I use to measure the results of this portfolio. The mission statement targets a 10% yield on cost (from dividends alone) to be achieved within 10 years. To get there, each stock must progress steadily via annual dividend increases. Price gains are nice but don’t help toward the central goal.

The portfolio is well on its way to its 10-in-10 goal.

Year

Dividends

Yield on Cost

Change

2008 (7 months)

$1316

2.8%

NA

2009

$1568

3.4%

19%

2010

$1799

3.8%

15%

2011

$2014 e

4.3% e

12% e

Next 12 months

$2099 e

4.5% e

NA

The “e” in the bottom two rows indicates that the dividends are projected based on information known now. By year-end, all of those numbers will be higher for the three reasons listed below.

The yield on cost is based on the “new original” value of the portfolio ($46,783) as of June 1, 2008. Note how the dividend stream and yield on cost both march continually upward. Yield on cost goes up steadily, because the divisor in the equation yield = dividends / price is fixed at the beginning value of $46,783 (this is a closed portfolio with no new money being added). But the numerator increases every time a dividend increase is declared or I reinvest dividends. Both events result in more dividends from the portfolio, which in turn drives up the yield on cost.

The portfolio exists at E-Trade. They have a tool called the Income Estimator that projects dividends into the future. The Estimator is a good tool, but it cannot predict perfectly, because it does not know some things:

  • Dividend increases as yet undeclared by each company. The portfolio’s companies raise their dividends annually. Until the increases are actually declared, the Estimator cannot include them. Some stocks in the DGP still have increases coming in 2011, others in early 2012. Those are not reflected in the estimates above.
  • Dividends on additional shares that will be purchased with incoming dividends. I allow incoming dividends to accumulate to $1000 then reinvest them. Reinvesting dividends accelerates the growth of yield on cost by adding a layer of compounding to the dividend growth rate (DGR). In 2011 so far, I have made two reinvestments, and it appears that enough money will accumulate for a third purchase before the end of the year.
  • Any other changes made to the portfolio, such as swaps into higher-yielding stocks. In April, I sold Sherwin Williams (SHW) and purchased two other stocks with the proceeds. That caused a jump in the portfolio’s yield as well as in its likely DGR going forward.

This year I am tracking the monthly changes in the Estimator’s projections. Here is what they have been for the “Next 12 months” for each month of 2011:

Estimate as of First of Month…

Dividends Next

12 Months

Yield on Cost

Change from Prior Month

January *

$1864 e

4.0% e

February

$1905 e

4.1% e

2% e

March

$1916 e

4.1% e

1% e

April **

$1917 e

4.1% e

0% e

May

$2021 e

4.3% e

5% e

June *

$2054 e

4.4% e

2% e

July

$2099 e

4.5% e

2% e

August

??

??

??

* Reinvested accumulated dividends (bought more Abbott Labs (ABT) each time)

** Sold Sherwin Williams (SHW) and redeployed proceeds by (1) adding to Alliant Energy (LNT) and (2) beginning new position in Johnson & Johnson (JNJ).

You will note how both reinvestments and the redeployment of the proceeds from the sale of SHW helped the estimates jump the following month. In the case of the two reinvestments, the estimates jumped on the basis of more shares owned. In the case of April’s swap of SHW for LNT and JNJ, it was a simple trade-up in yield. Other increases in the Estimator’s numbers are the result of figuring in dividend increases as they are announced.

Portfolio’s Holdings

These are the stocks currently in the Dividend Growth Portfolio.

Stock

Percentage of Portfolio

Abbott Labs (ABT)

9%

Alliant Energy (LNT)

10%

AT&T (T)

2%

Chevron (CVX)

6%

Johnson & Johnson (JNJ)

12%

Kinder Morgan Energy Partners (KMP)

7%

McDonalds (MCD)

18%

Realty Income (O)

11%

PepsiCo (PEP)

20%

Telefonica (TEF)

5%

The portfolio currently has about $200 in cash. When the cash accumulates to $1000, I will reinvest it, which will probably happen before year-end. As the dividend stream continues to accelerate, I will probably raise the trigger amount—to $1250 or $1500—in order to keep the number of new purchases down to about two or three per year. This is the first year in which there will be three reinvestments in a calendar year (2008 had one, 2009-10 had two each).

As you can see, this is a concentrated portfolio: It only contains 10 stocks. I am well aware that many dividend-growth investors believe in holding 20 or 30 or more stocks to spread out the risk of a disaster in any single name. I am comfortable with a minimum of 10 stocks, and I may allow the number to grow to 15 or 20 over time.

I review the portfolio every six months, and as long as a stock is performing adequately, I keep it. I have discussed portfolio reviews and my selling rules in other articles. In addition, like most dividend-growth investors, I follow a “buy-and-monitor” approach, so if a stock cuts its dividend (or if its dividend becomes perilous), I immediately assess the situation and decide whether to sell the stock. I made one such sale in 2008, dropping Bank of America (BAC) in early October, 2008 after it acquired Merrill Lynch. That acquisition threw BAC’s strategy into confusion; it had little prior experience in investment banking. Selling the stock at the time made a lot of sense for that reason. Of course, BAC went on to suffer significant declines in its price and cut its dividend to a cent per share. I avoided about half of the price declines and all of the dividend cuts. I used the proceeds to start my position in Abbott and another position in Diageo (DEO, which has since been sold).

Most risk control comes from stock selection and active monitoring, so I am comfortable with the small stock list. That said, I have no quarrel with those who feel better spreading risk around among more names. Part of this game is sleeping well at night. If owning more issues makes you more serene, by all means follow your heart on that issue.

Results II

Above, I presented the Dividend Growth Portfolio’s growing income, because that is the goal of this portfolio. I did not measure total returns, because total returns are not the goal of this portfolio.

Nevertheless, I have always measured total returns, because everybody does, and it seems to be a general expectation. I have usually measured total returns against the S&P 500 Index. My thinking has been that the S&P 500 represents a “plain vanilla” collection of stocks, and I want to measure my performance against that. The S&P 500 seems to be the most-used index for measuring results against “the market.”

Many investors believe that they should measure performance against a benchmark that replicates, or comes close to replicating, the strategy they are implementing. They would call the S&P 500 an “inappropriate benchmark” for the dividend-growth strategy. By that reasoning, I should measure the performance of the DGP against VIG or some similar ETF, fund, or index. I may do that in the future. But the argument against that is this: If you measure against a close or seemingly identical replica of your strategy, then comparative results do not really measure the efficacy of the strategy itself, they measure your implementation of the strategy against someone else’s implementation. Also, the comparison may be distorted by differences between your strategy and the nearest benchmark you can find.

Here are the total-return results of the Dividend Growth Portfolio versus the S&P 500:

June 1, 2008:

  • Value of portfolio: $46,783
  • S&P 500: 1280

June 30, 2011:

  • Value of portfolio: $53,033 (+13%)
  • S&P 500: 1321 (+3%)

This result—more than a 4x gain versus the index—comports with the many studies that show that dividend-growth stocks significantly beat other kinds of stocks or “the market” in total returns over time. I do not present the DGP as yet another such study, because its existence is just over three years and the sample is too small. Nevertheless, it is a living, ongoing “study” of sorts. It is not biased by 20-20 hindsight nor cherry picking. It is the result of real decisions made in real time with real money, and it includes the frictional losses from commissions.

Another method of measuring the results of a dividend growth index is the Chowder Index, named for a frequent commenter on this site. The measure is simply, did your dividend stream increase from the same quarter last year? The DGP has had a “win” on that basis every quarter of its existence.

On a Personal Note…

Many of you are aware that until recently, I maintained a Timing Outlook on my website and newsletter. I used the Timing Outlook in maintaining a Capital Gains Portfolio based on a strategy of seeking capital gains with market timing as one of the tactics. In June, I decided to eliminate that activity from my life. I have found dividend-growth activities to be more exciting, rewarding, and fun than timing and investing for capital gains. I know that will strike many people as backwards—going for 3-baggers is usually seen as exciting and dividend investing as boring.

Perhaps it’s a function of my age (I turn 65 this month), but I get a lot of pleasure from watching my dividend stream relentlessly rise every quarter and every year. I enjoy discussing and thinking about ways to tweak the strategy so that it gets even better. Along with many others, I have thought about the criticisms of dividend-growth investing. They have helped hone my thinking, but I don’t think anyone has punched a hole in the strategy yet.

Since dropping the Timing Outlook, I’ve started to pay less attention to the market’s daily gyrations and to “state of the market” and “state of the economy” articles. The Capital Gains Portfolio was all in cash anyway (its protective sell-stops had been hit), and it gave me great pleasure to move that money over to my wife’s and my “Perpetual Dividend Portfolio,” which is run on the same principles as the DGP. I’m anticipating having great fun picking investments for the “new money” in that portfolio. It also fits with my overall goal of rebalancing our retirement assets more in the direction of dividend-growth stocks.

And it’s not like dividend stocks don’t grow. Study after study has shown that dividend-growth stocks deliver the best total returns of any stock category, whether you reinvest the dividends or not. The DGP’s total value is growing, not just its dividend stream. So I am very comfortable with the decision. Hell, it’s even outgained Berkshire Hathaway (BRK.A) +13% to (-3%) since I started it.

Source: Behind the Kimono: Dividend Growth Portfolio Mid-Year Update