Preparing For Retirement Early: Set A Margin Of Safety For Your Total Return

Includes: KO, KSS
by: Canadian Dividend Growth Investor

Having found Seeking Alpha last year, I immediately fell in love with the Dividends & Income section, particularly the Income Investing Strategy subsection. The common idea is to buy quality companies at fair valuation or undervaluation, such that the dividend yield is likely to be higher than the historical average. As the income increases from companies you buy shares of, you use it to buy more and more shares. The share price slowly appreciates as the dividend increases. The snowball keeps rolling down the hill and becomes bigger. The value of our portfolio grows. Our net worth grows.

After I learned the concepts of valuation and diversification, my main focus in building my portfolio became identifying those companies with the traits I mentioned earlier. I enjoyed slow but steady growth in yield and price appreciation. However, the human emotion part of me took hold sometimes. This meant I sold holdings when they reached fair valuation or even before. The latter happened when I seemingly found another better buy. I don't know if I would have been better off holding the original company or not. There are too many factors to calculate, including dividends lost/gained, (unrealized) price appreciation, and possible tax implications.

It became apparent to me that just focusing on the growing income isn't enough, though it is the ultimate goal for retirement to have an adequate income stream that would eventually support my living expenses. Since I'm in my twenties, it actually makes sense for me to take some higher growth opportunities. By higher growth, I mean holdings that focus on capital appreciation instead of focusing on income only. These may be low yield, but high dividend growth companies with high earnings growth in the teens. Since these companies still pay a dividend, this method doesn't collide with my main goal of producing growing income. But I might end up selling some shares for capital appreciation, of which gains outsize the dividends and appreciation of possible core companies like Coca-Cola (NYSE:KO) and AT&T (NYSE:T).

Having invested in stocks for several years, I've learned to control my emotions better. I also learned to follow facts. For example, noticing a company with a decade or more of general earnings growth, and dividend growth, might make that company a possible good investment. I've determined that I will hold core stocks for dividend security and other stocks to add more growth to my portfolio. However, Mr. Market acts according to his will. So, I should aim for a total return with a margin of safety. Now, we've all seen the following:

Total Return = Dividends Received + Capital Appreciation

Then, total return with a margin of safety will be something like this:

Total Return With Margin of Safety = Safe Portfolio Dividend + Buying at a Valuation With Margin of Safety (i.e., buying at undervaluation whenever possible) + Adding Buffer to Expected Total Return

Creating a Safe Portfolio Dividend

The portfolio dividend is the total of the dividends I receive from all my portfolio holdings. To make that dividend safe, I diversify my holdings across stocks and sectors. I also set a maximum cost I have allocated to each holding. Any one company going bankrupt wouldn't devastate my portfolio performance. Diversification isn't enough of a safety net unless you're buying companies at fair valuation or undervaluation.

Buying Companies at Undervaluation

I strive to buy companies when they're trading at levels below their historical valuations. For instance, Coca-Cola historically trades at a premium, while Chevron (NYSE:CVX) historically trades with a lower P/E. Check out my article "How To Pick A Value Investment For Dividend Growth And Success" for more examples. Other than diversification and buying at proper valuations, I recently thought of not only setting an expected return for my investment, but setting it with a margin of safety. First, I will talk about estimating the return by using FAST Graphs and Value Line.

Total Return Estimation

1) FAST Graphs by Chuck Carnevale

Checking out Coca-Cola using FAST Graphs, I get an estimation of 6.5% for the five-year total return. That is the annualized return. The 10-year graph shows Coca-Cola has a normal P/E of 19.8. Adding in a margin of safety, I overlay a P/E of 19. It shows that by the end of 2018, the price would be $58.39. With yesterday's closing price of $38.65, that would actually be an annualized return of 8.6% if I expect Coca-Cola to continue trading at that premium.

Checking out Kohl's (NYSE:KSS) using FAST Graphs, 14.6% for the five-year total return. Due to overvaluation in earlier years, I decided to view it as a seven-year graph, having a normal P/E of 13.3. Adding in a slight margin of safety, I overlay a P/E of 13. By the end of 2018, the price would be $84.56. With yesterday's closing price of $52.22, that would be an annualized return of 10.12%.

KSS Seven-Year FAST Graphs

Click to enlarge images.


2) Value Line

Conveniently, I can access Value Line from my local library. Value Line provides individual company analysis and price projections for 2016-18. It also shows those projections in percentages as annualized gains or multi-year gains. Looking at the Aug. 2, 2013, issue of Value Line, it reported an analysis on Kohl's. It indicates a 2016-18 projection of $75-$105, an annualized gain of 11%-20%. Cross-referencing between the two services, I might conclude to expect to have annualized returns of 10% from buying Kohl's at the current price.

Setting a Margin of Safety for the Portfolio Total Return

For example, if I'm planning to achieve 8%-plus annualized returns, I would aim for, say, 10% for my portfolio's total return estimation. The portfolio will consist of a range of companies that have mixed estimated total returns. The estimated return of the portfolio will sit at an average of 10% to add a margin of safety for my planned 8% return. This total return is achieved by:

  • Having a mix of dividend companies, from ones with low yield and high dividend growth, to moderate yield and moderate dividend growth, to high yield and lower dividend growth.

  • Setting a maximum number of holdings I'm intending for capital gains of double digits.

  • Building an increasing income stream with intention of reaching 8%-plus yield on cost by year N. Number of years required is determined by the portfolio's starting yield, and the growth of yield. The companies to grow the portfolio income stream must be high quality and have consistent earnings. Companies I have in mind are Colgate-Palmolive (NYSE:CL), Coca-Cola, Kimberly-Clark (NYSE:KMB), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Chevron, and Exxon Mobil (NYSE:XOM)

Closing Comments

When you still have many years ahead of you until retirement, consider a focus on total return instead of purely focusing on income. For example, considering a company with low yield but high dividend growth due to high earnings growth will actually appreciate the price of the security accordingly. Also, consider setting a margin of safety for the estimated return of each of your investments.

At the end of the day, you're the manager of your money. Know yourself, your risk tolerance, and your temperament so that you don't buy or sell at the wrong times. More than one road leads to Rome. Build your portfolio with a margin of safety for your total return to have peace of mind.

Disclosure: I am long KO, CVX. 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.