Every time I write about my personal experiences with Dividend Growth Investing, I encounter those critical of the idea without a real understanding of exactly what it is and how it works. Here's an opportunity to explore the basics. As retirees, we have a number of investment approaches we can take to supply a monthly stream of income. After carefully considering each option, I feel Dividend Growth Investing is the best choice for me.
Recently, Seeking Alpha contributor Bob Johnson wrote an article where he explored the primary options available to provide income during retirement.
Most of the retirement options Bob discussed had one thing in common; they were based on the idea that investment income would likely be exhausted during a 25 or 30 year span of retirement. Simply stated, under this premise, stocks, bonds or mutual funds are sold during each month of retirement to provide income. Most traditional financial advisors recommend that 4% of your investment portfolio be withdrawn each year and that an additional amount be withdrawn equal to the amount of inflation. Most formulas suggest that investors with portfolios of 60% bonds and 40% equities have an 80% plus chance of outliving their money.
As I have discovered over the past year, there is an alternative that I believe every retiree needs to consider. I believe the alternative of Dividend Growth Investing provides the opportunity to enjoy income in excess of 4% of the value of your portfolio without a monthly withdraw from capital. I also believe that this monthly stream of income can grow at a rate that exceeds inflation. This approach is possible from a combination of carefully selected stocks with both safe dividend yields and sound dividend growth.
I believe that by following the steps I'm about to outline, everyday investors have the ability to assemble portfolios that can safely produce growing monthly streams of income that succeed in both bear and bull markets.
In order to succeed long-term, retirees must have portfolios that do two things: Control risk and preserve capital. Let's start with the steps necessary to control risk. There are of course risks associated with Dividend Growth Investing as there are with any and all alternatives. With bonds and bond funds, the risk comes with rising interest rate. With annuities, the risk comes from increases in the rate of inflation. With Treasuries, the risk is the erosion of capital necessary to produce income of 4% plus an amount equal to inflation. With Dividend Growth Investing, most would argue the greatest risk is from a loss of income which could occur from dividend cuts or elimination.
To control this risk the first thing a Dividend Growth Investor needs to do is construct a core portfolio comprised from holdings known as Dividend Champions, Challengers and Contenders (CCCs). CCC lists are maintained and up-dated on a monthly basis by contributor David Fish.
These holdings are part of a select group of over 400 stocks with extended periods of sustained dividend payments and dividend growth ranging from 5 years to more than 50. The primary reason these stocks help to control risk is that none of today's CCC companies cut their dividends in 2008 but each continued and even grew them. If you were retired and receiving monthly income from a portfolio of these stocks in 2008, even when the market tanked, your monthly income remained not only constant but even grew!
Take a quick look at the history of dividend cuts during the bear markets of 2002 and 2008. It is easy to locate the sectors incurring the greatest number of dividend cuts and eliminations during those bear markets. Clearly those holding technology and banks stocks during those time periods suffered more dividend cuts and eliminations. For that reason, many retirees constructing Dividend Growth portfolios will underweight technology and banks.
Another way many retired Dividend Growth investors seek to control risk is by selecting low beta CCC companies to anchor their portfolio. The current average beta of my portfolio is .6, nearly 40% less volatile than the S&P 500. I believe that one of the first things a retired investor needs to do is spend time really coming to terms with their personal risk tolerance.
Still another step to take in reducing risk is to select CCC companies with low payout ratios. Most favoring this approach suggest payout ratios less than 70%.
Many Dividend Growth investors, myself included, have elected to further minimize the effects of any dividend cuts on income by seeking portfolios of equal weighted positions. I am one of many who favor 50 such positions. By choosing this approach, I limit loss of monthly income to 2% if a stock in my portfolio suddenly cuts or even eliminates its dividend.
There is another risk facing Dividend Growth investors, the risk that the dividend growth of your holdings does not keep pace with inflation. Many of the Dividend Growth investors here at Seeking Alpha favor CCC stocks with 5 year Dividend Growth rates (DGR) of 8% or higher.
Still another way Dividend Growth investors reduce risk is by investing in companies that enjoy an economic advantage over competitors. This is often referred to as an economic moat. Examples include companies like Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD)and Johnson & Johnson (NYSE:JNJ).
Finally Dividend Growth investors reduce risk by diversification. My portfolio contains stocks in each sector as well as REITS and MLPS. About 10% of my holdings are in foreign dividend growth stocks like Rogers Communication (NYSE:RCI) and Royal Dutch Shell (NYSE:RDS.B).
Earlier, I mentioned that for a retiree portfolio to succeed, we must manage risk and preserve capital. While Dividend Growth investing doesn't require "beating the market" for its success, it too benefits from periods of high capital growth.
Over the past year I have back tested numerous portfolios using stocks from the CCCs and regularly discovered capital gains in excess of 10% a year for the 10 year period - 2002-2011 vs. 3% for the S&P 500 during the same period. My exercise in carefully examining the past ten years have convinced me that safe dividend growth and capital growth can co-exist in the same stock, especially when that stock is purchased at a fair or undervalued price.
Dividend Growth investors should seek to make purchases for their portfolios from equities considered to be fairly or undervalued. Many use Fast Graphs or Morningstar to help determine value.
Finally I believe every retired investor needs a formal business plan for their portfolio based on their own personal risk tolerance. This plan should provide the basis for a formal quarterly portfolio review. My personal portfolio plan is available here.
Ready to take the next step? Simply download the CCC spreadsheets, then customize the sheets based on the following criteria:
Yield at time of purchase. Most retired Dividend Growth investors commenting regularly on Seeking Alpha favor stocks yielding from a minimum of 2.75% to 4%.
Eliminate most stocks with payout ratios of over 70%
Eliminate stocks with 5 year Dividend Growth Rates (DGR) less than inflation.
Eliminate stocks that don't match your risk tolerance. For example, I eliminated all U.S. Banks and higher beta Industrials, Tech and Material equities.
After this exercise you will be left with a more manageable list of stocks for further review. Next, write your personal portfolio business plan, including guidelines for the purchase and sell of the each holding.
Next determine the current value of stocks you are considering avoiding those for the present that are considered overvalued. Give priority to the fair or undervalued stocks that enjoy an economic moat and grade "A" or better records of safety.
If you have done the work I've suggested and selected from the list of Dividend Champions, Challengers and Contenders those that are leaders within their industry with strong 5 year records of dividend growth you will not likely have to spend much time engaged in day to day stock monitoring. As a "Buy and Monitor" investor, you'll likely spend less time watching CNBC and reading corporate reports. For retirees, that means more time traveling and more time with your grandkids.
Interested in looking under the hood at a real Dividend Growth portfolio, mine is available here.
For those interested in a look at how I conduct a quarterly portfolio review, click here.
For those interested in another introduction to the concept of Dividend Growth investing, I recommend you consider this one by contributor David Van Knapp.
I hope in some small way I have encouraged each of you to learn more. Now its time to continue learning by posting your comments and questions below.
Disclosure: I am long KO, WMT, MCD, JNJ, RCI, RDS.B. 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.