The Safety Net Of Dividend Investing

Includes: CL, GE, JNJ, KO, PEP, PG, WMT
by: Tim McAleenan Jr.

Many of the articles that I have written on Seeking Alpha have encouraged investors to abandon focusing exclusively on stock price in favor of focusing on the earnings and dividends that each share of stock represents. Often, this approach involves changing the measuring stick for success by placing a growing income stream on a higher pedestal than a positive change in a company's stock price. Of course, this raises the question: What happens if a blue-chip company cuts or eliminates its dividend? We all know what happened to Bank of America (NYSE:BAC) and BP (NYSE:BP) shareholders that thought they owned a high-quality asset. The short answer is this: if you have a diversified portfolio that largely consists of stocks that raise their dividends each year, the added income from the dividend raises and reinvested dividends can often offset the income hit from a dividend elimination or decline.

What I find compelling is that the math is forgiving for investors that want to maintain purchasing power with their dividend income even if a particular dividend stock cancels its dividend. Let's say that I am maintaining a 25-stock portfolio that is generating $10,000 per year in dividends. One of the companies, which I had been counting on to generate $400 worth of income, suddenly cancels its dividend completely. Imagine something like owning Lehman Brothers or Wachovia when the financial crisis came around. To replace that $400 worth of income, the remaining $9,600 worth of dividends would have to grow by a little bit less than 4.25% to offset the dividend wipeout.

If you're filling your portfolio with the bluest of the blue-chip stocks, this should be easily attainable without breaking a sweat. Since 1990, Coca-Cola (NYSE:KO) has been compounding dividend growth at a rate of 11%. Since 1995, Colgate-Palmolive (NYSE:CL) has been compounding dividend growth at a rate of just under 11%. Since 2000, Johnson & Johnson (NYSE:JNJ) has been offering compounding dividend growth of over 12%. Since 2005, Wal-Mart (NYSE:WMT) has been compounding dividend growth at a 15% annual clip. Procter & Gamble (NYSE:PG) has increased dividends by 11.5% annually over the past five years. While slowing earnings growth will make it difficult for these firms to continue such stellar rates of dividend growth going forward, all of these companies listed seem likely to grant at least 4.25% dividend growth going forward based on their earnings growth and dividend histories.

By the way, my premise is not a circumstance that should be facing a prudent dividend investor every single year. If you're experiencing the complete loss of income from one of your long-term holdings each year, then you're probably taking on more risk with your stock selections than is necessary to achieve 7-8% annual income growth. Nevertheless, I find it comforting to know that if I assemble a diversified dividend growth portfolio, I can organically "plug in the hole" from one company's dividend elimination by achieving at least 4.25% annual dividend growth from the rest of the portfolio (and this should be even more attainable if you're reinvesting the dividends along the way).

One of my favorite quotes from President Abraham Lincoln is the observation that the best thing about the future is that it happens one day at a time. The good news is that investing is the same way. It can be mind-boggling to try to think about our expected dividend income requirements 10 years from now. But we only have to take it one day at a time by asking questions like: Are earnings still growing? Are dividends still growing? Is the company protecting its moat adequately and selling a product with profit sustainability? If your portfolio is stuffed with companies that have been raising dividends every year for the past decade or two, the answers to these questions ought to be yes.

And the thing is, it doesn't take a high IQ to figure this out. You basically have to do three things to take advantage of the safety net that a blue-chip portfolio of dividend stocks can offer. You've got to be diversified in the tradition of Benjamin Graham's defensive investor. If you own 30 companies of roughly equal weight across the gamut of corporate America, you can benefit from the safety of having your hand in every cookie jar. To paraphrase Standard Oil founder John Rockefeller, it's a lot better to have one hundred people owe you a dollar than to have two people owe you $50. When you have money coming in from electric utilities, oil companies, candy-bar makers, software developers, soda vendors, industrials, healthcare manufacturers, drug companies, and consumer staples, it is going to take a lot of things going wrong to wipe out your sources of income.

The second thing you have to do is recognize the excellent businesses, which is quite doable if you keep your eyes open. Growing up, every time I went to my grandfather's house, there was Pepsi (NYSE:PEP) stocked in the fridge. I mean, there was always Pepsi in the fridge. If the case got down to only a couple cans left, it meant that one of the grandchildren had to run over to Paul's Market in Ferguson, Missouri to restock the fridge. Little did I know at the time that I was witnessing the emotional power of a strong business brand. But now I know: it's my job as an investor to go through life collecting shares of the dozen or so businesses that share some of the same characteristics as Pepsi.

And the last thing you have to do is monitor your holdings. You've got to make sure that the dividends and earnings are still growing. You have to make sure the balance sheet is still somewhat clean, and the company is not loading up with too much debt (this can often be done using basic high school algebra. I use Value Line to look up how much debt the company has to pay back in the next five years, and then I compare that figure with how much profit the company is generating). And lastly, you have to gauge the market for potential threats to the business model of your business. Is there a reason to think that the world will be consuming fewer Pepsi products five years from now than today? If so, is it a large enough threat that you should consider selling?

When you follow the common-sense steps of portfolio construction, it is easy to create a system that automatically takes care of income replacement if necessary. If you own 30 of the most dominant firms that operate globally, you ought to be able to get dividend increases from all of them every year. But if you limit the size of your holdings so that it can withstand the occasional unpredictable dividend cut like General Electric (NYSE:GE) shareholders experienced, you can still rely on the dividend increases and reinvested dividends from your other holdings to fill in the gap. This is why blue-chip dividend investors that focus on income streams often see the amount grow every year.

Disclosure: I am long BAC, JNJ, BP, GE. 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.