If I invested $100,000 into the stock market in 2008 and saw the collective value of my stock holdings fall to $70,000 within a year, I'd be thinking "What the heck just happened?" Do I need to adjust my strategy? Are my stock selections failing me? One of the benefits of defining one's goals based on income generation is that it is easy to find the problem spots in the strategy and replace them as necessary.
Let's assume that I am generating $2,000 per year in passive income from my investment holdings. And let's also assume that 200 shares of Wells Fargo (NYSE:WFC) serve as one of the sources of the portfolio's income. At the start of 2009, Wells Fargo paid out a dividend of $0.34 per share, which comes out to $1.36 annualized. When the worst of the financial crisis hit, Wells Fargo had to slash its dividend to $0.05 per share, or $0.20 annualized. That represents an annual income decline from $272 per year to $40 per year.
While I have yet to meet someone who invests with the expectation of losing money, I do think there is a benefit in the way that a dividend investment fails. If you're a shareholder in Research in Motion (RIMM), there is no clear line of demarcation that notes the moment when the investment is in trouble. Is it when the stock price fell to $70? $50? $30? $10? There is no bright line test. But dividend-focused investing can shine the neon light on the problem areas.
A dividend that is cut or stops growing can send a clear signal to investors about what is necessary to restore the passive income status quo. In the example of Wells Fargo above, the investor immediately knows that he has just lost $232 in annual income at the moment that the dividend cut occurs. He can weigh the loss of Wells Fargo income against the growth in income of his other holdings. For example, maybe he owned shares of Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) that raised their dividends during the same year (2009) of the Wells Fargo decrease, and it may only take a negligible investment to get the passive income train back on track.
After all, if the $1,728 in his other passive income grows by 7% -- something that should be attainable if you stuff your portfolio with the likes of the Colgate-Palmolives (NYSE:CL) and Kimberly-Clarks (NYSE:KMB) of the investment universe -- his organic income will increase to $1,848 and his Wells Fargo holding will still be producing $40 per year. What's the point of this exercise? It's that if you define yourself as an investor in terms of income, it is clear to see where the holes in your strategy are, and what is necessary to fill them in. In this case, the Wells Fargo dividend blow-up resulted in a decline of annual income from $2,000 to $1,888. Our investor now knows he needs to replace $112 in annual income to make himself whole again. If his goal is to get back to $2,000, he knows that an investment of $2,800 in a stock that pays a 4.0% dividend will get him back on track.
This clarity is yet another element that showcases the appeal of dividend growth investing to me. I invest with the full expectation that I will have failures along the way. Recognizing this fact, my next question would be this: How do I readily identify the failures, and how do I go about repairing them? For dividend investing, this can be clear. The stagnation, reduction, or elimination of a dividend provides an objectively recognizable signal that an investment may be in trouble, and it also can identify what is necessary to remedy the failure.
If a stock holding reduces its dividend in a way that costs me $800 in annual income while the rest of my portfolio experiences dividend growth of $500 in annual income, I have a clear idea of what repair is necessary. To get my goals back in check, I need to increase my annual passive income by $300 + inflation. I appreciate that a dividend strategy shows me where the potholes are and also provides a mathematically measurable signal of what kind of action is necessary to repair the portfolio's income production.