The Importance of Dividend Investing

by: Roger Nusbaum

This post will fall deaf on some ears, as the topic often draws passionate comments, but I'll give it a try anyway.

Yesterday I read a post on Seeking Alpha called The Four Percent Rule For Dividend Investing In Retirement from an anonymous blogger named Dividend Growth Investor. The post basically laid out a premise for constructing a dividend-based portfolio focused on the rule of thumb of not withdrawing more than 4% in retirement.

An important building block of understanding (although probably not new to you) is that over very long periods of time dividends have accounted for about 40% of the total return of equities. Dividends matter in just about every type of the stock market behavior except for "up a lot," in my opinion. The way I look at, with equities up 65% or 70% in the last twelve months, whether or not you collected an extra 200 basis points doesn't mean that much, but if the market is anywhere from down 10% to up 15% then an extra 200 basis points could be very important.

The Dividend Growth Investor, per the article, would split a portfolio into four categories:

1) "The first component would be fixed income securities such as 30 year Treasury Bonds."

2) "The second component would consist of higher yielding stocks with low dividend growth. Likely inclusions in this list include Master Limited Partnerships."

3) "The third component of the portfolio would include mature companies which offer yields similar to average market yields, but which have enjoyed solid dividend growth."

4) "The last component will include companies with low current yields, which have the ability to generate double digit earnings increases. This could generate solid dividend growth in the future."

He did not suggest how to weight the four and did not mention whether this would be the totality of the portfolio.

In averring for the 30-year treasury (he may have been taking generically) he mentions the "stability in the principal and income would provide at least some cushion in certain catastrophic events." There was no mention of the risk of buying a 30-year bond if interest rates rise. I'm not sure if he does not know how the math works out, but if rates go up (they are very close to all time lows) then investors who bought 30-year paper with the intention of holding will be down a ton (about 12% in price for each point that rates move up) and then be stuck with a below market yield.

In point number two about MLPs, occasionally they get hit very hard as the Canadian ones were back in October 2006 when news of a tax status change came out. There is room in a diversified portfolio for some MLP exposure but to repeat from past posts is you are getting an 6% yield in a 1% (or zero percent) world you are taking risk, you either understand that risk or you don't. In the paragraph he also includes REITs, Realy Income (NYSE:O) 5.6% yield and National Retail Properties (NYSE:NNN) 6.57% yield, and utilities like Consolidated Edison (NYSE:ED) 5.34% and Dominion Resources (NYSE:D) 4.45 yield. Utilities tend to not do well if rates go up.

In discussing point number 3, he mentioned Johnson & Johnson (NYSE:JNJ) 3.01% yield, McDonalds (NYSE:MCD) 3.30% yield and Kimberly-Clark (NYSE:KMB) 4.20% yield.

Companies discussed in point number 4 were Walgreen (WAG) 1.48% yield, Becton Dickinson (NYSE:BDX) 1.88% yield and Medtronic (NYSE:MDT) 1.82% yield.

Assuming each of the four groups gets a 25% weighting in the portfolio, and giving equal weight within each group to names he mentioned, the average yield (assuming 4.72% for the 30-year bond which is where TYX closed yesterday) of the portfolio is 3.91%, obviously just shy of the 4% targeted in the title.

The biggest risk to this mix, and I realize my assumptions of what is implied could be incorrect, is that half of the portfolio is at serious risk if interest rates rise. I compared the names above to the TYX and found a stretch in 2005 where TYX went up for a few months and most of the names in that second group had noticeable declines during the run up in rates. I should note that the move up in rates was only slight, I picked that period because it lasted for several months.

If rates really move up, and that is the question to be asking at this point, then I think this half of the portfolio would get hit pretty hard.

My idea of a diversified portfolio includes exposure to every big sector of the market with stocks of many different attributes so that there is at least some exposure to whatever is leading the market. Value can be added by overweighting the area that ends up leading the market but if that call is not made correctly at least there is some exposure.

Low volume, high yielding holdings have risks too. In addition to the above, occasionally dividends get cut.

The 4% withdrawal rate is about taking money out at a rate that does not cause the portfolio to blow up. In theory a 2% yield and 4% average price appreciation will more than get the job done (this is a simplification because returns are never that linear). Using (recent) history as a guide the stock market goes up a lot every so often and a reasonably diversified portfolio will capture most of the effect, a gross overweight of dividend payers will not.

Getting a 4% yield for an entire portfolio is very difficult to do, 3% on the other hand is much more approachable. Not mentioned in article is that plenty of foreign stocks with volatility characteristics close to the market (so they could go up a lot if the market does) but aren't necessarily that interest rate sensitive. There are many high yielding foreign oil stocks (so regular equities tied mostly to the price oil as opposed to being income vehicles).

I'll mention long time holding Statoil (NYSE:STO), which is due to go ex-div in May, for its annual dividend. Based on current numbers, it yields about 4.3%. A few of those combined with some higher growth names could easily get the portfolio yield up into the high twos or close to 3%. I own plenty of high yielding stocks for clients, as I do believe in trying to kick up the yield ahead of the market, but not at the exclusion of higher growth names.

Even in retirement people need growth. Based on a 3% inflation rate prices/expenses go up 50% in 15 years. A fit 65-year-old with good genes could easily go through two fifteen year stretches.

Disclosure: In addition to Statoil, many clients own Johnson & Johnson and some clients own Consolidated Edison.

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