How To Build An Income-Generating Dividend Machine

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 |  Includes: CL, JNJ, KHC, KO, MO, PG, T
by: Tim McAleenan Jr.

I recently received a message from a reader asking about the best way to structure his life so that he can become a long-term investor who owns an ever-increasing amount of assets. I think that not only is this an essential conversation worth having, it is probably one of the most important.

Whenever I read most financial articles, be it on Seeking Alpha, Kiplinger, The Wall Street Journal, or whatever the source may be, there is this almost fanatical dedication to the idea of “the lump sum investment.” There are so many articles out there that claim something to the effect of “If you bought 100 shares of Apple (NASDAQ:AAPL) stock in year X for $50 per share, it would be worth over $40,000 today”. Heck, I’m even guilty of that—in a recent article, I pointed out how a $20,000 investment in Autozone (NYSE:AZO) would have grown to over $1 million over a span of twenty years.

These are fair points to make, but they sometimes seem completely disconnected from the manner in which most American investors accumulate stock ownership. After all, most of us don’t just take a $20,000 lump sum in January, buy Johnson & Johnson (NYSE:JNJ) stock, and then wait until the next year to make another investment. Most investments are ongoing—a few thousand here, maybe ten thousand there—that occur sporadically throughout the year. So what’s the most realistic approach to becoming a successful long-term investor?

I would make a check-list as follows:

1. First, establish an emergency fund of at least three to six months. Nothing can ruin wealth creation mor e quickly than having to sell at an inopportune time. You should never bet against Murphy’s Law—cars have a tendency to break down and refrigerators have a habit of going out at precisely the most inconvenient time. If you ever have to sell a stock holding to shore up necessities in your personal life, you are placing a severe limitation on your ability to create wealth. The first key to becoming a successful long-term investor is situating your personal life so that you can be sure that you will never have to sell any stock holding prematurely—because at that point, you would be giving up the only advantage you have over Mr. Market’s irrationality—the ability to ride out periods of high volatility until a company’s stock price reconnects with the company’s fundamentals.

2. This is probably the hardest part to this strategy, and requires the most discipline. But if executed successfully, it can increase one’s financial security dramatically. You need to build a stable of cash-generating assets that throw off money regularly to redeploy into other investments. The period that we’re living in now is a historical anomaly in that bond rates are incredibly low, so that creating a fixed-income portfolio that generates monthly income for stock investment does not offer the same possibilities that it did, say, throughout most of the 1990s. It’s still realistic to build a collection of I-bond, T-bill, and corporate bond investments that yield 4.5%, and you’d have to build a portfolio of a little less than $27,000 to reach a point where it generated over $100 per month for you to deploy to further investment. There’s other ways to get there—you can dabble in MLPs, or you can load up on shares of American large-caps such as Altria (NYSE:MO) or AT&T (NYSE:T) that boast a dividend around 6%, and if you buy a couple of high-yielders that have different quarterly dividend payout schedules, you can even structure your life so that you receive a check from somewhere each month.

3. Once you have a source of passive income that can fund new investments, you’ve reached the point where investing should become fun and increasingly lucrative—this is when the “snowball effect” begins. Let’s say that the combination of your high-yielding blue chips, bonds, fixed income, and MLP portfolio gives you $600+ in monthly passive income. You can establish a list of stocks that have a history of dividend growth, reasonable payout ratios, and relative immunity from technological disruption. Let’s say you’re able to make a list of 25-45 companies to put on your radar—companies like Johnson & Johnson (JNJ), Procter & Gamble (NYSE:PG), Heinz (HNZ), Coca-Cola (NYSE:KO), and Colgate-Palmolive (NYSE:CL)—companies that, from a dividend growth investor’s perspective, appear likely to take care of their investors for years to come. That way, when you take that $600 per month that your portfolio churns out, you can buy almost ten shares of Johnson & Johnson stock, which will then pay you $22.80 per year in dividends, and your average stream of income just grew by $1.90 heading into the next month. As an added bonus, Johnson & Johnson has a storied history of raising its dividends annually, and that appears likely to continue into the future. While you’re using your salary from your job or whatever it may be to meet your living expenses, you’ve got this income-generating machine that’s working alongside you and growing, compounding your wealth as your reward for having the discipline to make the initial savings in the first place.

This strikes me as the most sane way to approach investing. Headlines of fear, destruction in Europe, falling stock prices, and excessive federal stimulus are enough to give anyone a headache. Instead, chart an alternative path—have the discipline to create a portfolio that generates excess income, and then use that to buy blue-chip stocks that appear at least wildly undervalued with a long history of raising dividends, a low payout ratio, and relative immunity from destruction at the hands of competition or technological innovation. At that point, your monthly income should be increasing with every purchase you make. Wash, rinse, and repeat until it reaches the point that you’re ready to start spending the money being thrown off by your passive investments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.