Seeking Alpha

Retiree: Time Horizon Short? Should You Rethink Your Dividend Growth Strategy?

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Includes: ROST
by: Paul Wagner
Summary

A dividend growth strategy is excellent for building steady and growing cash flow over time.

But relying on dividends alone can be a slow way to retrieve your invested cash.

A real example compares and contrasts two methods of accessing cash from your investments.

I am now a dividend growth investor and I hang out from time to time with the SA community of like-minded investors. Over the years that I have been coming here I've run across numerous comments appended to various Seeking Alpha articles in which various investors profess to care not at all what the price of their shares are after they purchase them.

The explanation goes as follows: What are important are the dividends they receive from the shares they purchase, because dividends give them money to spend, either to pay for personal wants and needs or to buy more shares. They are content if those dividends are sufficient to pay for everything of every kind that they want to buy. They are further comforted by the fact that dividends are much more stable and predictable than stock prices, making their reliance on dividends "safer" than would be a reliance on prices of shares that would need to be sold to generate cash.

That makes sense, doesn't it? What difference does it make to a well-heeled DG investor what a fickle market does to a price for whatever mysterious, perhaps nonsensical, reasons it has? His financial liquidity is not dependent on selling shares, so whatever happens to the price is of no concern.

One intelligent, experienced dividend growth investor recently put it eloquently: "As long as the company maintains an investment grade quality and pays me a dividend, I don't care what happens to the share price. I have no intention of selling."

I am writing this article, not to criticize the spirit of that approach and mindset, but to look at things from the perspective of a retiree whose time horizon is narrowing day by day, week by week, year by year. It's true that a dividend growth strategy is an excellent one for directing saved cash into an investment portfolio that will create both a growing stream of cash flow and a growing value over time. It's also true that a "buy, reinvest, hold and harvest dividends" strategy is a rather slow way to receive the cash from the investment portfolio.

To make my point, I will ask you to agree with two fundamental premises:

  1. Your investment in a company is the difference between the amount of cash you paid for your investment less any cash you have derived from the investment.
  2. The cash you invested in a company was your money and getting back just the cash you invested back isn't "profit" or "income."

Calculating Investment

Leaving aside any commission charges, the formula for calculating the amount of your investment at a point in time would be:

Initial Invested Cash - Dividends Received - Proceeds of Sales + New Purchases = Present Invested Cash

In the case of a buy and hold investor who never sells any stock, it would be very easy to calculate his current investment: the formula would be simple: Initial Invested Cash plus New Purchases minus Total Dividends Received equals Current Invested Cash.

Example: Assume you are 70 years old and just inherited a portfolio of stocks that includes $10,000 worth of stock in Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), which doesn't pay a dividend. Since you are a dividend growth investor, you immediately sell the shares and invest the proceeds in a dividend-paying utility company. The utility pays you a $100 dividend every quarter, or $400 every year and has a long track record of raising the dividend every year.

After a year, your invested cash is $9600 ($10,000 minus $400). Each successive year dividends reduce your invested cash until eventually your cumulative dividend receipts total $10,000. At that point, your invested cash is zero. Up to and including that point, your cash profit is also zero. Thereafter, every dollar of dividend you receive causes your invested cash to become a negative number. The negative cash investment is your cash profit.

Assuming that the dividend amount rose by 4% every successive year, it will be in the 18th year of your ownership of the shares that all of your own money will have been retrieved. In other words,you will be in your 88th year when you -- or your estate -- has finally retrieved all of your original cash investment.

According to the Social Security Administration, the life expectancy of a 70-year old man is 14.32 years; for a woman, 16.53 years.

Calculating Investment Profitability

Before your cumulative dividends have exceeded the amount of your investment, the only way to know if your investment is profitable (and by how much) is to know what its stock price is.

This is the formula for calculating the net profit on an investment (ignoring any transaction costs):

Initial Invested cash - Present invested cash (from above) + Present investment value of security = Net Profit

In the case of the hypothetical investment in the utility company, if the value of the shares purchased never changed from the $10,000 purchase price, at the time that his cumulative dividends matched his original $10,000, his total profit on his investment would be $10,000. Changes in the value of the investment changes the investment's net profit, but it doesn't affect the invested cash balance. So, if the value of the shares went to zero at that point, the profit on the investment would be zero, the same as the invested cash.

Until shares are sold or dividends have exceeded money invested, the entire net profit of an investment is embedded in the market value of the shares. Some investors say "it isn't a profit or a loss until the shares are sold." If that were the case, it would take 18 years (in the above example) before you knew if you had made a profitable investment or not. And I am left to wonder what you would call the difference in the value of an asset and the amount of money you have invested in it? At any point in time you should be able to say how profitable your investment has been. That doesn't obligate you to forecast what your profit will be tomorrow, when it is most certainly going to be either higher or lower. Just because something is fluid, doesn't mean it isn't "real."

If Cash Flow Is All You Care About, Why Is "Profit" Important?

Depending on your age, the investing phase you are in and your cash needs, profit (and, therefore, share price) may take on more importance to you. Indeed, the older you are, if your dividends already meet or exceed your cash needs, it's questionable if you are really continuing to invest for yourself.

It's quite likely that you are just investing for your estate, which you intend to be distributed to one or more good causes, like your progeny or charitable organizations. That is certainly a noble goal, but, as far as your family is concerned, the affection and attention you give them while alive is no doubt a far more important aspect of your legacy than the amount of wealth you leave behind when you are gone.

If your children are financially independent already and if you don't have a charitable organization you want to leave a major portion of your wealth to, freeing some of your cash that is embedded in the profits in your portfolio can be used to enhance your own lifestyle and, perhaps, to create more memories that your children and grandchildren will have of the special things you were able to experience together while you were still able to.

Cash Flow and Profitability Under Two Different Strategies - A Comparison

Having real-life experience in more than one variety of investing strategy has given me some objective perspective on the pros and cons of each.

As some fellow readers have learned, I retired in 1997 at age 50, three years after my youngest child graduated from college. As a result of retiring early, our starting nest egg was quite modest. The mission of my investment strategy was to generate enough cash from our investments to pay for all of our living expenses for the next 12 years. At that time, Social Security checks would kick in and fund a meaningful portion of them.

If I had known about dividend growth investing then, it wouldn't have been a strategy that I could have used to accomplish the mission: the amount of money available to invest would not have yielded enough dividend income to meet expenses. My strategy was one I call "opportunistic trading," which was simply a function of smart purchases of great companies and opportune sales of shares at a profit. My goal was not to build a big portfolio; my goal was to pay the bills. I needed to do a lot (relatively speaking) with a little. As it turned out, my strategy performed way above what I expected of it and I had no need to take Social Security until I turned 70, and my portfolio value increased as well.

Opportunistic Trading Strategy

One of the companies that made it into my portfolio in 2001 was Ross Stores (NASDAQ:ROST), an off-price retail chain that has been one of the best non-tech related performers in the public markets since this century. While I bought my shares while still in my 50's, I think the way I handled the investment may be of interest to retirees now in their late 60's and beyond.

Here is the actual chronology of my ROST investment:

Date

Transaction

Shares

Price

Amount

Invested Cash

Shares Held

Market Value

5/24/01

Buy

600

23.97

14,382

14,382

600

14,382

11/7/02

Sell

-100

44.21

(4,421)

9,961

500

22,105

12/24/03

Split

500

9,961

1,000

22,105

1/29/08

Sell

-400

27.98

(11,192)

(1,231)

1,400

39,172

8/12/11

Sell

-300

67.83

(20,349)

(21,580)

300

20,349

12/15/11

Split

300

-

(21,580)

600

20,349

11/1/12

Buy

200

56.6

11,320

(10,260)

800

45,280

1/9/13

Buy

200

58.12

11,624

1,364

1,000

58,120

3/26/13

Buy

300

56.11

16,833

18,197

1,300

72,943

4/11/13

Sell

-100

64.07

(6,407)

11,790

1,200

76,884

6/27/13

Sell

-700

63.22

(44,254)

(32,464)

500

31,610

6/11/15

Split

500

-

1,000

31,610

12/9/15

Sell

-150

53.27

(7,991)

(40,455)

850

45,280

2/4/16

Sell

-100

56.41

(5,641)

(46,096)

750

42,308

5/25/16

Sell

-375

53.18

(19,943)

(66,038)

375

19,943

Various

Dividends

(4,375)

(70,413)

3/14/18

End Value

375

77.24

375

28,965

Although I call my strategy "opportunistic trading" it is obvious from this chronology that I wasn't a frequent trader -- the chronology covers 17 years involving only 12 trades.

Here is what the P&L for this period looks like:

Initial Invested Cash

14,382

Additional Purchases

39,777

Total Sales

(120,197)

Dividend Income

(4,375)

Invested Cash

(70,413)

Cash Profit

70,413

Ending Balance

28,965

Total Profit

99,378

The numbers show that I never had more than $18,197 of my own money invested in ROST (and that amount for less than a month), yet I generated $70,413 of cash income and ended with an investment worth approximately twice my initial investment. Because I needed cash, I generated cash. Simple.

Dividend Growth Strategy

Now, consider a scenario where I didn't need much cash and was a dividend growth investor that only buys, holds and harvests dividend checks. Assume that I made all of the same purchases, but none of the sales, over the same period of time.

Here is a pro forma chronology of a dividend growth strategy:

Date

Transaction

Shares

Price

Amount

Invested Cash

Shares Held

Market Value

5/24/01

Buy

600

23.97

14,382

14,382

600

14,382

12/24/03

Split

600

14,382

1,200

-

12/15/11

Split

1,200

52.95

14,382

2,400

127,080

11/1/12

Buy

200

56.60

11,320

25,702

2,600

147,160

1/9/13

Buy

200

58.12

11,624

37,326

2,800

162,736

3/26/13

Buy

300

56.11

16,833

54,159

3,100

173,941

6/11/15

Split

3,100

50.46

54,159

6,200

312,852

Various

Dividends*

(20,428)

33,731

3/14/18

End Value

6,200

77.24

6,200

478,888

This is the more than a dividend growth investor might expect: dividends and a ten-plus-bagger! That's what happens when you pick the correct stock, hold it and don't subject it to rigid concentration limits. You get rich.

Here is what the P&L for that investment, handled that way, looks like:

Initial Invested Cash

14,382

New Purchases

39,777

Total Sells

0

Dividend Income

(20,428)

Invested Cash

33,731

Cash Profit

-

Ending Value

478,888

Total Profit

445,157

*Note: No attempt was made to show the reinvestment of dividends and its effect on invested cash or additional "dividends on dividends."

The chronologies also ignore the timing of the dividends and thus the "Invested cash" figure is not completely accurate until the final "invested cash" number. Interestingly, the buy and hold DG strategy, while it created wealth for the owner, was very slow in returning cash. Less than half of the money invested had come back to the investor, so there had been no cash profit. That's the "bad "news. The "good" news is that at any time, the investor can avail himself of almost half a million dollars to do with as he pleased.

Summary

Based on my experience, I conclude that while a buy and hold dividend growth strategy is a great way to build wealth and long-term cash flow from dividend, it is not always the most efficient way of producing cash in the short term. If you are a retiree and your goal is to leave behind a large estate for someone else's benefit, I think such a strategy will likely accomplish it for you.

On the other hand, if you are a retiree with a time horizon that may not accommodate both the slow pace of cash flow your portfolio is providing and all the things you may want to see and do with your family now, you may want to focus a bit more on stock values and the opportunities the embedded cash in them may allow you to seize.

It's something I noodle on frequently.

Disclosure: I am/we are long ROST.