An Effortless Way To Compound Wealth And Retire Comfortably

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Includes: ABT, ADP, AFL, APD, BAX, CL, CLX, COP, CSCO, CVX, DNB, ED, EMR, FRT, GPC, HCP, HP, INTC, JNJ, K, KO, LMT, LOW, MAS, MCD, MDT, MMM, MO, MON, MSFT, NOBL, O, OHI, PEP, PFE, PG, QCOM, RAD, SJW, TEVA, TGT, TMK, UTX, VLO, VTR, WBA, WFC, WM, WMT, XOM
by: Financially Free Investor

Summary

We discuss some core principles around dividend growth investing.

We will present some extensive back-testing models to demonstrate how the DGI model is a sure and effortless way to compound wealth and get rich, albeit gradually.

The back-testing examples also demonstrate that in the end, it is not going to matter if some of your picks were laggards.

What is important is that you let your winners run. That’s what is going to accumulate most of the wealth in the long run.

In part 2 of this article, we will be reviewing the progress of our Passive DGI Core portfolio, which is completing three years on SA.

Summary

We believe the simplest way to generate passive income is through stock dividends. Obviously, there are other means to generate passive income, such as investing in real estate, but normally all of them require a large one-time capital investment and a lot of work; also, most often investments are illiquid. The most widely accepted way of generating dividend income is by structuring a DGI (dividend growth investing) model. Creating a DGI portfolio involves two basic steps, namely:

  • Identify 25 or more companies with large moats that pay regular dividends and have a history of raising them for at least ten years, preferably more.
  • Buy and hold such stocks for the long term and reinvest the dividends at least for the first 5-10 years.

We have published a DGI portfolio on SA named 'The Passive DGI Core Portfolio' since August of 2014. We are as convinced about the long-term success of this portfolio as we were when we first launched it. We will review the progress of the DGI Core portfolio in a follow-up article, as it completes 3 years of history this month on SA.

However, in this article, first, we will spell out the underlying principles & strategy for a DGI portfolio that anyone can easily structure. We will also present some extensive back-testing examples to demonstrate:

  • A DGI portfolio is far likely to outperform a broad market index, especially over the longer periods, like 10-year or more.
  • A DGI portfolio is a far superior strategy to draw 4% inflation-adjusted income (on the invested capital) compared to S&P500 index investing. Also, the DGI strategy lets you do this without ever selling the shares.
  • The back-testing examples also demonstrate that in the end, it is not going to matter if some of your picks turned out to be laggards. What is important is that you let your winners run and that’s what accumulates wealth. However, diversification is very important.

Here are some major principles of a DGI portfolio/strategy:

  • Invest Gradually

The portfolio requires that we do not invest all of the capital in one lot, but instead in several installments, preferably over a period of 5-10 years. This protects us from investing at the top of the market and takes advantage of dollar-cost-average. Most investors don’t have the stomach to tolerate large drawdowns and can panic just at the wrong times. Investing ‘gradually’ will protect the investor from such mistakes. Since no one can say exactly where the stock prices will be next month or next year, it is better to prepare for the worst scenario and hope for the best.

We do recognize that this advice may sound great for a millennial because they have the luxury of time or even a 50-year old who at least has ten more years before retirement, but what about someone, who has just retired or who may be two years away from retirement. We wrote an article recently which included a discussion on various strategies one can adopt in such situations.

  • Diversify But Don’t Overdo It:

Invest in 25-40 carefully selected stocks. Select two or three names from each of the 11 major economic sectors. Select some high yield low growth stocks but balance them out with lower starting yield but high growth stocks. You may select some well-established international dividend paying stocks as well.

Do not diversify beyond 40 stocks. This is not some magical number, but it may become difficult to manage over 40 stocks.

  • Reinvest The Dividends Automatically As Long As You Can:

We understand not everyone will have the luxury of reinvesting the dividend if they require the income today. If you need the income today, it is okay, withdraw the dividend income. Just do not withdraw from the principal amount.

However, anyone who does not need the income today should reinvest the dividends automatically in the original stocks and let the YOC (yield on cost) grow. A few years can really compound your yield like magic.

Back Testing Examples:

We always like to prove our thought process by doing some back-testing. Results from any back-testing aren’t perfect and cannot predict the future. But as investors, we only have past data to rely upon. Mark Twain is reputed to have said: 'History doesn't repeat itself, but it often rhymes.' The past data can often lead us to the powerful trends about the future.

We will go back in time to 1995 and select 25 dividend paying, large-cap, blue-chip stocks from that time.

How Did We Select 25 Stocks Going Back To 1995:

This is the biggest challenge with any back testing to avoid a selection bias. Even if you looked at the list of Dividend Aristocrats back in 1994, a vast majority of them have been dropped over the years due to various reasons. Some don’t even exist today as companies or as the same stock-symbols.

In the end, this is what we did. We took the list of Dividend Aristocrats from 1994, which contained 48 names. Out of the 48 names, only seven remain today in the current list of Dividend Aristocrats. We had to eliminate 23 companies (from the original list of 48) because some of the companies got acquired by others, a couple of them (like K-mart) entered bankruptcy. A number of them did just fine, but their symbols got changed due to various reasons. For example, JPM in the 1994 list was not the same company that it is today. So, out of 48 companies, we were left with 25.

However, this list of 25 did not pass our other test. We wanted to make sure that we are not overweight in any sector/industry and do not have more than two companies from any single industry. So, from the remaining 25 companies, we had to remove and replace 8 of them. First, we looked for companies from other sectors/industries that were missing in our list. Finally, we filtered out the names that had at least 12-15 years of dividend history as of 1995.

What About The Selection Bias?

Now, we can already hear a murmur of protest about the selection bias. What if we had picked up companies like K-mart, which were to fail or underperform in the future? What about some other names that did not fail but just underperformed the broader market? Well, sit tight till we present back-test #3. We think you will be pleasantly surprised.

List Of 25 Stocks That We Selected:

Symbol

Name

Sector

Industry

ADP

Automatic Data Processing (ADP)

Information Technology

IT Services

BAX

Baxter International Inc. ( BAX)

Health Care

Health Care Equipment & Supplies

CL

Colgate-Palmolive Company ( CL)

Consumer Staples

Household Products

DNB

Dun & Bradstreet Corp ( DNB)

Industrials

Professional Services

ED

Consolidated Edison, Inc. ( ED)

Utilities

Multi-Utilities

EMR

Emerson Electric Co. ( EMR)

Industrials

Electrical Equipment

FRT

Federal Realty Invest. Trust ( FRT)

Real Estate

Equity REIT

GPC

Genuine Parts Company ( GPC)

Consumer Discretionary

Distributors

HP

Helmerich & Payne, Inc. ( HP)

Energy

Energy Equipment & Services

JNJ

Johnson & Johnson ( JNJ)

Health Care

Pharmaceuticals

K

Kellogg Company ( K)

Consumer Staples

Food Products

KO

The Coca-Cola Co ( KO)

Consumer Staples

Beverages

LOW

Lowe's Companies, Inc. ( LOW)

Consumer Discretionary

Specialty Retail

MAS

Masco Corp ( MAS)

Industrials

Building Products

MCD

McDonald's Corporation ( MCD)

Consumer Discretionary

Hotels, Restaurants & Leisure

MDT

Medtronic plc. ( MDT)

Health Care

Health Care Equipment /Supplies

MMM

3M Co ( MMM)

Industrials

Industrial Conglomerates

MO

Altria Group Inc ( MO)

Consumer Staples

Tobacco

PG

Procter & Gamble Co ( PG)

Consumer Staples

Household Products

RAD

Rite Aid Corporation ( RAD)

Consumer Staples

Food & Staples Retailing

SJW

SJW Group ( SJW)

Utilities

Water Utilities

TGT

Target Corporation (TGT)

Consumer Discretionary

Multiline Retail

TMK

Torchmark Corporation (TMK)

Financials

Insurance

WFC

Wells Fargo & Co (WFC)

Financials

Banks

XOM

Exxon Mobil Corporation (XOM)

Energy

Oil, Gas & Consumable Fuels

**In 1995, Exxon Mobil was Exxon, prior to merger with Mobil in 1999)

Back-Test #1: (Investment in one lot in 1995)

Criteria: Bullet Points

  • To keep the first test simple enough, we invested 100% of the capital in one lot.
  • We invested $4,000 in each of the 25 stocks in January 1995.
  • We reinvested the dividends automatically in the original securities. No rebalancing was performed.
  • After the first year, we started taking an income of 4% on the invested capital. We also took a yearly increase of 2.5% from next year.
  • Start date: January 1995. End date: July 2017
  • Performance comparison with S&P500.

Here are the results in comparison to S&P500:

In the summary form:

Chart: Investment in 1995, income is withdrawn from 1996:

Back-Test #2: (Investment over 10 years, from 1995-2004)

Criteria: Bullet Points

  • In this test, we invested gradually over a period of 10 years.
  • We invested a total sum of $15,000 ($600 in each of the 25 stocks) every year starting January 1995 until 2004. Since we are spreading the contribution period to 10 years, we are increasing the investment amount to $150,000.
  • We reinvested the dividends automatically in the original securities. No rebalancing was performed.
  • We started taking an income of 4% on the invested capital starting 2005. We also took a yearly increase of 2.5% from next year.
  • Start date: January 1995. End date: July 2017
  • Performance comparison with S&P500.

Return Calculations:

In the summary form:

Chart: Investment over 10 years, no income is withdrawn:

Chart: Investment over 10 years, income is withdrawn from 2005:

What About Annual Rebalancing?

Usually, an annual rebalancing can boost your returns by a percentage point or more, but in this model, we are not suggesting annual rebalancing because of two reasons. First, because if we are investing over ten years, so at least for those ten years, rebalancing does not make much sense. Secondly, even though rebalancing can enhance results, but it also adds to the risk. What if a company that eventually goes bankrupt, but goes down gradually over many years, we would be adding to such a company by selling shares from some other company that has been a winner. So, in this passive model, we would rather let our winners run. Actually, we will demonstrate this point in Back-Test #3.

Back Test #3

Now, what if some of the names we picked weren’t that good because, in 1995, we did not have the benefit of hindsight? Let’s assume that, even though we picked up the best names based on our knowledge from that time, we ended up with a few laggards. Let's assume the worst case scenario where these laggards eventually went bankrupt. The lowest an investment can go to is zero in a worst case scenario.

We will take the same criteria as of Test #1. We will start with replacing one company out of our selection with some other investment that went bankrupt and essentially assumes that our whole investment in that company would come to zero. Then we will repeat the same test with 2 companies going to bankruptcy or zero value, then 3 and so on. We wanted to see how long would it take before the DGI Portfolio starts underperforming S&P500. Please note that we even replaced some of the star performers like PG, MO, WFC, and JNJ with companies that went to zero.

We stopped our simulation after replacing eight companies. But it is clear from the above example; it would probably take 9 or 10 companies (out of total 25) to turn into zero investments before this DGI portfolio starts underperforming the S&P500. So, even if we had a selection bias, we replaced almost 40% of the investments and wrote them off and still came at par with S&P500. That’s like winning the race with your hands tied on the back.

Simpler Alternative:

One simpler way for the most passive or non-DIY investors is to invest in ProShares S&P 500 Dividend Aristocrats ETF (NOBL). This ETF mimics the performance (almost) of the S&P 500 Dividend Aristocrat Index. The ETF charges 0.35% of the assets in fees every year, which is a little high in comparison to Vanguard’s S&P500 index fund, but in our view, the outperformance should more than compensate. For non-DIY investors, it is an ideal solution.

Concluding Remarks:

We believe the portfolio strategy described above is the easiest way to accumulate wealth over a long period. The only other requirement probably is saving enough on a regular basis. As we have tried to demonstrate by the back-testing examples that all you need is to pick a diversified group of solid, wide-moat dividend paying companies with sufficient history of consistently growing dividends. It does not matter if few of your picks don’t perform as expected or worse still wind up in bankruptcy, as long as the group as a whole did well. In the short run, its performance may not seem much different than the broader market, but over a long period of time, it can make a very substantive difference - probably enough to go from a frugal retirement lifestyle to a very comfortable one.

Our long-time readers know that in addition to a Core DGI portfolio, we also believe in investing in alternate portfolio strategies, mainly to enhance current income. Below is our investment allocation model and as you can see the DGI portfolio forms the foundation of the overall strategy. These allocations are just for broad guidance; everyone should decide what is right for them based on his/her goals and risk-tolerance. The other two portfolios focus on high-income and risk-management. However, we believe they are suited for active investors only.

Author’s Note: The Passive DGI Core portfolio is published as free-content. The other two portfolios ‘8% Income CEF portfolio’ and ‘6% Income Risk-Adjusted portfolio’ are part of our ‘High Income DIY Portfolios’ SA Marketplace service. For more details, please see at the top of the article just below our logo.

Full Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolio presented here is a model portfolio for demonstration purposes; however, the author holds many of the same stocks in his personal portfolio.

Additional Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, MON, ADM, MO, PM, KO, DEO, MCD, WMT, WBA, CVS, LOW, CSCO, MSFT, INTC, T, VZ, VTR, CVX, XOM, VLO, HCP, O, OHI, NNN, STAG, WPC, MAIN, NLY, PCI, PDI, PFF, RFI, RNP, UTF, EVT, FFC, KYN, NMZ, NBB, HQH, JPC, JRI, TLT.MCD, WMT, WBA, CVS, LOW, CSCO, MSFT, INTC, T, VZ, VTR, CVX, XOM, VLO, HCP, O, OHI, NNN, STAG, WPC, MAIN, NLY, PCI, PDI, PFF, RFI, RNP, UTF, EVT, FFC, KYN, NMZ, NBB, HQH, JPS, JRI, TLT.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.