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Plan, you say?

If that is your response, whether you are 5 years from retirement, 10, or 15, you could use some help. This article will provide some of that help and show you how to get on the path to an increasing retirement income that will supplement your social security or other retirement program. Set your goals, evaluate your resources and adopt this concept as part of your plan. It will address the matter of inflation, a force that often destroys retirement income. It provides a method for stock selection that you may adopt. In addition, it leads us to select three stocks as immediate buys based on current valuation - a place for you to start today.

Ways to Fund Retirement Income

Of people in their 50s and 60s in the US, about 20% have over $250,000 set aside for retirement. If you are in that group, good for you! If you are part of the other 80%, this plan will help you put your resources to work in a very effective way; you will grow your assets before you retire and provide increasing and inflation beating income after you stop working. The principles are the same if you have $25,000 to invest, $50,000, $250,000 or more. For purposes of illustration, let us assume you are 60 years old and plan to retire at 65. You have $100,000 available.

Savings

The very best use of a savings account is to keep cash, perhaps 3 to 6 months living expenses, easily available for an emergency. The interest rate on regular savings is only about 1% a year, and the best you can get with a 5-year CD is only about 1.5%. Inflation, with a long-term average rate of about 3%, will eat that up and more. There is a high risk that you will not have the money you need, when you need it, if you leave it in a bank.

An Annuity

An annuity is an agreement with an insurance company; you pay them a sum of money upfront and they give it back to you a little at a time, usually a fixed amount monthly for the rest of your life. With an immediate fixed annuity, the most basic and common kind, if you are a 65 year-old man and you pay $100,000 for an annuity, you will receive about $545 a month. If you are married and you want the payments to continue until the end of the life of a same-aged surviving spouse, the company will pay $470 a month. For individuals 70 and older, annuities can be a good supplemental investment, especially when interest rates are higher than they are now. The younger you are the lower the monthly payments are.

Bonds

Bonds are fixed income investments. When you buy a bond, you are lending money to the issuer, which is a government entity or a corporation. In either case, the credit worthiness of the issuer is the important consideration that describes the default risk and determines the rate of interest. The rating may range from AAA to CCC, C and D. An AA rated 30-year US government bond now yields 2.84%. A BBB rated bond issued by a corporation and due in 20 years will have a current yield of about 5.5%. Bonds pay the same amount every accounting period until maturity. When interest rates rise, the value of bonds falls. That is called interest rate risk.

Stocks

Unlike the all of the above, income from stocks can keep pace with inflation, and even provide increasing income above the cost of inflation. Stocks are shares of publicly listed corporations. As an owner, the earnings of the corporation belong to you, and part of those earnings is paid out to investors as dividends. Some corporations have policies or practices of paying out increasing amounts of dividends each year. Dividend Growth Investing involves buying stock in these companies. A small group of stocks, 105, has paid and increased dividends each year for over 25 consecutive years. These are Dividend Champions. The risk involved in purchasing stocks in companies with long records of success is not high. It is with careful selection of such stocks that we may expect a current return of about 3.75% in dividends and project a dividend growth rate of about 12% per year. The risk of not having the money we require in retirement is much less than with savings accounts and CDs, annuities or bonds. In today's world, good dividend paying stocks are the low risk investment.

Yield

The amount of the dividend paid on an annual basis, divided by the price of the stock, is the yield. If a company pays a $2.50 annual dividend on a stock selling for $50, that is a yield of 5%. It is important to understand that the company sets the amount of the dividend, and the market determines the price of the stock.

Dividend Growth Rate

If a company pays a $2.50 dividend this year, and next year raises it $0.25 to $2.75, that would be a 10% dividend increase. Estimates of future dividend increases are projected using rates from earlier periods, such the average 5-year rate.

$100,000 Invested in Dividend Growth Stocks

The table below depicts $100,000 invested in Dividend Growth Stocks. Since retirement is 5 years away, we will reinvest the dividends, that is, leave them in our account and buy more stock with them for the first 5 years. After that, we will draw upon the account for income. While we might expect the market price of the stocks to rise over time, we do not project any increase in this study. It is irrelevant to the income this model produces, so stock price fluctuations are not a concern. Neither are measures like total return. The one important metric is the growing dividends paid out; the income stream created by this $100,000 retirement income machine.

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Total Return

Someone asked me last week, "What is your total return on your portfolio year to date?" I answered, "A week in Paris, a week in London with stays in nice hotels, a 3 week trip to Southeast Asia, including time on a remote tropical island with a great reef, a vacation in Maine and a trip to Washington, DC." There are many ways to measure investing success; that is mine. Set your goals, invest wisely to meet them and enjoy spending your money.

Method

First, I went to the Dividends Champions Spreadsheet, which is a free resource maintained by David Fish, another Seeking Alpha author. You may access this at the Drip Investing Resource Center and clicking on your preference of the Excel or PDF version of Dividend Champions. Then I sorted them by yield, picking those companies that yield over 3%. Next, I selected those stocks which had a Dividend Growth Rate (DGR) that when combined with their yield would add up to a sum of 10 or more. That is, if the yield was 3%, the DGR must be at least 7%. If the dividend was 4.5%, then the dividend growth rate must be at least 5.5% to make the cut.

I came up with the below list of possible portfolio candidates with this method. You can set the minimum yield either higher or lower than 3% yield, it is up to you, as is Dividend Growth Rate. The older you are the more I recommend buying stocks with higher yields, 3½% and above, as you need more income sooner.

The above are companies that I suspect will help me achieve my goal of turning my $100,000 into a safe and growing income stream for retirement. Next, we apply further selection criteria to the list. The intent of doing this is to reduce risk by only buying the soundest and strongest companies, and then only at the right price.

Credit Rating

The stock investor, as well as the bond buyer, can use corporate credit ratings as a measure of predictable and reliable corporate performance. Investment grade bonds are those with a credit rating at or above BBB- . All companies on our list meet that criterion. I previously removed two stocks, which though they are rated BBB+, are noted by Standard & Poor's as having a negative outlook. They are Pitney Bowes, Inc. (NYSE:PBI) and Old Republic Insurance (NYSE:ORI). Interestingly, they are two stocks, which have very high yields. The reason is that they have business problems and have gone down in price, which raises the yield percent. This kind of situation is called a yield trap, and should be avoided by the investor.

Payout Ratio

A company has earnings of $300 million in a year and for purposes of this illustration, they have 300 million shares of stock outstanding. That means they earned $1.00 a share. If they paid out $0.50 in annual dividends, that would mean they paid out 50% of earnings and the Payout Ratio is 50%. They might keep the remainder to invest in new equipment or hire more people.

If they were paying out over 75% of earnings, we might wonder if they were reinvesting enough of the profits to sustain growth and continue growing the dividend. There is no right or wrong rate. It rightfully varies by industry and company. A low yield and low payout may indicate a rapidly growing young high-tech firm, a large yield and payout could indicate a mature industry with few growth prospects, such as a regulated utility. Some special types of companies, such as Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) have special tax provisions and are required to pay out a high percentage of their earnings by law.

However, high payouts are danger signals for most companies. In addition, companies with high payout ratios do not perform as well over the longer term.

Debt Level

Too much debt can require an inordinate amount of a company's gross profit, leaving little left for other things. A shortage of current funds can also indicate a problem.

Price/Earnings (P/E)

This is a ratio determined by dividing the earnings of a stock (not the dividend) by the price. If a stock has a P/E of 15, one could say accurately that you have to pay $15 for $1 of earnings. An average P/E, such as for the entire S&P 500, might be about 15. A Price/Earnings ratio of 6 or 7 is low and 30 is high, in general. A high P/E may reflect optimism about the future of the firm. Perhaps the stock with a low P/E is underpriced and a stock in the same industry with a high P/E is overpriced. It is worth investigating.

Return on Equity (ROE)

This is a measurement of how well the company management is utilizing the stockholders' investments to make money. In the below table, we use a tool that gives us not the Return on Equity, but rather the return on equity compared to the average of each industry.

Results

We started our selection process with the Dividends Champion spread-sheet, so we know that all of these firms have paid increasing dividends for over 25 years. After they each passed a screen for dividend yield and dividend growth rate, we then checked the S&P long-term bond rating for each company. All are rated investment grade or better with no negative outlooks expressed by Standard & Poor's. However, four small firms are not rated. If they are to be considered further, more investigation must be done.

One of the hurdles I use in my own portfolio is a Market Capitalization size of a minimum of $5 billion, and for some types of holdings $15 billion. Larger firms are often more liquid and there is more information available about them. They can attract better management and top notch researchers. In addition, larger firms are more apt to have economic moats, such as well-accepted brand names, technological advantages or pricing power due to large market share. These act as barriers, moats, against others wanting to enter the business.

Areas of concern are highlighted in yellow. We are left with 10 stocks highlighted in bright green, which passed all our hurdles. Two other stocks, Leggett & Platt (NYSE:LEG) and Nucor (NYSE:NUE), are colored in a dull green. There was one issue with both of these, and that is a high payout ratio. The question is, is this a temporary aberration due to some unusual event, or is there an ongoing problem. My research led me to keep Nucor on the list and eliminate Leggett & Platt. The three large and popular stocks that did not win the green highlight are Clorox (NYSE:CLX), Altria (NYSE:MO) and AT&T (NYSE:T). It is important to know more about these companies before purchasing them.

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Current Purchase Selections

If a stock clears all the hurdles and has all the attributes one looks for in a solid long-term investment, that does not mean you should buy it today. One should purchase undervalued stocks, when they are "on sale" and out of favor with the market. At worst, pay no more than fair value.

Valuation

Two online sources help us estimate valuation. One is F.A.S.T Graphs, a program that among other things compares a firm's current P/E to its historic P/E, and allows you to make a visual estimate of fair value. I have labeled my interpretations as Overvalued, Undervalued or Fairly Valued. The other is Morningstar's rating system. It uses a modified future earnings model and gives a rating of 1 Star (Strong Sell) to 5 Stars (Strong Buy) to indicate valuation. Finally, we will look at the consensus figure of multiple professional analysts.

F.A.S.T. Graphs

The F.A.S.T. Graphs chart shows the current price of a firm compared to its valuation. The orange line traces the fair value of the company. The dark blue line indicates the historic P/E. The black line is the current price of the stock. When the black price line is below the orange fair value line and in the green area, the stock is undervalued.

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Chevron, Emerson Electric and JNJ are Buys

With only a quick glance we can see that the US integrated oil major, Chevron Corporation (NYSE:CVX) is far below fair value on F.A.S.T. Graphs. It has a low P/E of 8.3 compared to its historic average of 12.6 It earns 4 Stars from Morningstar and it has the best rating by analysts at 2.1. Giant drug maker Johnson & Johnson (NYSE:JNJ), a reliable Blue Chip, is a buy as is the global industrial control and communications firm, Emerson Electric (NYSE:EMR).

For illustrative purposes we will show a Discounted Cash Flow valuation model. Money Chimp has this easy to use calculator on line.

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  • Recent Market Price, CVX $113.90 Calculated Value, CVX $129.44
  • Discount from fair value, -12%

Selected Buys

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Based on this study, I added to my Chevron position. I hold my portfolio limit amount of JNJ. Emerson Electric is fairly valued and I would be a buyer at a slightly lower price. Indeed, all of our final cuts are buys; they are just not buys today.

It is up to you to set your own goals, and set your own selection criteria. Write them down and use them as part of your overall investment plan. I have my preferred criteria and standards and they need not necessarily be yours. You may be certain that I make mistakes. While we have covered most of the key issues, you must exercise your own due diligence. Sometimes data on the internet is in error. When in doubt check several sources. Read company annual reports, especially the letters to stockholders. Certainly, you will make more good choices than bad ones. All shall be well.

Related Articles

A Dividend Investing Primer, by Evelyn C. Roth

Constitution for a Dividend Growth Portfolio, by David Van Knapp

The Importance of Due Diligence, by Bob Johnson

Part 2 will have timely selections from the list of 178 Dividend Contenders, stocks with dividend increases for 10 to 24 years. It also includes sections on Risk, the Market, Diversification and Reviewing and Revising your holdings. It has aggressive goals. The stocks pay high dividends immediately and increase dividends quickly for greater payouts with no initial reinvestment of dividends.

Source: 5 Years Until Retirement? What Is Your Plan?