Confessions Of A Young DGI

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Includes: BLK, CVX, FBIOX, GIS, GOOG, GOOGL, KMI, KO, LMT, MA, PEP, PG, PM, ROST, V, XOM
by: Dividend Math Guy

Summary

I discuss how I apply dividend growth in my own investing, and how my approach and mindset differ from those of "standard" dividend growth investors.

Total return matters.

Value matters.

Growth first, utilities last.

Although I primarily consider myself a DGI (dividend growth investor), I have noticed from reading numerous articles and comments here at Seeking Alpha over the course of the last few years that my investing style differs from common conceptions, misconceptions, and stereotypes about dividend growth investing. Previously I have written about how I would apply DGI if I were already rich. This article is about how I actually invest in my quest to become rich.

About Me

I intend to retire as soon as I have built a dividend growth portfolio yielding 3%-4% whose dividends are sufficient to cover my expenses during my first year of retirement and whose dividends are expected to grow at a rate exceeding the rate of inflation.

If things go according to plan, I predict that I will be able to retire in 15-20 years. I have a savings rate of about 50%, and combining my savings rate with my current portfolio value and fairly conservative (in my opinion) estimates of dividend growth rates and future market values of certain securities puts retirement about 17 years out. It could be as early as 15 years if things go wonderfully, or as many as 20 or more if my savings rate gets cut and/or things in the market go poorly.

I have come to realize that my investing style is some mix of dividend growth, value, and growth at a reasonable price. I now explain how I combine these styles.

Total Return Matters

Total return is very important to me. It is a common misconception that DGIs don't care about total return. Many DGIs would tell you that total return is important but is not their primary focus. For me, income (particularly future income) is important, but after-tax total return is more important. After all, if I had X+1 dollars I could buy your X-dollar DG portfolio and have money left over to spare. It doesn't matter how I made that money.

There is a misconception that DGIs only buy stocks like Coca-Cola (NYSE:KO), AT&T (NYSE:T), and Southern Company (NYSE:SO) -- companies that pay generous and slowly-growing dividends, but which have already come close to saturating their markets. Of these three stocks I hold Coca-Cola, not for its market-beating potential (actually, in terms of before-tax total return I think it will lag the broader market), but rather for its stability and consistency. I have conviction that KO will still be a dominant player in the beverage industry when I retire, and that I will be able to rely on a growing dividend from it, at least in-line with inflation, for as long as I live. Coca-Cola is like a beverage utility to me, but international and unconstrained from traditional utility regulation.

While companies like Coca-Cola have a place in my portfolio, alongside them and in larger quantities I hold faster-growing dividend growth names like Visa (NYSE:V), Ross Stores (NASDAQ:ROST), and BlackRock Inc (NYSE:BLK).

Let me re-emphasize the after-tax portion of my statement about after-tax total return. I do not intend to hold all my stocks forever. Some stocks, such as Coca-Cola, I intend to hold forever, living off of their dividends during retirement, so for these I never intend to realize capital gains. Other stocks, such as Ross Stores, I intend to sell at some point, and on these positions I will have to pay capital gains taxes unless they are sheltered in my IRA. I am fortunate in that I am able to invest more than the $5500 yearly IRA contribution limit for my age group, so I have to hold some of my stocks in taxable accounts, and previously I have written about how it ends up working better in the end if I hold the buy-and-hold-forever dividend stocks in my taxable accounts and the faster-growing buy-now-sell-later stocks in my IRA.

In short, to help maximize my after-tax total return I hold stocks like Coca-Cola in my taxable account and stocks like Ross Stores in my IRA. This may be counterintuitive, since it might seem like a better idea to shelter Coca-Cola's larger dividend yield from taxes (currently KO yields 3.25% and ROST yields 0.94%), but it ends up being more advantageous to shelter the larger eventual expected capital gain on the Ross Stores position, provided the Coca-Cola position is never sold.

Growth First, Utilities Last

Several contributors on Seeking Alpha refer to their dividend growth portfolios as "houses," and advocate building the foundation (utilities and consumer staples) before building the walls (supporting positions such as Lockheed Martin (NYSE:LMT) or Deere (NYSE:DE)) and the roof (speculative or capital gains plays such as Visa). See, for example, Chowder's writings or this article from Dividend House.

I see this as somewhat backwards because again, total return matters. Does anyone really think AT&T is going to outperform Visa over the next 17 years? Visa is a company with no debt and no pension plan, has been growing earnings at 22% per year and is expected to grow earnings at 18% per year going forward, has operating margins north of 50%, has a built-in inflation hedge, and has decades of expansion and growth ahead of it. Compare this to AT&T, which has essentially saturated its market in the United States and is seeking to grow through acquisitions, requires constant spending on infrastructure to remain competitive, requires regular spending at broadcast spectrum auctions, has a large pension plan it has to deal with, has a mountain of (well-managed, to be fair) debt, and is only expected to grow earnings at 5% per year going forward.

This isn't to say that AT&T is a bad investment. I think it's a fine investment if it fits your needs for where you are in your investing career. My point is that it would take something disastrous happening to Visa or something unusually great happening to AT&T to make an investment in AT&T outperform an investment in Visa over the course of the next 17 years. And even if that happens, does anyone really think a blend of companies like AT&T will outperform a blend of companies like Visa over the next 17 years?

I have an intended blend for my retirement portfolio.

  • Utilities and Telecom: 15%

  • Energy: 15%

  • Consumer Staples: 30%

  • Restaurants: 5%

  • Real Estate (REITs): 10%

  • Health Care: 10%

  • Other: 15%

Since total return matters, it makes sense to buy the faster-growing things you want before the slower-growing things you want. Right now, utilities, telecom, consumer staples, and REITs are underweighted in my portfolio, while faster-growing sectors such as Health Care and Other (including companies like Visa, Ross Stores, and BlackRock) are overweight. As I get closer to retirement, or when outstanding values present themselves, I will fill in the gaps between my current allocation and my intended allocation.

In terms of portfolio weighting I know where I want to be when I retire. I don't have to be there yet.

I Don't Chase Yield. I Chase Dividend Growth.

I own no BDCs, MLPs, or mREITs, and I own only one utility. Although I will eventually own a portfolio yielding 3%-4%, currently my portfolio yields under 3%.

Seeking Alpha contributor Chowder employs the following (non-mathematical) formula in his investing:

High Quality + High Current Yield + High Growth Of Yield = High Total Returns.

If a stock maintains a constant yield, its total return is equal to its dividend yield plus its dividend growth. That is, for a stock with a constant yield, mathematically we have

Yield + Growth of Yield = Total Return.

While no stock actually maintains a constant yield, this formula can be used as a piece of the puzzle of predicting future returns.

My reason for bringing this up is to point out that I lean hard toward the Growth of Yield portion of this formula in my current investments, since total return matters and lower-yielding companies tend to be quicker growing. As I grow closer to retirement I will lean more toward the Yield portion, although I do not intend to own anything that can't at least be expected to raise its dividends in-line with inflation. Under current market conditions, I don't see myself buying anything yielding more than about 5%.

Value Matters

It is a common misconception that dividend growth investors are willing to pay any price for dividends and dividend growth. Procter & Gamble (NYSE:PG) was trading for $93 about 6 months ago, but I don't recall reading much about DGIs buying it at that price. I certainly wasn't. Now that it's trading for $80, it's looking much more attractive.

Personally, lately I have been investing at least half of my investable capital each month into Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM), as I am bullish on the energy majors, their stock prices are much better now than they were a year ago, and I am getting close to my desired long-term energy allocation (currently 13%, versus my long-term goal of 15%). I have no problem overweighting energy right now, either, as my 15% energy target is a long-term goal and not something that has to be maintained even on a yearly basis. When something is attractive I load up on it, and when it becomes overvalued I buy something else. When energy stocks were pricey last summer, I was underweight energy (and lamenting it at the time), but buying beaten-down Ross Stores and Visa instead, which have since gone up 47% and 30%, respectively. I am still buying Visa a little bit here and there, but I find Ross Stores to be a little overpriced at current levels.

My Top Ten Holdings

My pure-growth holdings are Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and the Fidelity Select Biotechnology Portfolio (MUTF:FBIOX). I also consider Google, Visa, MasterCard (NYSE:MA), and Ross Stores to be growth at a reasonable price holdings, at least when reasonable prices present themselves.

Aside from Google and FBIOX, all of my holdings can be viewed as dividend growth stocks. My current top ten holdings, by weight, are the following.

Stock/fund

Weight

Yield

5-year dividend growth rate

Fidelity Select Biotechnology Portfolio

11.84%

-

-

MasterCard

5.82%

0.68%

60.55%

Visa

5.64%

0.70%

30.88%

Google

4.12%

-

-

Lockheed Martin

4.03%

3.11%

18.95%

Philip Morris International (NYSE:PM)

4.01%

4.81%

11.51%

Chevron

3.87%

4.27%

8.25%

Kinder Morgan Inc (NYSE:KMI)

3.85%

4.86%

n/a

Ross Stores

3.77%

0.94%

24.05%

Johnson & Johnson

3.71%

2.99%

6.79%

Total weight

50.66%

Some of these positions are weighted so heavily within the portfolio because they were purchased before large price run-ups, while some (notably Chevron) have been the objects of recent focused purchasing activity. Exxon Mobil is somewhere in the top 20, and will probably become a top-ten holding because of purchasing activity before the current oil slump is over. A good portion of the remainder of my portfolio contains more common dividend growth names such as Coca-Cola, PepsiCo (NYSE:PEP), General Mills (NYSE:GIS), and Procter & Gamble.

The Future

Most of my long-term growth-oriented holdings are now in place, and future purchases will be focused on (although not exclusive to) companies with bright futures yielding 3% or more. Eventually I will dispose of or trim my holdings in biotechnology, credit card stocks, Google, and Ross Stores, and I will purchase more utilities, consumer staples, and REITs to bring my portfolio toward its retirement allocation. But not yet.

Disclosure: I am/we are long BLK, CVX, FBIOX, GIS, KMI, KO, LMT, MA, PEP, PG, PM, ROST, V, XOM, GOOG, GOOGL.

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.