Mix Up Your Relationship Between Dividends And Total Returns

Includes: BRK.B, CMG, IBM, V, WFC
by: Tim McAleenan Jr.

A traditional approach to investing would suggest that investors should spend their working years trying to put together as high of a net worth as possible, and then when the time to live off the assets arrives, the investor is expected to either shift to a drawdown policy or reconfigure his assets so that he can live off the income organically generated by the portfolio. The logic behind this conventional wisdom is two-fold: (1) it does not place importance on income until the time comes at which you need money to pay for living expenses, and (2) a high net worth strategy can provide the "raw material" to become a significant income-producing asset when it is the right time to make a transition in strategies.

This is a perfectly valid approach, but it is not the only way to structure your portfolio. There are some advantages to reversing the process and placing a priority on the accumulating of cash-generating assets first, with an eye towards capital gains later. The wisdom of this approach is that you spend your early investing years trying to find a way to get five hundred dollars, one thousand dollars (or whatever the target amount may be) in income generated per month so that you can spend the second stage of your investing life allocating an endless stream of fresh capital that arrives in your checking account each month. From there, you will likely add to your income base without intentionally doing so. Considering that 405 out of the 500 companies in the S&P 500 currently pay dividends, it is likely that any new future investments you make will end up adding to your future pool of available capital to invest each month, even if making capital gains investments supplants dividend investing as your primary objective.

One thing that makes it easier for Warren Buffett to make investments in low-yielding companies like IBM (NYSE:IBM) (which yields below 2%) and Wells Fargo (NYSE:WFC) (which was paying out a $0.05 quarterly dividend during the financial crisis when Buffett was adding shares) is the knowledge that Berkshire Hathaway (NYSE:BRK.B) is generating $1 billion in profit that gets sent to headquarters to get deployed each month. Even if your eventual end game is high total returns (rather than income), the possession of a stable income infrastructure can provide the means by which you accomplish those ends.

An "income first" strategy can be a great way to take some of the stress out of investing and make it easier to tolerate volatility in your investments. Some high earnings growth investments experienced some severe volatility during the last financial crisis. Visa (NYSE:V) fell to $42, Chipotle (NYSE:CMG) fell to $86, and IBM fell to $70 per share. If those were your "starter" investments that constituted the backbone of your portfolio, it could have been heartbreaking to deal with the severe declines in your net worth if you did not have the right temperament to trust your analysis of those companies' long-term earnings power. However, if you already had an income base established that generated $1,000 per month in investable income, you might be able to deal with the wild fluctuations a bit easier.

An additional advantage of putting an "income base in place" (say that ten times fast!) as your first investment priority is that it builds a system that allows you to invest when markets are declining. If you follow the advice of John Neff, Charlie Munger, or John Templeton, you know that the market crashes are the times when the "big money" gets made. The key is to craft a strategy that allows you to be a net purchaser of stocks during these periods of maximum pessimism. If your first priority is to get $500-$1000 in investable income coming into your checking account each month, then you have put yourself in a position to take advantage of the opportunities that the market offers.

Investing strategies are often presented in all-or-nothing terms, but that does not have to be the case. Oftentimes, income investing is cast as something at odds with a total return approach to investing. But it does not have to be that way. In particular, dependable stocks that offer high yet reliable current income can serve as a springboard for a total return strategy. If you want to invest in deep value stocks and high earnings growth companies, you could add some ballast to your strategy if you establish an income infrastructure first to make those high return investments.

Disclosure: I am long IBM. 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.