The Reluctance To Touch Principal: Why Dividend Investors Think Like Farmers

 |  Includes: CL, CSCO, INTC, JNJ, MSFT, XOM
by: Tim McAleenan Jr.

I had never heard of Magnolia Financial Planning Services until recently, but I can tell that I like the firm already based on the informational links that explain its wealth-building philosophy. One of my favorite passages from Magnolia's website is titled "Managing Investments Is A Lot Like Farming." Here's a look at an excerpt from it:

Managing investments is a lot like farming. In late winter and the early part of the spring when nothing is growing, the farmer begins planting seeds that will reap a harvest in the fall. We have been in a winter- like non-growing season for our economy for a few years now. But like the farmer, an investment manager plants seeds that will grow in the warmth of the spring and summer to bear fruit later.

Just like the farmer, we look at previous years for investments that have grown. This involves researching companies management track records to predict how the companies will fare when better times come. In fact, company managements plant seeds in a similar manner. The strongest tech companies such as Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), and Intel (NASDAQ:INTC) are currently buying smaller technology companies at good prices and reinvesting the cash that they have piled up during the tech boom. They are also using their strengths in their markets to gain market share from the competition, positioning themselves well for when the growth comes.

Also just like the farmer, managers must be patient. The good seeds that are planted will not grow overnight. Often there are bumps along the road, but persistence will pay off in the end. Farmers also must focus on the big picture. They are concerned about the final results at harvest time. They do not worry about getting a final product each day or month. If they were to worry about that and open the fruit each day to check its progress, they would end up ruining the fruit. Likewise, as investors, we should not obsess every day or month about the progress of our investments. We need to stay focused on our long-term goals.

I appreciate this quote for explaining what a slow, gradual grind the path to steady wealth-building can be. I could immediately relate to this sentiment because I have made a mental connection between dividend-growth investing and farming before. In particular, I think the farmer mentality becomes particularly apparent when an investor switches from the accumulation stage of his or her life to the spending investment money stage.

A clear-cut example of this is that many long-term dividend growth investors are very reluctant to sell shares to produce income, even if it is possible that the end result is financially the same.They view selling shares as the equivalent of eating the seed corn that should continue to be left for a later harvest. If an investor picks up 500 shares of Johnson & Johnson (NYSE:JNJ) by the end of his stock accumulation phase of life, he or she does not want to sell 20 shares annually to meet part of his or her income needs. He or she would much rather take the $300 quarterly check that Johnson & Johnson sends instead of reducing the share count to 480 by year's end (which would make fewer ownership units available to produce sustained organic income). When you toss out those 20 shares to meet your income needs, you aren't just throwing away $48.80 in immediate income, but rather the $52 those shares could have produced the year after that, the $56 they could have generated the next year, and so on.

The difference between selling shares to produce income and letting the shares produce income is not a moot point. When an investor owns 250 shares of Exxon Mobil (NYSE:XOM) and chooses to only take the $570 in annual dividend income, that investor is choosing to exercise his or her right as a minority owner in the oil giant to receive a share of the profits. If the investor sells six or seven Exxon Mobile shares to generate the same amount of income, he or she is choosing to reduce his or her part ownership in the business to meet the income needs of today (and thus reduces his or her dividend income by about $15 annually). One strategy eats a bit of the fruit naturally produced, the other nibbles at the seed corn to reduce the output of future harvests.

And what if you fall into the numbers driven camp and find my farming analogy to be nothing more than psychological mumbo jumbo? Well, I mentioned earlier that some investors might be able to produce the same end result by selling shares that they would achieve by utilizing dividend income alone. Well, that's a heck of a premise to take for granted. In the past decade, we had two noticeable stock market declines: one in 2002, and the other around 2008-09. Such declines come with the territory of truly long-term investing. Most investors who own stocks are probably planning for a retirement that lasts around 20 years or so. Well, don't you think a financial crisis type of stock market experience will occur during that 20-year time frame? And if not, don't you want to be prepared for one?

Severe stock market declines represent the moment when the farming analogy shifts from the arena of semantics to significant long-term wealth differentials. Let's look at a real-world example. From 2007 to 2008, Colgate-Palmolive (NYSE:CL) investors who chose to live off the organic income of their investments witnessed a pay raise from $1.40 per share in 2007 to $1.56 in 2008. An investor with the "I'll just sell some Colgate shares each year" mentality saw prices plummet from a 2007 high of $81.30 to a 2008 low of $54.40. That's about a 33% decline in value. Selling some stock during such a price decline can quickly undo many years of diligent saving and investing.

Is it possible to pare back income needs during stock market declines or rely on other income to ride the storm out? Sure. It's doable for investors to calibrate their portfolios so that they minimize stock sales during a declining stock market. But it's also easy to see why investors who display an "only touch the dividend income" attitude want to put themselves in positions to live independent of market fluctuations, placing their faith in the continued payouts of reliable dividend growth firms instead of the roller-coaster whims of Mr. Market.

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