Seeking Alpha
Long-term horizon, dividend investing
Profile| Send Message|
( followers)  

I'm not sure how you spend your lazy Sunday afternoons, but sometimes I'll happen to catch ESPN's "World's Strongest Man" as I flip through the channels. It's not exactly a staple within one's programming options, but in my opinion, it's a watchable commercial placeholder. Surely all the tests of strength are impressive, but perhaps the most grandiose of the events is the "bus pull." Without getting too detailed, it's exactly how it sounds: a rope is attached to a bus and the object is to pull the bus a certain distance. In the beginning, it takes a good bit of effort to create some momentum. But once the tires start turning, the bus begins to pick up speed -- that is, as much speed as one could expect from a bicep-propelled pull movement. By the end of the 20 or so meters, the bus actually has a fair amount of pace as it crosses the finish line. In fact, spotters are often used as a means to ensure that the bus doesn't travel too far past the line.

Now how am I going to relate this to dividend investing, specifically, dividend growth investing? That's easy. Think of dividend growth investing in the same manner as pulling a multi-ton bus a certain distance. Now admittedly, if it were truly this difficult, many would forgo this strategy for a simpler one; but illustratively, the process is fundamentally the same. When you're thinking of a bus being pulled from a standstill, we can equate this starting point to standing here today with zero dividend income. Once the bus starts moving, we know that this represents the annual increases in one's dividend income throughout their lifetime. These increases come in three basic forms: consistent contributions, growing dividends and reinvesting payouts. Finally, as we imagine the bus furiously crossing the finish line, we can parallel this to reaching one's "financial fulfillment," whereby one's dividend income covers their expected expenditures.

In reality, you could use anything you like as an illustration -- a train, airplane or car, for example -- as the ideology of starting from a standstill, gaining speed and cruising to the finish is the same. However, I used this particular "man pulling bus" example for another reason. When we're watching on ESPN, all we see is the 40 seconds or so that it takes to move the bus from point A to point B. That is, we don't see all of the hours spent in the gym training. It takes years and years of preparation just to be in the position to pull a bus.

Related to dividend investing, sure it sounds great to eventually live off dividends. But the natural problem, or at least an inclination of the problem, is finding a way for one's current dividend income, say $300 a year, to eventually reach say $50,000 a year. It seems that there are a few steps being looked over. Moving back to our illustration, it's as though someone asks you to move a bus and you realize that you haven't spent more than one day training for it. Let's hit the gym.

First and foremost, I would like to indicate that the process is neither particularly quick nor easy. Like most things, success is likely to be directly attributable to the amount of time and effort that you put forth. So let's start out with some stretching exercises: establishing an emergency fund, eliminating debt and making more than you spend. These concepts seem relatively simple, but in actuality, all too many people fall victim to forgetting the basics, a la pulling their hamstring. Once the stretching exercises have been completed, we can move on to the workout.

Imagine that you have an emergency fund, no debt and make more than you spend. However, you have not yet begun to invest. After researching a variety of potential investing strategies, you decide that the long-term potential of dividend growth investing is for you. Now to be sure, there are other worthwhile alternatives out there -- for example, a low-cost indexing strategy is likely the preferred alternative for the majority of people. But let's say that you decide that you're willing to do a little extra homework and feel more confident about the prospects of profitable businesses paying dividends than the potential rationality of markets, even over the long-term.

So here we are. We're ready to invest and we have exactly $0 in annual dividend income, which is a far cry from our goal of living off of dividends. Now I have no idea how much you make. But it is reasonable to assume that you would be able to periodically put away an amount to invest. In the first year, let's say that number is $10 a day, or $3,650 a year. In fact, I used this precise amount in my article "$10 A Day Keeps The Retirement Woes Away." Whether you make $10 an hour or $100,000 a year, saving $10 a day by either cutting out a few unnecessary expenses or working a few extra hours isn't inherently unreasonable. Given that frictional expenses and bad days are likely, we'll call it $3600 to invest by the end of the first year. Now, it might be enticing to pick out your 10 favorite dividend growth stocks and begin your investing career. However, trading fees would quickly undercut such a strategy. Instead, allow us to limit the fee damage and pick only two dividend growth options. We could call it Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO) paired with AT&T (NYSE:T), or PepsiCo (NYSE:PEP) coupled with Kimberly-Clark (NYSE:KMB). The precise holdings, if one is only allowed two at a time, are likely to be highly debated. But let's assume you find two DG stocks that have an average yield of 3.3%, and you expect the dividend to increase by 6% a year. In the next year, instead of $0 in annual dividend income, you would be the proud recipient of $118.80. Now, by no means are we anywhere near our goal, but we've put in the first couple months of training. By saving $10 a day, you're now earning $10 a month.

The obvious outside criticism here is that with just two holdings, you are in no way diversified. Which is true, but I would argue that you can get there over time. Moreover, we're not diversifying for the sake of diversifying. Rather, we want to add more holdings to increase the likelihood that our income continues to increase, not because we are concerned about short-term price fluctuations. Let's say that you continue to save $10 a day for the next four years such that you now have 10 holdings at the end of year six with a total nominal contribution of $18,000. Additionally, we make the wide sweeping assumption of a continuous 3.3% yield, 6% dividend growth rate and free reinvestment. That same $118.80 of original income in the second year is now $149.98 worth of payouts at the end of year six. In total, you would receive about $715 in yearly payouts, for a yield on cost around 4%.

Now obviously, if you have a six-year time horizon, then $715 isn't going to take you very far towards financial fulfillment. But it should be noted that even with a 40-year time horizon, this method only equates to about $43,400 in dividend income. Which might seem almost sufficient, but we must consider this in relation to today's purchasing power. Assuming a constant 3% rate of inflation, we find that the $43K number is just $13,300 worth of dividends in today's dollars. So we know that even with a lengthy time horizon, 40 years in this case, it's going to take more effort than saving $10 a day to reach financial fulfillment. But luckily, it's not impossible.

After five years of saving $10 a day, perhaps we're fortunate enough to make a little bit more money, or else find some previously hidden inefficiency. In the next five years, perchance we can bump up our investable funds to $20 a day, or $7,300 a year. After the eleventh year, our original $118.80 in annual income breaks the $200 mark and our total annual dividend payouts reach $2,566 -- not bad for saving an average of $15 a day for the last decade.

I'll save the trouble of depicting different scenarios and move closer to the punch line. We'll assume that moving forward, you are able to save, aggregate and invest $10 more a day after each five-year interval, i.e. $30 a day in years 11-15, $40 a day in years 16-20 and so on. What's the total affect after 40 years of diligently saving?

(click image to enlarge)

We can see via the screen-shot of our trusty "Retirement Planner 9" that one would receive about $112,000 in yearly dividend payouts after diligently investing for 40 years. Translating that to today's purchasing power, we see a value of $34,300, or close to $94 a day. Now it is overwhelmingly likely that many will look at that $34K number, compare it to their current and future expenditure needs and simply state: "But that just isn't enough."

To this point I would like to make three indications. First, while the $34,000 worth of today's purchasing power might not cover all of one's expenses, it would certainly make a large dent in the necessities. Second, it's much better than the alternative of wasting or not investing the money today. That is, the alternative of not investing is not, say $60,000 in yearly income, but rather $0 or perhaps $3,000 worth of purchasing power. Finally, the fact that one might receive $34,000 in yearly income if they prudently save said amounts is not the takeaway. You have the ability to do whatever applicable math fits your situation. The takeaway is that we can use such models as a benchmark for our future endeavors.

For example, if you think you can live off dividends by saving say $5 a day for 20 years, then you're clearly mistaken. For the more rational-minded, we can see that if you want a greater inflow of income than $34,000 in 40 years, or better yet before then, then you're going to have to find a way to add more capital, find larger dividend growth rates, higher initial yields, or else a combination of the three. Perhaps you start out with a $20K initial investment, or better yet a $100K initial investment, in the first few years. Going back to the world's strongest man bus example, I would equate a large initial investment to getting into the bus and starting the engine.

It can be disheartening to see an annual dividend income of say, $100 or $500 in the beginning years, especially if we're transfixed by a much larger number in the future. But we know the factors of success: consistent contributions, time, growing payouts, reinvestment and finding sustainable investments (sustainable in the fact that the company will last for the long-term and will continue to increase its dividend in the future). Obviously, this is easier said than done in practice, but in general, dividend growth investors can feel reasonably confident about the idea that Coca-Cola will still be selling beverages, PepsiCo will be offering more snacks, people will still be shaving with Procter & Gamble's Gillette razors, blowing their noses with Kimberly-Clark's Kleenex tissues, using Johnson & Johnson's Band-Aids and Listerine, and continuing to use their cell phones in the future. But the most important step is likely to be simply beginning to invest in dividend stocks. From there, you can make rational goals moving forward. All abroad the dividend bus -- next stop, financial fulfillment!

Source: Getting The Dividend Bus Rolling