If Switching From A Total Return Strategy To A DGI Strategy Was So Simple, Then Why Isn't Everyone Doing It?

|
Includes: KMB, KO, MCD
by: David Crosetti

Summary

Some investors believe that changing from a Total Return Investment Strategy to a DGI Strategy is "simple."

Reality tells us that it's a bit more complicated than one might assume.

Taking some time to consider the "reality" might be in order -- if you have an open mind.

Introduction:

In a recent article, Dividends: A Key Component of Total Return, there was a particular comment that really intrigued me. Here's what was posted:

Investor A. DGI since birth. Has stocks worth $1 M. on 1/1/2018, the first day of retirement.

Investor B. Doing all sorts of investing, Has portfolio worth $1M. Buys the same portfolio as A on 1/1/2018, the first day of retirement.

So I cannot see the path dependence (how they got there on 1/1/2018) of the future of A and B. I must be missing something, as to me it seems that both have exactly the same future.

Now extrapolate that to the scenario that B has amassed slightly more than $1 M due to luck or due to prudent choice of investments. He buys the same portfolio as A (with the same allocation) on 1/1/2018. To me it seems that B's future will be slightly better.

I must be missing something.

Now, I don't know if that comment was meant to be rhetorical or not. But the more I thought about it, the more it made me consider the proposition.

You have two investors. One is a DGI and the other is not. Both have accumulated a portfolio that is valued at $1M over their investing lifetime.

Let's face it, a million dollars is a lot of money and creating a portfolio with that kind of critical mass is impressive, regardless of how the investor achieved that much money in their portfolio.

So, for those two investors, let me say this: even though you are hypothetical investors, congratulations on a job well done!

Is Changing Your Strategy Really Simple?

Let's take a moment and look at this scenario. For some reason, the investor who is not a DGI decides that he/she needs to convert his $1M portfolio to a DG portfolio and this can be easily accomplished (it really can) and this investor would have exactly the same future as the DGI moving forward.

The comment suggests a starting date of 2018 for this exercise, but I don't know why 2018 has any particular "special value." So that's problem number one.

Another one of the problems with this type of exercise is that there is usually no DGI portfolio to model. Every DGI has a somewhat unique portfolio with different companies, different share counts, and different yield points.

But it is easy to accept that if the investor who is a DGI owns a portfolio that yields 3% and the non-DGI investor purchases the exact same stocks that are in the DGI portfolio, that he too will own a portfolio that yields 3% and both will get $30k in dividends over the course of the new year.

But Let's Dig A Bit Deeper:

On the surface, then, I would tend to think that the scenario presented by our commenter actually makes sense, on its face value. However, let's peel the onion back a little bit and see how we can get to a more realistic situation.

I have a portfolio that I've written about for a couple of years and shared with readers on Seeking Alpha. It's called The Perfect Portfolio. Now, let's be honest. It's not "perfect" at all. It was perfect, however, when it was created because it was perfect in meeting the criteria behind its creation.

My mother was a laddered CD investor. She was a genius when it came to maximizing additional income from CDs and locking in rates for periods of time that were often in excess of currently available CD rates at the time.

But that all changed in 2008, when interest rates for CDs plummeted and so as her CDs matured, we decided to invest the money from those maturing CDs into dividend growth stocks, to replace the income derived from interest payments.

What's In My DGI Portfolio?

At the end of 2015, The Perfect Portfolio looked like this:

We invested $300k in $100k increments over three successive years and invested in DGI stocks.

The portfolio holds 16 different companies and these companies, over time, have grown at different rates, thus becoming an unbalanced portfolio, where certain companies have become a little larger than some investors would like. But, let's not get to far ahead of ourselves at this point in the discussion.

Now, I know that the portfolio value is less than $1M. We could arrange the portfolio to represent $1M, but then we would be changing things from the reality that is the portfolio. So, for the purposes of our discussion, let's leave the actual portfolio in place and make some observations based on a real portfolio as opposed to one that is made up to skew the commentary in any way to reflect any particular bias. Can we do that?

So this portfolio is the portfolio of the DGI, for the purpose of our comparison. Whatever is in the portfolio of the non-DGI is irrelevant in this model, because the construct of the model is that it would be an easy task for the non-DGI to convert his/her portfolio into the exact same one as the DGI portfolio and in doing so, the results would be the same for both investors going forward.

Dividend Income Will Supplement Retirement Needs:

When we look at projected income for this portfolio, based on the existing dividend rate as of 12/31/2015 our income for 2016 looks like this:

The portfolio, as it exists, throws off a yield of 3.37% and that translates into $18,474 of dividend income for the DGI that can be used to supplement his/her retirement income stream. If this were a million dollar portfolio, the income stream would, of course, be larger.

If you were a non-DGI, but you were going to convert your existing portfolio to a DGI portfolio to match this one, you are going to have to ask a couple of questions it would seem to me.

Questions:

In the construct of the original comment, the non-DGI investor merely has to purchase the same number of shares that are in The Perfect Portfolio and instantly, both investors will find themselves in "exactly the same place."

But do they?

First, I can almost guarantee that the comment stream for this article will ignore the premise and suggest that the stocks held in this portfolio are not "the best" stocks for a DGI to be holding. But that's not part of the original argument, now, is it?

Second, let's look at the cost basis for the stocks held in this portfolio. The non-DGI investor is going to have to invest $548k to receive $18k in dividend income. That's almost $250k more than I invested.

Here's where Yield on Cost raises its "ugly head." I realize that both of us will get the same $18k in dividend income, but to be honest with you, I feel a bit more smug knowing that I invested $300k to get $18k and that you have to invest $548k to get the same income.

Something like buying stuff on sale vs paying full price.

Third, how comfortable are you with purchasing these same companies at the prices they were selling for as of 12/31/2015? Do you like the idea of purchasing Kimberly Clark (NYSE:KMB) for $127 a share? How about McDonald's (NYSE:MCD) at $118? Think Coca-Cola (NYSE:KO) at $42 is a screaming value?

Fourth, how do you like liquidating your entire portfolio to have the cash to replicate mine? If you are in a tax deferred account, that's not a big deal, but if you are in a taxable account, that's going to present some challenges to the amount of money that you will net out from selling your portfolio.

Fifth, after the non-DGI investor transitions into a clone portfolio, relative to mine, I may decide to rearrange things a bit. I could take profits on the stocks that have performed well and reinvest that money back into shares of new investments and actually increase my dividend income by doing so. Now the non-DGI could do the same, but in replicating my portfolio, he has no "gains" to capture.

He is in a net neutral situation and can only face either share price increases or share price decreases. How will he cope with that? I don't know. But, I'd rather have my cost basis covering my downside risk than be in his situation.

Summary and Conclusion:

I can appreciate that this discussion is not complete. I know that there will be many more thoughts and comments shared as this article gets read by folks from both sides of the equation.

I look forward to the comment stream and hope that you will add your two cents.

But, I don't think it's as simple as some people think, if they are going to be honest about it.

Disclosure: I am/we are long INTC MSFT PG VZ ABT ABBV CL CVX KMB JNJ MO RAI MCD T XOM.

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.

About this article:

Expand
Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here