Over the next few weeks, we shall dive into the exciting field of Dividends – the magical stream of free money that companies pay you just for owning their stocks.
In simpler times (i.e., those before 1960), this stream of dividends was the primary reason anyone would even consider owning something as risky as stocks. In the most recent half century, however, stock investing has become more popular and a mania has sprung up around it. This has driven up share prices when measured against the underlying earnings of the companies, and it has spawned a whole legion of market timing and momentum-based trading that attempts to predict the immediate future of stock prices based on recent fluctuations in those same prices.
The more I read about investing, the more I am convinced that buying boring but successful old companies with high earnings, high dividends, and low share prices (exactly what Warren Buffett has done for decades to become the richest investor in the world), is the best way to be a successful investor. Buying index funds indirectly accomplishes this, since there are plenty of boring old companies mixed into the S&P500 index, but for a purer and more advanced form of seeking out higher income, dividend-specific investment is a field to look into.
Academic studies of stock market performance strongly suggest that if there is any way to beat the returns of the overall stock market on a risk-adjusted basis, it is by buying stocks with high dividend yields and a low price-to-earnings ratio – also known as Value investing.
And from an early retirement perspective, retiring based on a diversified stream of dividends, rather than a fluctuating set of share prices, leads to a much less volatile financial life. When the stock market dropped by over 50% around 2008, retirees living off of their dividends barely noticed, since the underlying companies barely cut their dividend payouts during that time.
As the final icing on the cake, dividend earnings typically increase along with inflation over time, making them a much more viable source of lifetime income than a mattress stuffed with cash or a savings account earning 1% interest.
We’ll open the series with this guest posting from a guy who goes by the name Dividend Mantra. You can learn more about his philosophy by reviewing all his archives at dividendmantra.com.
What is Dividend Growth Investing?
MMM was kind enough to invite me to do a guest post introducing some of his loyal readers to dividend growth investing and some of the basic fundamentals behind this investment strategy. I’m not going to get too crazy with numbers and ratios, but instead I’m going to focus on the qualitative nature of this investment strategy.
A Little About Me
First, a little background on yours truly. I was born in 1982 and got serious about saving, living frugally and investing in mid-2010. It was when I found out that my net worth was negative and I’d be likely working until I was dead that I decided to change my ways. I read a fantastic book, titled Your Money Or Your Life, and this definitely transformed my relationship with money and the way I looked at work, money, consumption and time. I decided that the limited time that I’m given here on Earth should be used how I see fit, and not in exchange for bigger and better objects in an endless pursuit of the enigmatic Mr. and Mrs. Jones.
I now save well over 50% of my net income and invest that excess capital into dividend growth stocks. Although I highly recommend diversifying your capital into multiple investments, I’m going to just concentrate on stocks today as that is primarily where my net worth lies currently.
Simpler Than You Think
Dividend growth investing is a strategy of investing whereby an individual engages in long-term investments with quality businesses that are expected to grow revenues, earnings and dividends over a long period of time by selling/manufacturing/distributing products that people want or need every single day. These investments are made by purchasing common stocks of these businesses that pay quarterly, semi-annual or annual dividends to shareholders. These companies typically have a long-term successful track record already behind them. Examples of these businesses include Coca-Cola, Wal-Mart, Colgate-Palmolive and ConocoPhillips. These businesses are all generally household brand names that produce quality products that people want and need. I try to invest in companies that I use every day. Although I’m significantly frugal, I still drink Coke, I brush my teeth with brand name toothpaste because I trust it, and I shop at major retailers like Wal-Mart because they’re convenient, cheap and usually centrally located along a bus line. Speaking of the bus, it runs on gas…which is refined from oil. Although I don’t own a car, I still have an indirect need for oil which is where investments in quality, large international oil producers like ConocoPhillips come into view.
Concentrate On Value, Quality And An Economic Moat
Although money managers and brokers want you to believe that investing in the stock market is incredibly difficult, it’s really not. Notice I used the word “investing” in the preceding sentence. Long-term investing in the stock market is an incredibly efficient way to build wealth for a patient and focused individual. People who trade in and out, hopping from one investment to another are simply transferring their wealth from their wallet to the brokers that facilitate trades. That is not investing; that is betting.
Concentrate on value. Any object or service in the world has a price and a value behind it. Price is what you pay, but value is what you receive. It’s no different with stocks. Paying a premium for a quality business will always be better than getting a “steal” on a stock with a lousy underlying business. I typically try to invest in quality companies that have a price to earnings ratio (the price you’re paying for the earnings of the business) of less than 20, and preferably less than 15. With a price to earnings ratio of 20, that means I’m paying $20 for every $1 of earnings. A lower valuation, and consequently a lower p/e ratio, means that investors are expecting lower growth going forward. It’s important to realize that the market isn’t always correct and it’s key to capitalize on businesses that are high quality and trading for a cheap price. At that point, you’re getting great value for a cheap price.
Concentrate on quality. Recognizing quality is key for a successful investor. Quality is usually backed by a consistent product with a brand name that people are usually willing to pay a premium for. Again, going back to my Coca-Cola example, I’m willing (even as frugal as I am) to pay a premium for Coca-Cola over store-brand cola because to me it tastes better. I’m certainly not alone, because Coca-Cola sold over $35 billion worth of products last year. If you want to commit money to an investment it’s probably a good idea to try the product if it’s applicable. Want to invest in McDonald’s? It’s easy to check out a couple different locations and see if they’re busy, serving a consistent product, clean and offering efficient, quality service. This isn’t always applicable to an investment, but if it’s available to you it’s a good idea to see the company behind the stock. The key is doing your research and discerning quality.
Concentrate on companies with an economic moat. An economic moat is a competitive advantage that a business has that prevents other businesses from infringing on its market share. Companies that have pricing power, economies of scale, brand names, large distribution networks and barriers to entry have economic moats. Think of a company like a castle. The larger the moat around that company, the better defense it has against outside forces (competing companies). Coca-Cola has a large economic moat because of its global footprint, large brand name exposure, quality of product and economies of scale through volume and distribution. These aspects of Coke’s business are extremely attractive and that’s why Coca-Cola usually sells for a premium over its competitors. They have a majority piece of the market share in almost every market they compete in. That provides an investor peace of mind and the odds are strong that this company will be able to continue to boost earnings and dividends for many years to come. Do you ever see those old ads for 5 cent Coke bottles? They don’t sell for that anymore. That’s called pricing power. This is important, as a dividend growth investor is looking for dividends that grow at a rate that exceeds inflation. Growing dividends come from growing earnings and cash flow. You can’t increase earnings if you don’t have pricing power.
I personally invest the majority of my net income into quality dividend growth stocks every single month. This is a form of cost averaging for me, as I do not believe in timing the market. Some months the market is down, and some months it’s up. I try to buy on dips within each month. I try to commit at least $1,200 to each transaction, so as to limit the effect of broker fees. I use Scottrade, and they currently charge $7 per transaction. I use income from my paycheck and combine it with dividends received from the prior month and used that combined capital to purchase shares in quality businesses. For instance, earlier this month I purchased 35 shares of Illinois Tool Works (ITW) at 46.68 per share, 30 shares of Emerson Electric (EMR) at $50.88 per share and 50 shares of AT&T (T) at $28.87 per share. My ultimate goal is to produce a passive stream of income from dividends that exceed my expenses, thereby rendering me financially independent. My expenses currently hover the $1,100 mark per month. I expect my dividends to exceed my expenses before my 40th birthday.
For beginners I would recommend building a core portfolio around large dividend growth businesses like Procter & Gamble, Coca-Cola, Pepsi-Co, McDonald’s, Wal-Mart, Johnson & Johnson and similar companies. These are typically consumer based stocks that aren’t as hard-hit when economic dips occur. Once you have your core portfolio built, you can branch out into companies in other sectors that still produce quality products and have a long-term track record of raising dividends and earnings at a rate that exceeds inflation. Companies like Exxon Mobil, Intel, General Dynamics, Illinois Tool Works, Medtronic and Visa come to mind here.
I didn’t want to get too detailed with numbers, ratios, balance sheets, cash flow statements and the like. I wanted this to be a basic primer on dividend growth investing and I want prospective investors to always remember the basics. When you’re looking at stocks, you’re looking at owning a piece of a company that produces something of value. If you don’t personally see how that value translates to long-term growth then it’s probably a good idea to invest your money elsewhere.
Full Disclosure: I’m long ITW, EMR, T, XOM, INTC, GD, MDT, PG, KO, PEP, JNJ, WMT, MCD, COP.
Thanks for reading!
Update from MMM : This fantastic guest posting ended up sparking a huge and somewhat unruly discussion in the comments. Experienced stock investors may enjoy reading through, while beginners might end up more confused than when they started.
Writer J.L. Collins took the time to make a nice summary of the arguments with a clear summary here: http://jlcollinsnh.wordpress.com/2011/12/27/dividend-growth-investing/
Future tip: the comments section of this blog doesn’t work for big discussions longer than about 10 exchanges. Every opinion is welcome, but if you ever get riled up and want to take it outside, why not head over to the Reddit Financialindependence section and spark one up there? Lots more fun and more wise people to weigh in. Then post a link to your new thread in the comments section here.