Income Investors: For Every 2 Ts, Buy 1 HD

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Includes: ABBV, AMGN, BA, D, ENB, EPD, FRT, HD, ITW, LRCX, O, PG, PM, PRU, SBUX, T, TXN, UPS, VOD, VTR, XOM
by: Financially Free Investor

Summary

Income investors, including retirees or near-retirees, need some growth, especially dividend growth in their portfolios.

The best way to get some zing in your DGI portfolio is to invest a part of it in the so-called fast dividend growers, even if their current yields are lower than others.

We go over the process of how to identify such stocks and structure a DGI portfolio of High Yield stocks such as AT&T and High Dividend growers such as Home Depot.

Today, we are going to provide a slightly different perspective for Income Investors. The term "Income Investors" does not necessarily mean retirees or near-retirees. Even younger investors could be income-oriented investors even though they may not need the income today or even for a decade or more. If you are an income investor and are relatively young, you need some growth stocks in your portfolio. They don't always have to be the Amazon (NASDAQ:AMZN) or Netflix (NASDAQ:NFLX) of the world since they provide absolutely zero income. They just need to be dividend-paying stocks, but growing their earnings and thus dividends at a high annual rate. We are talking about stocks like Home Depot (HD) and Boeing (BA). Sure, you need many stocks of the kind of AT&T (T), which will boost the current income yield of the portfolio. In fact, they are essential for a retiree or near-retiree who needs the income today and not in a 10-year time. But for the portfolio to provide sustainable income growth, you need some stocks of the kind of Home Depot. Depending on your age and time horizon, you need 1 HD for every 2 Ts or maybe 1 HD for every 3 Ts.

When we say "relatively young," it can mean many things. You could be in your late 40s or early 50s. You could be in your 60s and still be relatively young if you expect to live to 90 or 100. Retirement can last a long time as much as your working lifespan and many times even longer than that. This longevity is good but requires our retirement funds to last much longer. This is why even if you are in your 60s or even early 70s, you need some growth stocks that also pay some dividends. That said, these are the decisions best made on an individual basis based on a person's own personal situation, goals, income needs, and above all risk tolerance.

High-Growth, Low-Yield (HGLY) versus High-Yield, Low-Growth (HYLG) Stocks

Let's say we have three investors - Steve, Mark, and Jim.

All three invested $10,000 in January 1994 and did not withdraw anything until 2018. They reinvested all dividends in the original stocks.

Steve invested all his money in High-Yield stocks T and Federal Realty (FRT) (50% in each).

Mark invested 50% each in HGLY stocks HD and IBM (IBM was a growth stock in the 1990s)

Jim invested 33% (one third) each in T, Realty Income (O), and HD (2 HYLG, 1 HGLY).

Please note that the above stock selections are random and too narrow and may not be reflective of a fully diversified portfolio. Nonetheless, the idea is just to demonstrate the comparison among the high current yield stocks, the high dividend growth stocks and a combination of both. Let's see how our three investors ended up at the end of August 2018:

Results courtesy Portfolio Visualizer

Steve's Returns (High Yield only):

Mark's Returns (High Growth only):

Jim's Returns (Blended - 2 High Yield, 1 Growth):

Steve's portfolio returned 9.30% on an annual basis. Not bad over 25 years, but it still was the worst performer out of the three, and barely keeping up with the S&P 500.

As you can see, the highest returns came from Mark's portfolio, which was invested in two growth stocks, albeit with the most drawdowns as well. However, it was quite possible that he could have picked a far worse stock than IBM and the return would have been less attractive. In fact, IBM has performed quite well and on its own would have returned 11.8% on an annualized basis over 25 years. It has only lagged the broader market in the last 4-5 years. So, it may not be unreasonable to think that Mark was just plain lucky to have picked exceptionally good stocks.

Jim's portfolio provided more than 2.5% higher annual returns than the S&P 500, with least drawdowns of the three. The 2.5% outperformance was enough to return 100% more in total returns than the S&P 500 over 25 years. Just by adding one growth stock to Steve's portfolio, Jim was able to boost performance and reduce the risks significantly. These examples are not perfect and could be accused of hindsight and selection bias. However, we believe it still proves a point that for relatively conservative income investors, Jim's portfolio would be better than the other two.

Home Depot of Today May Not Be The Same As Home Depot of 1986

Well, Home Depot appears to have its mojo intact with regards to the dividend growth, but certainly it can't provide the growth of the last three decades. However, on the other hand, IBM is no longer a growth stock that it once was. In the rearview mirror, it is easy to see all these trends, but to find the dividend growth stocks of the future is difficult.

Fortunately, it is relatively easy to identify them for the short and medium term with some degree of certainty. So, what we need to do is to identify a set of high dividend growers for each passing year and replace the previous year's list with the new ones.

How To Recognize The HDs of Today

We do not believe there is one permanent way to identify High Growth dividend stocks. In other words, a high-growth stock today may become low-growth after 5 years or even sooner. But new ones may qualify. So, to overcome this difficulty, we will apply our selection process on a yearly basis, and if need be, we will replace some (or all) of the dividend growth stocks with new ones.

To identify our high dividend growers, we will apply the following filters:

  • The market cap should be >= $20 Billion
  • The dividend growth of the last 5-years >= 15%
  • The current yield is at least >= 2%.

Some of the optional filters are based on personal preferences. We could relax or change some of the conditions:

  • The stock is a member of the S&P 500
  • Or the stock is listed on NYSE or NASDAQ
  • Or the market cap to be reduced to >= 10 Billion
  • Or the dividend growth requirement be reduced to >= 10%
  • Or the current yield could be lower than 2%, but >= 1.5%.

For the purpose of this article, for the most part, we will stick to the first set of requirements. However, the second set provides certain options to enlarge our spectrum of stocks that we could select from. For example, Boeing has grown dividends at a remarkably high rate of 27% over the last 5 years, but the current yield is a tad bit lower than 2%, at 1.98% to be precise, due to high current valuations. So, if we want, we could relax our requirement a bit and include Boeing in our list, it will be okay. We guess you get the idea.

How To Make a Balanced Portfolio Today

So, let's assume we want to create a new DGI portfolio today with 20 stocks. We want to create a balanced DGI portfolio with a mix of high-yield-low-growth (HYLG) with high-growth-low-yield (HGLY) stocks in a ratio of 2:1. That means:

We will select 14 stocks (roughly 2/3rd) that are HYLG. These will be for the long haul, and we should rarely sell when something has changed fundamentally with a specific company or when it no longer meets the original criteria and/or goals. We will select 6 stocks (roughly 1/3rd) that are HGLY. These will be selected on a yearly basis, and some (or all) of the stocks may change from year to year. To start with, based on the criteria listed above, we selected the six stocks for our sample portfolio. Please note that they may change next year.

Ticker

Company Name

Sector/

Industry

Current Yield

5-Yr Dividend Growth

High Growth

Low Yield

1

HD

Home Depot, Inc.

Home Improvement

2.01%

24.10%

2

BA

Boeing Co

Aerospace

1.98%

27.50%

3

TXN

Texas Instruments Inc.

Tech/Semiconductor

2.26%

21.50%

4

SBUX

Starbucks Corp.

Beverages/ Restaurant

2.69%

24.0%

5

LRCX

Lam Research Corp.

Technology

2.56%

42.3%*

6

AMGN

Amgen Inc.

Healthcare/Biotech

2.64%

23.90%

High Yield

Low Growth

7

T

AT&T Inc.

Telecom/Media

6.28%

2.18%

8

VOD

Vodafone Group PLC

Telecom

8.20%

4.66%

9

PG

Procter & Gamble Co

Consumer Staples

3.44%

3.08%

10

ABBV

AbbVie Inc.

Healthcare

4.06%

16.01%

11

ENB

Enbridge Inc.

Energy

5.97%

13.10%

12

EPD

Enterprise Products Partners L.P.

Energy-MLP

5.94%

5.12%

13

D

Dominion Energy Inc.

Utility

4.61%

8.4%

14

PM

Philip Morris Intl

Tobacco

5.87%

3.29%

15

PRU

Prudential Financial

Financial

3.65%

13.8%

16

XOM

Exxon Mobil Corp.

Energy - Oil & Gas

4.09%

4.8%

17

UPS

United Parcel Service

Shipping & Logistics

2.93%

7.86%

18

VTR

Ventas, Inc.

REIT-Healthcare

5.27%

2.73%

19

O

Realty Income Corp.

REIT- Retail/Office

4.52%

4.55%

20

ITW

Illinois Tool Works

Industrial

2.88%

15.87%

AVERAGE

4.10%%

11.32%

You may have noticed that the average yield of the portfolio is not that shabby at all. It is 4.10%. The average yield of the first 6 stocks, which form our HGLY group, is 2.36%. The average yield from LGHY group (14 stocks) is 4.83%. You have 1/3rd of the portfolio invested in dividend-growth stocks that are likely to grow dividends at 15% or more. The average dividend growth (for the entire portfolio) has been more than 11%. But let's be conservative and assume our LGHY stocks grow their dividend at an average of 5% rate, by adding the 6 high-growth stocks (dividend growth 15% plus), our dividends for the entire portfolio should grow at least 8% per year. This would be enough growth that you could draw up to 4% dividend income from the portfolio with at least 5% raise every year and still never touch the principal (if you so like). So, here you go; you can have your cake and possibly eat it too.

Conclusion

DGI is a very popular strategy among income investors. Some of them need income today as they depend on it for their current expenses. Some others need the income, but they may have flexibility as to how much they must withdraw. Also, many investors don't need the income today, but they may be just preparing for eventual retirement. Depending upon your personal situation, income needs, and the risk tolerance, you would need to determine the right balance between the high yield stocks and high dividend growth stocks in your DGI portfolio.

We have described one such approach in the article. We have also tried to demonstrate why a mix of the two types of DGI stocks is desirable for most people. This approach will also ensure that we are not always chasing the high yield for the sake of high yield. This mix is also one form of diversification just like we would want to diversify among various sectors/industries of the economy. The only drawback of the strategy we can see is the need for the yearly review of the high dividend growers to ensure if they still meet our goals.

Author's Note

When this article gets published, I would be traveling for a few days. So, I may not be able to respond to your comments in real-time. I will try my best to respond as soon as possible. Thank you for reading and your understanding. All the best to everyone - FFI.

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. Any stock portfolio or strategy presented here is only for demonstration purposes.

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

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.