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Go here for Part I

Plan, you say?

This two-part article describes the plight of many Americans. Retirement is right around the corner and many in their 50s and 60s are not on a path that will lead them to a prosperous retirement. In the past decade, real income, that is income after inflation, has gone down. Years ago we made projections when considering our retirement. Plans based on wages increasing at 2% to 4% a year are dashed. Today's dollar is only worth 70% of what was ten years ago, and we have fewer dollars than we did then. We expected we could live off CDs yielding 6% to 8%. They no longer exist.

This article will provide some help and show you how to move toward an increasing retirement income that will supplement your social security or other retirement programs. You will learn how to create an income machine that will address the matter of future inflation. You can set attainable goals, evaluate your resources and adopt a concept that will make your life easier as time goes on. This concept is Dividend Growth Investing and variations of it have made many investors prosperous. Beyond a sound methodology, we also offer a selection of stocks for your consideration; they are suitably valued for purchase today.

Ways to Fund Retirement Income

It takes money to fund retirement plans. Many people nearing retirement do not have enough resources. Whatever you have, this plan will help you use your savings effectively. It will work if you have $25,000 to invest, $50,000, $250,000 or more. For purposes of illustration, let us assume you have $100,000 to invest.

In Part I of this article I surveyed the things you can do with your financial assets. The options presented include keeping your savings in a bank, purchasing an annuity, investing in bonds and buying stocks. In that article, I illustrate how well you can do with a few good blue-chip dividend-paying stocks, which are yielding over 3% and are increasing their dividends on an annual basis. I searched for these great companies in the list of Dividend Champions at the Drip Investing website. David Fish, a Seeking Alpha author, maintains this free resource. The 105 Dividend Champions are companies that have increased their dividend annually for at least 25 years. In this article, we extend that search for Dividend Growth opportunities to the Dividend Challengers, companies that have grown their dividends for at least 10 years and up to 24 years. The two initial screening criteria for our income machine portfolio are yield and dividend growth rate.

Yield

The yield is the amount of the dividend paid, on an annual basis, divided by the price of the stock. If a company pays $5.00 in dividends on a stock selling for $100, that is a yield of 5%. It is important to understand that the company sets the dollar amount of the dividend, and the market determines the price of the stock.

Dividend Growth Rate (DGR)

If a company pays a $5.00 dividend this year, and next year raises it $0.50 to $5.50, that would be a 10% dividend increase. To estimate future dividend increases, they are projected using rates from an earlier period, such the average past 5-year rate. In the example below, selections are stocks with a high 5-year dividend growth minimum rate of 9%. Even those who are very near or at retirement age will see their income ramp up quickly.

The Selection Process

We list the 178 Dividend Contenders by yield, from highest to lowest, and eliminate all that do not yield 3% or more. Next, we cut out all of those that have dividend growth rates less than 9%. We also eliminate those with a Market Capitalization of less than $5B. A lower yield with a high DGR may be suitable for younger investors. A lower DGR is also an option for older and well-funded investors looking only for maximum yield today. Some investors add the yield percent (such as 4) and DGR (perhaps 7) together and settle for any combination that totals 10 or 12.

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After our initial screens, each company was credit checked at Standard & Poor's; a F.A.S.T Graphs Report provided a way to look for excessive debt or lack of liquidity, as well as review other ratios. Lockheed Martin (NYSE:LMT) carries a large debt load, but when looking at the company closely, it became apparent that LMT has good coverage of its debt and it also has $11/share in cash. Resources for this were Yahoo Finance and Seeking Alpha Portfolio data, in addition to the F.A.S.T. Graphs report.

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Diversification

It reduces risk to own a number of different stocks and to choose them from different sectors of the economy. If you have $100,000 to invest, you might want to own 20 different companies, with an investment of about $5,000 in each one. By selecting the best opportunities available at any given time, it is likely that they will be in different industries as is the case above. However, it might not be prudent to select all three of the telecommunications companies shown, especially if we had selected one previously from the list of Champions or elsewhere. Neither would it be prudent to omit the large and profitable consumer staples sector, represented by companies like Procter & Gamble (NYSE:PG) and Kimberly-Clark (NYSE:KMB) or the energy sector, which includes Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP).

The stock market, as measured by the S&P 500 or the Dow Jones industrial Average, goes up and down. Currently, the broad market is near a 5-year high, that is to say, stocks are pricier than they have been in years. Some of the best blue-chip dividend growth stocks are overvalued due to the demand for their growing dividends and the income they produce.

The Market

It is best to look at the market not as a stock market, but a market of stocks. We advocate the purchasing of individual stocks, scrutinizing and evaluating each of them. At any point in time, some will be dear and others will be bargains. Rather than attempt to time the market, it is best to watch a list of stocks, and at a given point in time buy those with the best valuation.

When initially building a portfolio and putting money to work, you may decide to buy some fairly valued or slightly overvalued stocks. That is an individual choice. You may decide to wait and purchase a stock only when the price dips to a predetermined level. These are alternatives, and the choices are up to you based on your individual circumstances and the amount of patience you can muster.

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Valuation

Which stocks are undervalued, or at least fairly valued, today? From our initial list of 178 Dividend Contenders, we shaded 8 a dark green above, as undervalued today. Another 5 are possibly undervalued, but there is no consensus using our tools. A next step for these might be to value them using a discounted earnings model as illustrated in Part I of this article. We used the Morningstar rating as one source of information. They use a modified discounted cash flow model to arrive at their rating. In general, stocks with a 4 or 5 star rating are suitable for purchase. In their premier version, they also suggest a safe buying price and give a calculated Fair Value. The F.A.S.T. Graphs are discussed and illustrated in Part I of this article. My interpretations are Overvalued, Fairly Valued or Undervalued. The stocks shaded in dark green have a Morningstar 4 or 5 star rating and either a "F" or "U", F.A.S.T. Graphs indication.

Risk

One must always consider risk. Allow me give you my day-by-day, working definition of risk. Risk is the event or circumstance that could cause you not to have the money you need, when you need it. Probably one of the riskiest things you could do with your hard-earned savings would be to put them in a FDIC insured account in a bank. How is that risky? It is risky because it is almost certain to decrease in value over time, and you will not meet your future needs. Investing all of your money in government or corporate bonds is even riskier. That is because though they pay a little better than money in the bank, they will dramatically decrease in market value when interest rates rise from their now record lows. If you thought that cash and bonds were where you could retreat to safety, then I ask you to rethink that. The only way I know of that one can stand a chance of beating inflation and still having increasing income is Dividend Growth Investing.

Income

Our first year's dividend income at 3.75% is $3,830 on the $100,000 we invested. At the 17.75% dividend growth rate, income climbs to $7,362 in year 5, and to $16,666 at year 10. Will the growth rate stay the same? It will vary from year to year, but some stocks have increased at that high rate over time. Even if it falls from nearly 18% to the DGR of 12%, it will still provide great rewards, as do our choices in Part I of this article. It will still handily beat inflation and produce a growing stream of income.

What will the value of the stocks be in ten years? In a sense, it is irrelevant to this study. Markets always change and stocks routinely go up and down 20%, and sometimes more than that. In the long term, the trend is up at a rate of about 7%.

Here is how your income might grow over the years. I, and thousands of other thoughtful investors are achieving good incomes with this general methodology. The traditional advice from advisors is that you can withdraw 4% of your principal annually, plus an allowance for inflation. Look how much better this is!

I suggest you embrace Dividend Growth Investing today.

Review and Revision

Circumstances of companies change over time, and it is necessary to review your holdings once or twice a year. If any of the companies cut their dividend payment, replace them as soon as possible. If a company increases its dividends at a markedly lower rate for two or three years in a row, scrutiny is called for. Is their payout ratio also rising? That can be an indication of weakness, and flagging profits. It might be better to replace them with a better performing company in order to achieve your goals. As in the case of the criteria you use to purchase stocks, it is best to have a written plan concerning when you will sell and replace them.

Fluctuations in the market price of a stock, which also changes the reported yield and market capitalization, should not be a large concern. A big cause of market swings is emotional response to news, over reaction, which does not reflect the soundness and intrinsic value of the companies. Usually, the best strategy is to make as few changes as possible in your portfolio.

We were careful in stock selection, vetting our portfolio of as much risk as possible. We expect that these will continue their superior dividend growth. However, a range of returns is possible from any investment. From this point, we suggest you do any additional research you feel is warranted, complete your own due diligence, and go forward with confidence and without fear. Enjoy your growing income!

The first part of this article includes further information on alternative investments such as Bank Savings, Annuities, and Bonds. A full description of the selection process is included and valuation tools are illustrated. The 105 Dividend Champions, stocks with a record of dividend increases for 25 years, are considered and 3 are selected as buys.

The Importance of Due Diligence, By Bob Johnson

Sectors and the Business Cycle: A Primer, By Bob Johnson

Dividend Stocks Remain Relatively Attractive Despite Concerns Over Valuation And Taxes, By Jeff Paul

Disclosure: I am long CVX, KMB, PG. 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.

Source: 5 Years Until Retirement? What's Your Plan? Part II