My Dividend Growth Investing Epiphany

by: Dividend House

Summary

My husband recently surprised me when he announced that he planned to retire in the next 4 to 6 years.

I panicked. I realized that we had no idea how to harness our investments to generate an income stream that would last.

While reading everything I could find on retirement investing, I came across Seeking Alpha and the concept of dividend growth investing (DGI).

I was skeptical about DGI until I had an epiphany – investing in dividend growth stocks and investing in rental properties represent similar investment philosophies.

We now purchase dividend growth stocks and rental houses, reinvesting the income they generate.

Retirement Looms

Earlier this year, I was in a state of panic when my husband announced that he planned to retire in the next 4 to 6 years. While I'm only 53, my husband has just turned 62. It is understandable that he'd like to see some light at the end of his working life tunnel. We both are lucky to have enjoyed careers in engineering, management consulting, marketing, and strategy. We are both still working full-time. As a result, our investment portfolio looks healthy on paper.

Unfortunately, that's not the whole story. There was no rhyme or reason as to why we had invested over the years in much of what we did. No strategy at all. We had just made our best guesses regarding initial investments in our 401ks and 457bs at each new employer and went on autopilot after that. When we changed employers, we ignored what had gone before and started over. Clever, huh?

As a result, if you had looked underneath the covers of our investments earlier this year, you would have found a scattered hodgepodge of funds accumulated from various employers over the years. (Seriously, we had at least 25 different mutual funds.) But the thing that was really scary - we had no idea how to harness this haphazard basket of investments into an income stream that would last us through retirement. Not a clue.

Having lost money on a couple of small forays into the stock market based on uninformed stock tips from friends and relatives in the past, I was fearful of our abilities to invest successfully in the market. To me, stock investing looked a lot like gambling. After all, wasn't our portfolio inexplicably cut in half in 2008-2009? (Luckily, our benign negligence paid off in this case. We watched uncomprehendingly as our portfolio lost half its value only to regain and surpass its value in the succeeding years.) What the heck was going on? Clearly, for serious money, stock investing was best left to the professionals. Or, was it?

Being a penny pincher, I hated the idea of paying someone else to manage our money. That would only lower our portfolio's returns, spelling less income for us. To make matters worse, in my grandparents' generation, a money manager had absconded with the family money. Not only didn't I trust money managers to optimize our portfolio, I couldn't be sure that they wouldn't be outright crooks. On the bright side, I like solving puzzles. It was clearly time to put aside my fear, take a deep breath, and figure this thing out!

In my newfound state of resolve, I started reading everything I could find on investing for retirement. Luckily, I stumbled across several Seeking Alpha articles. At first, I was skeptical. Who exactly was Seeking Alpha? Why were people giving away so much of their insight? You get what you pay for, right? But, not only did this site discuss particular investments, some of the contributors discussed how they think about investing. Some particularly talented folks (like Chuck Carnevale, Regarded Solutions, Brad Thomas, BDC Buzz, David Fish, David van Knapp, Mike Nadel, Bob Wells, David Crosetti, George Schneider, Eli Inkrot, Adam Aloisi, Chowder, and more) were teaching others how to think for themselves! (Love that!!!)

In an attempt to "pay it forward," I will document our journey from clueless mutual fund investors to active dividend growth investors (DGIers) in the hopes that it helps others journeying down the same path. This first article discusses how I got comfortable with relying on dividend growth investing as an income generation strategy for retirement. Subsequent articles will cover how I am converting our hodgepodge of mutual fund investments into a DGI portfolio (a topic on which I've seen relatively few articles) and how I structured our DGI stock portfolio, including questions I think everyone should be thinking about alongside some of the options we considered and the answers we think work for us. Along the way, I'll also share our DGI portfolio as it looks to date - the good, the bad, and the ugly.

Why DGI?

Now, back to the beginning of our journey. After weeks of extensive research, I had an epiphany. Dividend growth investing is like investing in rental properties! This flash of insight gave me a path to retirement investing that I could "buy into" (pun intended!). Here's my thinking:

1) Cash flows. I invest in rental properties for their cash flows, in the form of monthly rent checks from tenants. Similarly, I invest in dividend growth stocks for their cash flows, in the form of recurring dividend payments.

2) Time horizon. In real estate investing, my husband and I are not "flippers." We purchase single-family rental homes fully expecting to own them for as long as the IRS will let us depreciate them. (This is 27.5 years for residential real estate.) DGI is done best with long time horizons because a long time horizon yields DGIers a bonus - the cumulative effect of dividend reinvestment over the portfolio's accumulation years.

3) Purchase price. When I'm purchasing a rental property, I try to get the best price given market conditions at the time. I analyze the fair value of the property by looking at comps in the area and the size and condition of the property. Ultimately, if I find a property I like at a price that allows me to generate enough positive cash flow, I purchase the property. The lower the purchase price of a property, the faster I can build up a war chest to buy another one. It's the same with stock investing. The trick is figuring out if a selected stock is currently selling at a good price. (More on this in later articles.) If you think of each share of stock as a "little house," the lower the price, the more "little houses" or shares you can purchase with your war chest. Just like in real estate, the more "little houses" or shares I own, the more income I receive.

4) Market fluctuations. The only time I care about a house or stock price is when I'm buying or selling (which in the case of rental properties, should be once every 27½ years). So, focusing on price just doesn't make sense. It's academic what my rental properties are worth for over 25 years at a time! Just like in real estate, the actual value of our stock portfolio based on today's stock prices is largely irrelevant unless I have to sell. Of course, in real estate and stock investing, you never want to put yourself in a situation where you have to cash out at a specific time in the future. You need to be able to outlast the current market cycle. Once you are in the distribution phase of retirement, this will be possible only if you have invested in enough quality stocks that continue to grow their dividends even during recessions, providing the income you need.

As I continued to learn, I decided that investing in dividend growth stocks actually has some advantages over real estate investing (aside from not receiving middle-of-the-night calls that the water heater has busted!). Here's my thinking:

5) It's easier to dollar cost average, smoothing out the effects of pricing cycles. House buying is very lumpy with large amounts spent only a few times a decade (at least in our case!). Through dividend reinvestment programs (NYSEARCA:DRIP), you can reinvest in your stocks every time you receive a dividend. Sure, that means your dividend is buying fewer shares sometimes than others. But you can put this on autopilot (something my husband and I have proven we like to do!). Happily, many Seeking Alpha articles verify that the ups tend to balance out the downs.

6) It's easier to diversify. For us, diversification within real estate investing has meant owning single-family homes in different cities. Of course, it could also mean moving into different types of real estate (like apartment houses or shopping malls). But both approaches to real estate diversification take a lot of new analysis to figure out. Within dividend growth investing, you can diversify by simply buying into different industries while using the same basic stock investing principles.

Okay, let's say you are intellectually on board. But you've got to get there psychologically, too. Here's how to test if you are really ready for dividend growth investing.

When the market drops, what will you do?

If you were to wake up tomorrow and your home's value had dropped in half, what would you want to do? Sell immediately? (If so, give me a call!) Or would you want to wait until the market came back before selling? I have found that when the real estate market drops, everyone tries to hold onto their properties and wait the cycle out. Most families have most of their personal net worth tied up in their home. So, they hold on for dear life, if they can, riding out the down cycle. That's our intuitive reaction, isn't it? Maybe it's because there is a tangible asset visibly present all around us that reminds us that there is still value in holding onto our homes that helps us think logically.

For some reason when the stock market drops, most people have the opposite reaction. They want to run screaming for the exits. I guess the herd mentality kicks in. (This also explains why some people get in lines without knowing what they are in line for.) Here's how the faulty logic goes. If everyone else is selling, they must know something I don't. So, I'd better sell too before I lose even more money! It's easier to catastrophize your thinking when the market is down. Without a tangible asset to hold on to, stocks feel ephemeral.

The key here is to realize that, just like with your house, nothing has really changed one day to the next for that business in which you are a part owner. As many SA contributors have shown, Fortune's wheel will turn yet again. Remember when almost everyone's portfolio dropped in half in 2008-2009? If you held on during that time, your portfolio is almost certainly higher than it was before the drop. So, at worst, when the market drops, revert to real estate thinking and hold on for dear life. Even better, the DGI pros understand that the drop can be a sale and go on a buying spree. If you think Coke (NYSE:KO) or Johnson & Johnson (NYSE:JNJ) will still be around in 50 years, then why not buy them at a bargain?

Condition yourself to think as follows - every time the stock market drops in value, some really attractive dividend stocks have just gone on sale!

Conclusion

My personal epiphany is that buying rental properties and dividend growth stocks amounts to the same investment philosophy (thus, the moniker "Dividend House"). I buy both assets at good prices to enjoy the income they generate. (In fact, I think of each share of a dividend stock as a little rental house!) When the stock market is down, I comfort myself that some quality stocks may have gone on sale and think about bargain hunting. In any case, while my "little houses" may be worth less on paper, they are still sending me periodic cash payments - a reminder that the businesses they represent are sound and ongoing.

If this philosophy works for you, you can follow our journey as we transition to dividend growth investing. Next time, I'll discuss how I have started transforming our hodgepodge of mutual funds over into a dividend growth portfolio (we are already generating five figures of dividend income on an annualized basis!). I'll follow that up with a description of our current DGI portfolio, including why we made the decisions we have and what we are still trying to figure out.

Disclaimer: I am not a financial advisor. My articles are meant to explain my own thought process as I evolve into a dividend growth investor. It is not meant to recommend this path to anyone else. Please come to your own conclusions about what investment philosophy to pursue and which stocks to invest in.

Disclosure: The author is long ABBV, ABT, AFL, APD, BAX, BMY, CBRL, CINF, CLX, CMCSA, COP, CTL, CVX, DE, DLR, ED, EMR, GE, GIS, GPC, HCP, HTGC, IBM, JNJ, KMB, KMI, KO, KRFT, LMT, MAIN, MAT, MCD, MMM, MO, O, OHI, OLN, OMI, PEP, PFE, PG, PM, SO, SWK, SYY, T, TCAP, TGT, TUP, VOD, VTR, VZ, WAG, WEC, WFC, WMT, WTR, XOM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.