When we think about dividend growth investing, we often think about a horizon of 20, 30 even 40 years in front of us. The true power of dividend growth investing can only be unleashed after such a long period of time. After all, owning shares of Coca-Cola (NYSE:KO) with a 3% dividend yield is not that impressive. However, this company had maintained a dividend growth rate of 7% for over a decade now. This means that if you wait seven years, your dividend yield based on your cost of purchase becomes 6%, if you wait 14 years, 12% and so on….
Unfortunately, we don't all have 40 years in front of us. After discussing this matter with several older investors, they have expressed the sentiment most bloggers and financial advisors always presume, we have 20-30 years in front of us to build a strong portfolio. If you decide to switch your investment strategy at the age of 50, it is getting a little bit late to build a dividend growth portfolio as you can't virtually benefit from the power of compounding interest for a few decades. In this case, is it too late for you to build such portfolio? Should you quit and aim for another strategy? What kind of yield can you expect when you retire if you have only 10 years to build your portfolio?
These are the kinds of questions I had in mind while writing this article. What would I do if I had only 10 years to build my portfolio before retiring?
Main Concept; You don't really have only 10 years…
One thing many investors forget about investing is that it doesn't end when you retire. I agree with you; the best-case scenario is when you can live off your dividends and never touch your capital. However, if you are 10 years from retirement and you decide to seriously invest, let's face it; you are a little late for the parade. Nonetheless, it doesn't mean that you should quit and give up on managing your money. Why? Because you have a lot more than 10 years to go…
Let's assume you are 55 and you retire at 65. This leaves you with 10 years to build a retirement portfolio. However, on your 65th birthday, the money you have saved and invested doesn't vanish overnight. Chances are you will live until the age of 85, then, it means you have 30 years of investing in front of you. Life is great, isn't it?
I guess the main concept you have to give up is to live off your dividend and never touch the capital. Unless you are making lots of money or you have incredible saving abilities for your last 10 years, I think it is inevitable that you will have to take a part of your retirement income from your capital. In fact, if you have built a solid dividend growth portfolio during your last 10 years, you will never outlive your capital if you withdraw around 4% of your capital each year (including dividends paid). This is a simple rule of thumb that has been proven over years.
Still, I would not go ahead and build the same portfolio that I'm building. Here's what I would use as a filter to pull out a list of candidates.
#1 Dividend Yield over 3%
You already know my interest for low dividend yield paying stocks offering both strong dividends and capital appreciation growth potential. Companies like Disney (NYSE:DIS), Apple (NASDAQ:AAPL), 3m Co. (NYSE:MMM) are all amazing companies paying very low yield. Unfortunately, I would discard such companies with my first filter. Since we don't have much time (10 years is very short) to build a strong dividend growth portfolio, we have to select companies that will at least beat inflation year after year.
When I pull out filters for my stock research, I usually put a maximum yield. This time, I will include higher dividend yield companies. Others metrics will clean-up the rotten fruit from the basket.
#2 Payout Ratio under 100%, Cash Payout ratio under 80%
I think the very first mistake I could make while building a higher yield portfolio is to not consider that higher yield paying companies might also be subject to cut their dividend. There is no point of selecting companies that will cut their dividend in the upcoming years. Companies with a payout ratio over 80% are playing with fire. They will eventually pause their dividend increase policy and might eventually stop it if the business is not doing well.
The payout ratio is less important for me compared to the cash payout ratio. This is the reason why I can accept companies with a 100% payout ratio since it's based on accounting principles. I would rather use the cash payout ratio as it is directly linked to the company's bank account. If the cash payout ratio is over 100%, then the company has to borrow the money to distribute it to its shareholders.
#3 Five-Year Revenue & EPS Growth Positive
In an ideal world, I'd like to pull out a graph showing both revenue & EPS trends for the past 10 years. This is how I analyze companies. It looks like this:
Getting only the number for 5 years or 10 years can be misleading. Depending on when you pull out your metrics, the number could not tell the truth about the current situation. Imagine if you have a graph going like this:
The metric alone will post a small growth, but in reality, the company is struggling keeping up its sales up. However, while pulling out a filter, this is still a good start. You will have plenty of time to look into each companies when you shorten your lists.
#4 Positive Five-Year Dividend Growth
One key element of my strategy is to select companies with positive dividend growth perspectives. In an ideal world, I would require five consecutive years with a dividend increase as a minimum. Unfortunately, I don't know of any stock filter giving me this information. This is why I take the five-year dividend growth metric and will eventually look into each company. For me, there is no point of selecting companies with management that are not fully committed to increase its payouts year after year. The whole purpose of selecting dividend investing as my core strategy is to benefit from the power of compounding dividend growth over a long period of time. Remember, even if you have a time horizon of 10 years, chances are you will reap the benefit of your investments for another 20 years afterwards.
Is There Anything You Would Add?
I'm not a fan of pulling out 30 metrics with my filters. I already know I will have to look closely at each company individually before selecting them. This is why I rather pull out a larger list that will give me more options on how to shape my portfolio in the second test.
In the next article, I will start from the list generated by these metrics. But I'm curious to know if you would use any other metrics to build your retirement portfolio?