The Dugan Family Retirement Investing Plan - Version 15

by: Dennis Dugan

Summary

Superior performance, in any endeavor, is best achieved by developing and executing a plan.

The core of a good plan is to have well-thought-out objectives (the what) and strategies (the how) to follow to achieve the objectives.

Both objectives and strategies are big picture and long term. Goals (what) and tactics (how) are little picture and short term, and are stepping stones to achieving objectives.

Summary

I'm a graduate of the United States Naval Academy and spent 5 years as a pilot in the Marine Corps before embarking on a 40-year business career, followed by retirement. My business career started as a design engineer and went through stints as manager and executive in sales, marketing, general management, strategic planning and president and/or CEO of a dozen companies in many industries. A few of the lessons learned (and applied) in those 45 years are that clear purpose and simplicity in everything, be it planning or execution, are required for true success.

In the realm of investing for retirement, one's purpose in the accumulation stage is to build a nest egg large enough to supplement social security and pensions to guarantee a happy retirement until death. In the distribution stage, that purpose shifts to producing, growing and guarding income from the nest egg. Dividend growth investing, from the CCC list, is our choice of a over-arching strategy that aligns with our beliefs and values to fulfill our purpose and achieve our long-term objectives.

The "simple plan" is to:

  1. stay mostly (like 90+%) invested in very high-quality CCC stocks, with a cash cushion for riding out downturns, that produces sufficient income to meet our needs, forever.
  2. never, ever overpay when buying stocks
  3. seldom sell. Portfolio churn is driven by emotion and always (say always one more time) ends up producing worse results than would be achieved by buying high-quality stocks at a fair price and keeping them. Do sell if a stock's price exceeds its value by 20% and there are alternative, equally high-quality stocks available. There is money to be made by taking advantage of mis-priced stocks. Also sell if the underlying characteristics of a stock have permanently changed for the worse. This should seldom happen if we're careful in the buying phase. If it happens often, we're making mistakes in the buying phase.
  4. Spend sufficient time reading and learning about the economy, business cycle, investing and world affairs that I feel fully and accurately informed at all times. This is a required frame of reference for successful investing.

5. Follow a disciplined process that continuously evaluates CCC stocks for quality and value. Over time this will provide a continuous flow of buying suggestions when excess cash is available and it will make me very knowledgeable about a small universe of high-quality stocks. I'd rather know a lot about a small universe than a little about a larger one.

History

Like SA contributor Bob Wells, my wife and I are fans of planning before executing.

We are 68 and 69 respectively, have been mostly retired for 2 years and are fortunate to have nest eggs sufficient to allow us to live well primarily on the dividends from our portfolios. While retired, I do maintain my 2 corporate board of directors positions and provide strategy and planning consulting services to a few long-term corporate clients each year. That leaves me plenty of time to work on building my investing knowledge.

I've been a follower of SA for about 5 years and consider myself to be a seasoned, self-directed, value-oriented, DGI investor.

Five years ago, we began formalizing our retirement investing plan and, as our knowledge has increased, have made many modifications since. Our plan provides a discipline in buying and selling that takes a lot of emotion out of play. This article is meant to share the plan and invite comments on how it may be improved.

From here on, this article is a cut and paste of our plan, including having cut and pasted within the plan from articles we have read in SA and other places. That said, the context to us makes sense, even if it seems slightly disjointed without knowing our particular context.

Background, Framework and Objectives guiding investing plan

"The author and investor James O'Shaughnessy tells the story of a study done by Fidelity Investments. The company wanted to find out what group of its clients did the best. As it turns out, the most successful group of Fidelity investors wasn't men or women. It wasn't young or old. It wasn't big portfolios or small investors. No. It was people who had forgotten they had Fidelity accounts. That's even lazier than buy-and-hold! It's buy-and-forget-you-ever-bought. I can't say I'm surprised. The reason is simple. To be a good investor, you have to counter many of your natural inclinations, like getting rattled in a bear market or finding comfort in following the crowd. I'm sure the people who watched their accounts every day were far more inclined to buy and sell at the wrong times, while the blissfully ignorant stayed wisely quiet."

Buffett: it is madness to risk losing what you need in pursuing what you simply desire.

With "X" being the amount of money we plan to withdraw from our investing accounts each year, our investing objective is $0.8X per year from dividends, plus 0.2X per year from proceeds from selling stocks. 0.8X from dividends requires an average yield of about 2.8%. Therefore, we should try to achieve an average yield a little north of 3%, with an individual bottom on any stock of 2.3%; because a high, long-term, dividend growth rate is a more valued characteristic than high yield to us.

To wit, Donaldson Capital Management says "...research revealed some surprising results. Over any longer period, say five to ten years, the companies with the lowest dividend yields and the highest consistent dividend growth were the top performers."

Information garnered from reading thousands of SA articles has led me to believe some investing principles are long-term, rock solid (for our needs, anyway) in guiding our investing:

  1. high DGRs and low payout ratios trump the opposite
  2. low beta stocks outperform high beta stocks for investors who aren't traders
  3. dividend payers/raisers outperform non-dividend payers over the long term
  4. be a value investor (never overpay)
  5. stocks with high yields and low dividend growth perform relatively better in falling interest rate periods; stocks with high dividend growth do best in rising rate environments (which is likely for at least the next 5 years)
  6. stocks with investment grade credit ratings and/or low debt to equity ratios provide an extra measure of safety

I also believe low beta stocks can be a good substitute for bonds in a portfolio. It was fascinating when I found out that over the roughly 90 years before the great recession there were three +/- 30-year periods of solid interest rate trends: say from about 1920 to 1950, interest rates fell; from 1950 to 1980 they rose and from 1980 to 2010 they dropped again. What happens to bond prices in those environments? Prices fall when rates rise and rise when rates fall. Given that 90-year history, and rates having a very high probability of rising from here forward (and maybe for a long, long time), bond prices are sure to fall. That expectation leaves no room for bonds in our portfolio. As I wouldn't buy a stock whose price I thought was going to steadily decline over the next 5 years and beyond, so also will I not buy a bond for the same reason. Therefore, a good bond substitute is lower beta stocks purchased at the right price and endowed with the right characteristics, as described above.

The value of buying stocks with those characteristics are proven, in our minds, by the following graphs, statements and information.

"Here's the latest proof: After slicing and dicing the data from 1972 through the second quarter of 2013, Ned Davis Research found that dividend growers return an average of 9.8% per year. That compares to a return of only 7.3% per year for straightforward dividend payers."

http://www.dividendsandincomedaily.com/2013/11/04/dividend-aristocrats-2/

Source: Rising Dividends Fund, Oppenheimer, page

Our Strategies to Meet Our Objectives

For the 0.8X fraction of annual cash needs from dividends, those dividends should be from companies whose long-term history is raising dividends faster than inflation so purchasing power isn't lost. The balance, 0.2X, needed from stock sales, represents about 1% of our portfolio value. Anticipating a 5% to 7%/yr average long-term increase in portfolio value (allowing for ups and downs), not counting dividends, I expect the portfolio value to increase over time and therefore provide a necessary cushion to achieving planning objectives. Over time, and by buying DGI stocks, the requirement for 0.2X from stock sales should diminish to $ zero as dividends grow to be greater than $X/year. Until that time, we keep 5 years of the $0.2X/yr needed in cash at all times. This luxury allows us to forget about stock price fluctuations and concentrate on continuously improving the quality of our portfolio.

When we have raised cash by following our selling rules, we increase our portfolio quality by using the self-created Dugan Scoring System to identify stocks which are very high quality, and then we filter by the below criteria. The Dugan Scoring System is explained here.

We keep cash in a separate account to foster discipline and draw the cash component only from this account. We replenish cash in the 80% of years when capital gains occur and/or when some stocks have met our selling rules. Note: this may not work as well as planned, as IRA monies should be withdrawn last, saving but for RMD requirements.

Stock prices follow earnings in the long term. So, stock prices should increase at roughly the DGR and vice versa. Therefore, the primary filters to identify stocks to buy, after applying the Dugan Scoring System, should be valuation (we use relative Graham number from David Fish's CCC list), followed by estimated EPS growth, followed by DGR histories.

Be a buyer of only high-quality dividend stocks with solid competitive advantages. Our holding period is forever, as long as the dividend is at least maintained and it doesn't become over-valued. Do a thorough review every quarter to see if some stocks can be replaced with higher quality without, on balance, sacrificing yield. Quality in this case means higher: estimated EPS growth; better 10-, 5-, 3- and 1-year DGR histories; better relative Graham number; lower debt/equity ratio or lower payout ratio.

Concentrate efforts on stocks that grow earnings and dividends at rates much greater than inflation over long periods and that have provided outstanding total returns over time. For the most part, this means confining choices to the highest quality half of the "All CCC" tab of the CCC list, for security of dividends continuing and growing, and to limit downside swings in portfolio value. Pay attention to forward-looking allocation recommendations.

Don't buy illiquid stocks. Think Northeast Indiana Bancorp Inc. (OTCQB:NIDB). Story: Using the processes described here, I bought a bundle of NIDB using a market order in early 2012, forgetting it was illiquid. I ended up paying about 10% per share more than the then-current price. Even so, I did make a ton of money. But it took me 1.2 years to unwind my position, ending just a few months ago. Since then I only buy with limit orders.

Did I say don't buy illiquid stocks?

Buying Filters (using full CCC list)

From Chuck Carnevale and FASTGraphs:

"In this Part 2, my focal point is on recognizing the difference between a company's market price at any moment in time, and its true worth or intrinsic value. I suggest that the success secret that all great value investors possess is that they understand the difference between intrinsic value and market price. But more importantly, they base their investment decisions on their calculations of intrinsic value. If the market offers a ridiculously high bid they will often sell, and if the market offers a ridiculously low bid they will not only refrain from selling, but will gleefully jump on the bargain price instead."

We continually run filters, using CCC, to identify potential buy targets. Sometimes we're guided by SA article recommendations. When we run filters on CCC, we sort by each category below, usually in the order presented, and delete companies that don't meet the minimum criteria. Of course, we sometimes change the minimum criteria for reasons we believe are appropriate for the time and circumstance.

  1. Each month, apply the Dugan Scoring System to the All-CCC tab, eliminate the bottom scoring half, then filter per below
  2. Est. 5-year EPS growth > 7% (in order to achieve a DGR at least 2xinflation and avg total returns > 7%/yr)
  3. Graham < 80
  4. NY EPS forecasted growth > 7%
  5. 5-yr DGR > 7 %
  6. 1-yr DGR > 7%
  7. Look at 10-, 5-, 3-, and 1-yr DGR histories for no non-performing periods (insert column after 5-yr and sum 1-, 3- and 5-yr totals and delete all less than 25)
  8. D/E < 0.8 (but compare to sector)
  9. Payout ratio < 80% (but compare to sector)
  10. Min yield 2.3%
  11. Reduce risk by using a min of 7 years on the CCC list, and/or a lower Graham, and/or a lower payout ratio
  12. Maybe filter by market cap
  13. All of these filters reduce the list from well over 700 to 15 to 25 potential high-quality companies
  14. Check FAST Graphs to verify valuation, future expected earnings growth, number of analysts, credit rating, etc.

Selling Rules:

  1. By y/e 2015, reduce stock positions to 50, from y/e 2012 number of about 95, and 85 as of 7-13-2013, and 59 as of 7-27-2015. This goal was achieved.
  2. Do an in-depth quarterly review on each stock owned for Dugan Scores, valuations, EPS forecasts, DGR histories and Schwab ratings
  3. Sell if valuation is 20% over-valued by FastGraphs and confirmed by CCC list relative Graham number.
  4. Sell if Dugan Score is sliding negatively and there are higher scoring companies which have similar criteria
  5. If current yield in less than 2.5%, think about selling and replacing with stocks that are higher quality (Dugan Score) and/or better valued
  6. If it cuts, freezes or suspends its dividend, sell.
  7. Consider tax implications of selling in non-IRA accounts.
  8. To shore up downside risk, use the "trailing stop strategy" for all stocks."One simple form of the trailing stop strategy is a 25% rule. Sell any and all positions at 25% off their highs. For example, if you buy a stock at $50, and it rises to $100, when do you sell it? If it closes below $75 -- no matter what." Use 15% for IRAs and 25% for taxable accounts. Implement this during the quarterly review or anytime I discover one of my stocks is 25% off its high.

What's so magical about the 25% number? Nothing in particular -- it's the discipline that matters. Many professional traders actually use much tighter stops -- the Investor's Business Daily newspaper, for example, recommends an 8% stop. Ultimately, the point is, you never want to be in the position where a stock has fallen by 50% or more. This means that stock has to rise by 100% or more just to get you back to where it was when you bought it.

By using the trailing stop strategy, chances are you'll never be in this position again. The thing is PLACING ACTUAL STOP ORDERS IS A BAD IDEA. We do not recommend placing stop orders at all. The dirty NYSE traders will pile up all the stop orders, and then execute them all at a horrible price. Interestingly, stocks often close higher the very same day, after the NYSE traders make a mint executing stop orders. DON'T put a stop order in the market. Simply sell the day after you hit your stop. Use the quarterly review to execute this strategy.

Other helpful selling (and buying) tips from "The 8 Rules of Dividend Investing"

"Rules 6 & 7: When to Sell

Rule # 6 - The Overpriced Rule

Common Sense Idea: If you are offered $500,000 for a $250,000 house, you take the money. It is the same with a stock. If you can sell a stock for much more than it is worth, you should. Take the money and reinvest it into businesses that pay higher dividends.

Financial Rule: Sell when the normalized P/E ratio is over 40.

Evidence: The lowest decile of P/E stocks outperformed the highest decile by 9.02% per year from 1975 to 2010.

Rule # 7 - The Survival of the Fittest Rule

"When the facts change, I change my mind. What do you do, sir?" - John Maynard Keynes

Common Sense Idea: If a stock you own reduces its dividend, it is paying you less over time instead of more. This is the opposite of what should happen. You must admit the business has lost its competitive advantage and reinvest the proceeds of the sale into a more stable business.

Financial Rule: Sell when the dividend payment is reduced or eliminated.

Evidence: Stocks that reduced or eliminated their dividends had a 0% return from 1972 through 2013.

Source: Rising Dividends Fund, Oppenheimer, page 4. Source: The Case for Value by Brandes Investment Partners, Page 2"

Source: Rising Dividends Fund, Oppenheimer, page 4

Rules of Thumb for Retirement Investing Plan:

  1. High yield (>3%), low payout stocks (< 60%) outperform over time.
  2. High yield, high DGR (greater than 11% (which is avg for CCC)) stocks outperform over time.
  3. Don't buy MLPs or REITS with yields less than 4%.
  4. Don't put MLPs in IRAs as distributions are often considered non-taxable returns of capital.
  5. Assets paying interest (bonds and preferred stock) should be held in IRAs since the interest is always taxed as ordinary interest anyway).
  6. REIT dividends are non-qualified and are usually treated as ordinary income, therefore shield the dividends in an IRA.
  7. High growth stocks where cap gains will be greatest are better off in a taxable account.
  8. Utility dividends are qualified and therefore tax is lower than ordinary income. They should be in a taxable account.

Conclusions

In my strategy and planning consulting practice, one of the more valuable sayings is "Any road will get you there if you don't know where you're going." The value of the saying is that great performance, in whatever endeavor, is founded on first, knowing where you want to go (and why), and second, how best to get from here to there. That's the essence of planning. And planning is the essence of great performance.

The processes outlined in the plan above are not implied to be the best ever invented. We have found that they simply are the good for us, for now. It is our hope that they may also prove beneficial, in whole or part, to SA readers.

It is also our hope to receive comments and constructive criticism to further improve our quest for a truly effective retirement investing plan.

Happy investing.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.