When investing for income, many retirees focus on the dividend stream. Living off dividends in retirement is helpful in creating a consistent stream of income, which does not fluctuate as wildly as stock prices do. Focusing only on the distributions, however, without giving much thought to anything beyond the juicy current yield, could be dangerous.
Dividend investing is a process with several stages, in order to minimize risk of income reduction in retirement. The first stage should be selecting quality income candidates from a pool of securities which have certain characteristics that the dividend investor is looking for. For example, I tend to purchase companies which have consistently raised dividends for at least ten years in a row. As a result, I start my screen with the list of Dividend Achievers.
The second stage should be applying a set of entry criteria to the list of qualified candidates, in order to narrow it down to a more manageable list for further research. This set of criteria should reflect important points of the investor’s strategy, determined based off their experience in the markets and risk tolerance.
The next stage should be analyzing each security in detail. Given the wealth of data on the internet these days, many investors tend to focus on the quantitative side of analysis. While it is helpful to see the trends behind the data and it is fun to project past results, investors should not stop there. Evaluating qualitative characteristics such as branding, product mix, competitive advantages, strengths, weaknesses, opportunities, trends and industry factors should be an important part of the analysis tool-set. Obtaining an understanding of the business by reading annual reports or research reports and news stories as well as observing the business operations in person would also add to the investment evaluation of the business.
While creating a diversified income stream is important, investors should also not forget about capital gains either. It is important to understand where the distributions are being derived from. There have been certain investments where investors have receiving a large portion of the distribution as a return of capital, rather than income. While the cashflow was high enough to lure investors into the high yielding investment, the security was paying these distributions on borrowed time. Once the capital base is depleted, investors would end up with no income and their security might be worthless.
One such security is US oil and gas royalty trusts. Most of these pass-through entities tend to pay high current distributions every month out of their royalty interests in Oil and Gas fields. As these fields get depleted, however, there comes a time when there would no longer be any revenues and thus no profits to distribute to shareholders. A larger portion of the current distributions of these businesses represents a return of capital, which is logical given the fact that for every barrel of oil equivalents pumped out of the ground, there is one less barrel to be pumped in the future. Once all the barrels in the reserve have been depleted, there will be no more oil to be produced and sold.
Dividends typically account for 40% of annual total stock market returns. The remaining 60% come from capital gains. It is also important to not forget about capital gains because they ensure that over time your principal investment maintains and even grows its purchasing power. That is why selecting companies which have future prospects for growth is so important.
Companies whose future growth is virtually unlimited include:
McDonald’s Corporation (MCD), together with its subsidiaries, operates as a foodservice retailer worldwide. This dividend aristocrat has raised distributions for 35 years in a row. Over the past decade, the company has managed to boost dividends by 26.50% per year. Yield: 2.80%
Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. This dividend aristocrat has raised distributions for 49 years in a row. Over the past decade, the company has managed to boost dividends by 13% per year. Yield: 3.50%
The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. This dividend aristocrat has raised distributions for 55 years in a row. Over the past decade, the company has managed to boost dividends by 10.90% per year. Yield: 3.40%
The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverages worldwide. This dividend aristocrat has raised distributions for 49 years in a row. Over the past decade, the company has managed to boost dividends by 10% per year. Yield: 2.70%
Unilever PLC (UL) provides fast-moving consumer goods in Asia, Africa, Europe, and the Americas. This international dividend aristocrat has raised distributions for 11 years in a row. Over the past decade, the company has managed to boost dividends by 9.20% per year. Yield: 3.70%
Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. This dividend aristocrat has raised distributions for 37 years in a row. Over the past decade, the company has managed to boost dividends by 17.80% per year. Yield: 2.80%
Disclosure: Long MCD, JNJ, PG, KO, UL, WMT