The other day on my post titled Coronavirus is Killing Me in a Different Way, long-time reader Apex (who is known for leaving awesome comments on this site) left this suggestion:
I think many here might find an exploratory dividend stock post valuable as a means to consider another source of passive income.
Comments from the community of people who have been doing this giving details on what they are doing and what kind of criteria they use to select dividend stocks would be very interesting.
Things like weighing yield vs company strength vs long term dividend security and growth etc.
Turns out, I was interested in this sort of post myself.
In fact, I had become so interested that I contacted my go-to expert for dividend investing, my friend and ESI Money reader, Mike H.
Mike has been featured on the site several times, including:
- Dividend Stock Investing as a Source of Passive Income
- Millionaire Interview 30
- Retirement Interview 20
He’s a frequent commenter as well and often leaves extremely insightful and valuable comments.
A few days before my coronavirus post went live, I contacted Mike and asked his thoughts on dividend investing. I was looking at buying some dividend stocks since the market was down and now seemed like a great time to add another stream of income to my finances. He sent me a well-thought-out response that started my own journey to buying dividend stocks.
I’m still on that journey and haven’t yet decided how to proceed, but rest assured if I do, I’ll be sure to share details.
Anyway, based on Apex’s request, I contacted Mike and asked if he’d put together something for us. His response is what follows.
It’s not meant to be a complete guide to dividend investing (otherwise we’d be asking him to write a book), but it’s a solid introduction and overview.
From there you can ask questions as well as start your own research.
And with that, here’s Mike…
——————————————–
With the recent market turbulence, I’ve seen a lot of comments from people who are asking about buying dividend paying stocks (at lower prices) for an extra source of income.
ESI also asked me what dividend paying stocks are catching my interest, so I thought it would be timely to write this article.
This is the toughest, most uncertain market we have had in many years so what I’m offering would be a strategy that you could implement with extra money on hand.
While there is no way to time the market bottom, you can do well buy just buying in at these lower valuations and holding, providing that the companies bought are able to weather this storm.
To get you started, here are the seven steps I use for growing passive income through dividend investing:
1. Decide on your investment objectives.
It is important to consider what you want to accomplish before you take any action at all.
Are you looking primarily for income? Mostly growth and some income? Or something else?
The reason the investment objective is so important is:
- It will guide you into deciding what stocks meet your criteria and which ones don’t.
- Having and knowing what you’re looking to accomplish will help you stick with your strategy during periods of market distress.
Dividend paying stocks that have been able to consistently raise dividends have far outpaced inflation. A dividend-focused investor has been able to receive income from the company while retaining their ownership position.
While that sounds like an enticing benefit of ownership, there are some downsides to owning stocks.
The first is, of course, the stock price could drop, far outpacing any gains you might have from receiving dividends.
In addition, there is the risk of major volatility with the market repricing your ownership stake, either higher or lower. Certainly investors don’t mind when prices go up but when prices drop, and specifically crash in times of high uncertainty, then people tend to panic and sell out. This usually happens at the worst possible time so that investors end up locking in losses.
This is why you need to know what you’re trying to accomplish and stick with it. If you do this, history shows that you’ll likely weather any major storms and come out better on the other end.
You should also think about your investing strategy. Will you be investing a lump sum or do you plan to continually invest smaller amounts over a long period of time? Will you reinvest dividends into undervalued companies or take them out as income?
These are just some of the reasons you need to begin with your strategy in mind — what you want to accomplish and how you plan to achieve it. If you start with this step, it makes the others much easier as well as prepares you for future challenges you may face.
2. Get the right mindset by thinking like an owner.
Once you know your strategy, you need one extra step before digging into possible stocks to purchase: you need to get your mindset correct.
There is a saying that time in the market beats timing the market. Generally speaking, this is true even when exposed to unexpected shocks in the market.
This is why you need to adopt an ownership mindset.
Taking an owner’s mindset, you acknowledge that you are buying a piece of a business rather than just trading a stock ticker. As an owner, you would like to seek out a stake in a well-run business that has been consistent in generating growing profits and sharing that back with the owners of the company.
You are also motivated by personally using the company’s product or services where practical.
In short, you want to own a well-run, profitable, successful company that you have at least some interest in or connection to.
3. Create your target list of companies you would like to own.
Within the market there are many sectors represented: financials (banks, insurance, investment firms and credit cards), consumer staples (food and beverages), utilities, healthcare, energy, technology, consumer discretionary, industrials, telecom, materials and real estate (including REIT’s). A good portfolio is diversified and contains the strongest companies from a blend of sectors.
A good way to find companies with a solid track record is to go through the list of Dividend Champions, Contenders and Challengers. This is available online through several sources, and one is listed here.
A Dividend Champion is a company that has successfully grown their dividend for 25 consecutive years or more.
A Dividend Contender is one that has grown their dividend for 10 consecutive years.
A Dividend Challenger has grown their dividend for 5 years or more.
This list acts as a screen to identify companies that have demonstrated a high level of quality, as it takes a strong business model to continually generate more profit to increase the dividend in successive years.
The companies that continue this trend through the coronavirus crisis of 2020 will be even more battle tested.
Many of the Dividend Champions are likely products and brands that you already know: Walgreens-Boots Alliance, Chevron, AT&T, Johnson & Johnson, Cardinal Health and others.
It is good to come up with a list of preferable companies that you would like to own and feel comfortable to forget about micromanaging so you can hold them for a long period of time and benefit from the underlying growth of the business.
4. Evaluate the list based on five criteria and objectives.
It is important to be able to prioritize the target list based on the relative attractiveness of the business to find the best value for your investing capital at any moment in time. A good strategy to consider when selecting quality companies is to buy and hold them for the long haul, so you’ll want to select quality companies likely to perform well for many years or even decades.
Before we get into the details of how I evaluate potential stocks for purchase, let’s quickly review some key sources for very important performance data.
Public companies are required to file an income statement, cash flow statement and balance sheet each year, and each is an important document. The income statement shows the earnings, cash flow tracks the cash generated from the business, and balance sheet lists the assets and liabilities of the business.
If you were to think of a household or small business, the cash flow (listed in the cash flow statement under the line “cash generated from operations”) is your salary or profit from the small business, the net income is the net household savings after paying expenses, and the balance sheet of a business (under the liabilities part of the balance sheet listed as shareholder equity) is a close proxy to the net worth of a household.
Each statement tells you something about the business and helps you value it from that perspective.
With that said, now let’s look at how these statements can be used in selecting quality dividend stocks.
When considering the sustainability of a company (besides the history of being a steady dividend grower) I like to examine the following:
- Revenue growth over the past 10 years. A mature business should still show some revenue growth. A simple way to do this is to look at the latest annual report and one from 10 years ago. Plug both numbers into an online compound growth calculator. Low to mid-single digits of growth is okay for a mature business.
- Earnings growth per share over the past 10 years. Since dividends are paid out by earnings, the growth here is essential to the company doing well. You won’t be able to grow dividends unless earnings are growing. Earnings growth usually tracks revenue growth unless the net profit margins change or the company reduces the share count (typically through share buybacks that are then retired).
- Cash flow growth per share over the past 10 years. This can be found in the cash flow statement in the annual report (cash generated from operations). Cash is the lifeblood of the business and is used for investment in the business, working capital, to pay off debt, and pay dividends. Normally earnings correlate with cash flow however the latter is another indicator of the health of the business.
- Examination of the balance sheet of the business. Here I’m looking to see that long-term debt payments can be adequately serviced by earnings. A debt to earnings ratio of 3 or below, examined in the current annual report is manageable. It is also interesting to see if long-term debt is continually rising versus going down. Sometimes debt increases because of an acquisition so this could be good or bad depending on the earning power of the acquisition. Some very capital intensive businesses such as utilities will have numbers higher than this. This would be okay if the company was in a regulated market where there is price stability and little competition as there is more predictability of earnings.
- Dividend coverage ratio. Here I’m looking to see what percentage of earnings and of cash flow are spent to pay the dividend. Some of this depends on the industry (for example REIT’s are required to distribute 90% of their taxable income) but a good ratio is 50% or less as the company would have more flexibility to keep paying the dividend while continuing to reinvest in the business.
With all of these factors in mind, it is good to buy a company when it is undervalued, or when the financial ratios of the P/E (price of the stock per share divided by the earnings of the company per share) are tracking lower than previous history of the company. A good time for this is when there is a market crisis or if there is a change in sentiment about the company.
5. Examine your acquisition strategy – how much would you like to own and how do you want to deploy it?
In step 1 we talked about your acquisition strategy and how it ties into your investment objectives.
For example, suppose you would like to have a portfolio of dividend paying stocks that is worth $300K and that pays $12K per year in dividends. You may want to think about diversifying this across 30+ companies as well as across a few industry sectors.
That would mean that on average, each position you hold is $10K per company. So you would need to think about how you accumulate that $10K.
If it is when the company is undervalued, you may want to think about buying in multiple steps, say purchases of $2K each. This is useful during market corrections, as there is no real way to time the bottom and you can periodically make investments when conditions appear attractive and will dollar cost average into a reasonable entry point.
6. Make purchases, buy additional shares, and monitor.
You may decide to buy additional companies and let the value of your portfolio get larger over time, and increase your goals in dividend income. You can add positions in the same companies or look to acquire new companies.
Some people choose to reinvest dividends in the same company as they receive them and many brokerages offer that option automatically. Others prefer to take the cash from dividends and pool this to select the most attractively valued stock.
Monitoring takes a lot less time than doing the research to make the initial investment. It is typically going through what is new with the company when a new annual report is released. The stronger the business, the more you don’t have to worry about small details of the business.
7. Repeat the cycle as needed.
You will likely find that over the years this is a steady wealth-building machine so if you merely repeat these steps, you will find yourself becoming richer with each passing year.
To put this in perspective, I’ve been able to grow my own dividend portfolio so that it is now paying out approximately $130K per year (assuming no major dividend cuts) since following this strategy over the past 6 years.
If all of this seems too complicated and requires too much effort you can always invest in a dividend paying stock fund using a low cost ETF. Or you could simply invest in a broad market ETF and will receive dividends from the subset of companies that pay these.
That’s a quick overview of my strategy in selecting dividend stocks. I’m happy to answer any questions you may have in the comments below.
Good luck in your own investing journey!
Is there any analysis of how dividends might be affected this year? I’m down 30+% and some holdings are already cutting dividends. What kind of a reduction might we get?
You raise a great question. The answer is it depends on the portfolio construction and the impact of dividends being cut is tied to how long the economy is in lockdown. Certainly as a part owner of the company, you can expect to Board to divert all sources of free cash to keeping the company afloat. As a dividend growth investor, I’d rather take a pause of dividends to shore up the company over the company going insolvent. Equity holders could get wiped out in the worst case and that is a permanent loss of capital so that is really the worst case scenario.
The dividend cuts I’ve seen thus far are: airlines and some players in Oil & Gas that have a weaker and more leveraged balance sheet. Industrials will also face some challenges. There is one company that I hold that is a mining company and I expect a lower payout in Q3 (they pay out twice a year).
I can say I’ve been through some of this before when oil and gas companies and some industrials cut their dividend at the beginning of 2016 but since I’m pretty broadly diversified my overall dividend income grew that year, but only very slightly.
-Mike
Hi Mike
Thanks..I’m hoping for some dividends even if they’re cut, as I doubt I’ll be able to work much till it’s ‘over.’
Otherwise I might have to sell something and of course I don’t want that.
I have 2 reit dividend payers in my portfolio (top international exposures) who have both revoked a dividend declaration issued in February that should’ve paid in April. Ie this was during cum div period, but now reversed.
So no divi… Guess what also happens to the share price of a reit that doesnt pay dividends.
Keep safe everyone, dividend investing is about to get clobbered just like in 08/09
Hi Bob,
Sorry to hear that happened to you. What were these two companies where this happened? Normally REIT’s are required to distribute 90% of their taxable income out to shareholders. Maybe they are facing a liquidity crisis and needed to hold on to those payments.
I reiterate my earlier comment that it is far better to take a dividend suspension then a full equity loss.
Going back to 2008 – 9 the main industry that clobbered dividend investors was financial (banks) as they needed to build up their capital reserves to new levels due to the crisis. Some industrials like GE also suffered then mainly due to their Finance arm.
It’s safe to say that any company that is looking for or receiving a government bailout will cut their dividend.
These are tough times to sell the benefits of dividend growth investing but for those with extra money and willing to make some calculated investments they should do very well in the coming years.
Good luck,
-Mike
Yes liquidity crisis because debt is tied to asset value. Their asset values are being written down hence covenants are being breached.
Reits are highly geared so to have a chance at surviving they need to conserve cash. I just havent often experienced a reversal of a resolution passed to declare dividends. I feel it weakens the dividend investing case for me if I cannot rely on cum/ex div at the moment for deployment to individual firms.
Happy to buy the market though.
Are these mortgage REIT’s or equity REIT’s? I tend to favor the latter although the payments from the former can be higher through leverage. But during times of stress this can quickly come undone.
They are equity reits. They own some of the best commercial and retailproperty in my country.
Sorry to hear that. That’s why I diversify and have REIT’s as less than 10% of my overall portfolio.
Mike
Im in O and STOR and VGSLX. are you referring to these reits or others?
I’m also in STOR, OHI and WPC. O is a fine REIT and one that I will add in time. VGSLX should be okay too.
Article is a good reminder on what to do.
One of the things I look for is dividends. With the mkt as it is, I figured it’d be cut or stopped temporarily. Thats ok. “all investments come with a risk”… Im in the growth stage and do not need any of it in the near future. Although it hurts to see the drops we’ve seen.
Mutuals (indexed) – long term, divi’s reinvested – growth and income strategy
Bonds – monthly divi’s — divi’s go to money market for reinvestment/balancing strategy
ETFs – short term – divi’s go to money market if held for more than a qtr / buy n sell as necessary – profit strategy
REITs – mid term – divi’s reinvested – growth strategy
I go back and forth on individual stocks. Been there, done that; would be some great buy in opportunities now (well since it went up yesterday not as cheap but still…).
I don’t think all companies will cut their dividends. Certainly the consumer defensive stocks continue to make money as people continue to buy their products (SJM, KHC, GIS, PEP, etc).
The depth of the valuations will depend on how long this goes for so with that uncertainty out there, I totally understand why people would like to hoard cash (as well as TP!)
-Mike
I wondered what had happened to you. Just checked my spam folder and marked four of your emails as “not spam”.
THANKS!!!!
I just had the same problem happen the last two weeks! Marked as not spam, hopefully it adjusts the filter.
I know. They are killing me…
Hi ESI, great timing for this article. My goal has been to use my Roth as a potential additional source of funding in retirement. I’ve been building out divvy’s for a few years now with idea of tax free distributions when the time comes, or an excellent legacy tool if I don’t need it. This is one of the few investments that I have that really “checks all the boxes”. This is my “side hustle” lol. I use a service that rates Dividend Safety, I use Morningstar Dividend Investor, and I subscribe to many authors on Seeking Alpha for ideas, analysis, portfolio’s, and commentary/debate. Right now is really busy because I’m trying to buy more safe income at the least possible cost, using dry powder and my shopping list. The double black swan really hurts the NW balance, but it’s a real time for opportunity if you are ready and have done your homework over the years. Yes Oil and REITs have been killed more than the overall market, but if your Dividend is relatively safe, you ride it out just like Bogle would do, and buy more with your dry/accumulated powder. Good luck to everyone in these strange times, wash hands & stay safe.
Great guideline to build a dividend portfolio.
The previous weeks have shown some great potential opportunities especially in sectors that were getting clobbered by a perfect storm (oil and gas and energy look very attractive). I didn’t go for the individual stocks but instead invested in sector funds (vde for example) as it was at a historical low. Hopefully a few years from now this move will look to be a steal
Hi Mike,
Thanks for a good break down of your analysis model. It is great to have a first had account from someone who has personally built a dividend portfolio that is throwing off a six figure income.
I would like to dig in a little deeper and ask if you would be willing to share some specific metrics that you use.
Lets start with the 5 metrics you mentioned.
10 year revenue growth – You mentioned low to mid single digit growth.
10 year EPS growth – You mentioned this usually tracks revenue growth. Do you shoot for the same low to mid single digits?
10 year cash flow growth – Do you look for the same numbers here or something different?
Long term debt payments – You mentioned debt to earnings below 3.
Dividend Coverage Ratio – You mentioned 50% or less except for REITs.
These numbers all speak to the underlying strength of the company and ability to maintain the dividend. However, when taken in a vacuum this can point to companies with dividend payout ratios that are all over the spectrum and I suppose depending upon your goals for investing any of those might be valid choices, but I would like to look at the specific investment goal of creating a passive income portfolio that throws off the maximum income per dollar invested that is relatively safe from long term reductions in company value and long term reductions in future dividend streams.
So in that vein I would have the following specific questions for you.
1. Are there specific dividend yields that you are looking to exceed when making a purchase. More specifically, (a) what is the floor you are looking for, (b) what is the typical or average yield you usually get on new purchases in your portfolio, and (c) Is there a yield that is generally a warning sign to you of being too high that you would use as a sign that perhaps this company / yield indicates long term unreliability because the company cannot be relied upon to be able to continue to pay that kind of a yield.
2. How would you weigh yield against some of your other metrics to make a decision about which company would be a better long term prospect. For instance. Say you have a company with a 5% yield and 3% 10 year revenue and earnings growth versus a company with a 2% yield and 7% revenue and earnings growth. Which one looks more attractive to you. Is the 5% yield with low single digits growth a better prospect or do you think the higher growth company with the 2% yield eventually catches up and surpasses the lower growth company. The numbers I listed above are just made up, I am more interested in how you would apply these kinds of metrics in general in assessing each company to pick your list of favorites that you want to purchase.
3. When you get your list of favorites, what kind of entry point are you looking for? (a) A drop of X% or more in stock price means I want to buy? (b) Once the price drops to the point that the yield is equal to Y% I want to buy? (c) The first one of these companies to get to some metric Z, I will put $X into that company?, (d) etc.
4. How much do you personally rely on the list of Champions, Contenders, and Challengers to get your list of companies you are interested in buying? Would you buy a company that is not on any of those lists? Do you prefer Champions due to their long term strength or do you find their yields suffer and the sweet spot for the trade off between yield and safety is lower on the list? Or do you simply find that your metrics guide the way and those lists do not really factor into your decision making?
5. Do you try to keep close to equal ownership of most of the stocks in your portfolio or do you favor certain industries or certain stocks that you prefer because of (a) higher yield, (b) safer long term company strength, (c) better history of larger increases in dividend payout, (d) etc.
6. Would you be willing to list the stocks that are in your portfolio (perhaps with an industry tag showing how much you are diversified into different industries)? (With the obvious caveat that this is not advice to purchase, and just because you own a stock from years ago doesn’t mean you would personally buy more today). This would be helpful not for getting a list of stocks to buy, but in seeing what your model has actually produced as a list of viable options for you (year(s) of purchase would also be potentially instructive here in seeing what your model pointed to at different times). This would be very instructive to see if the list is companies we all know very well or is it full of companies we may have hardly heard of or is a mix of both. For instance, if the model points to a bunch of stocks I haven’t heard of do those get excluded or does my ostrich nature in certain industries not affect what gets purchased.
Thanks for taking the time to share your insights.
FYI, I just bought some stocks today and will be detailing exactly what I did on my next two posts this week.
Looking forward to reading that, ESI!
-Mike
Hi Apex,
I love your questions, as they are very thoughtful. Those questions make me think deeper about my answers and I appreciate you asking them.
To answer your question, I’m not looking for a specific floor on yields but it’s a matter on balancing the quality of the company and exposure I’d like to have against having income now. Some of the biggest gaining companies I’ve had (Visa, Nike) have very low yields but other great characteristics of growth. Other nice gainers have been companies (TGT, MDC) that I bought when the yield was above 4% and the company was able to return back to growth and the valuation went up, with the yield going down. I try to balance higher yields and slower growth and vice-versa as I would like income now and growing income in the future. There are multiple ways to receive compounding – some comes from income today that is continually reinvested and some comes from low income today that has a higher growth rate of dividend payouts. One way to look at this is the simple addition of the current yield plus the long term growth rate approximates the compound rate of return and here I am targeting 10% when I evaluate companies.
Using your examples listed in question 2 I may well buy both of those companies but I would look to get as much margin of safety as possible when buying them, this depends on the opportunity the market serves up and the cash I have on hand.
I try and create a list of favorites and estimate a fair value for each one, using the assumptions on future dividend growth rate (derived from long term profitability and dividend growth coupled with consensus expectations on future growth, I try to be conservative) and the current share price. Then I look to buy if it is undervalued by more than 10% for a quality company and compare how attractive this is to other options out there. If there is an attractive company that I own that has dropped significantly I may add more but I will also look to make sure it isn’t too overweight in my portfolio (my largest single stock is about 6.5% of the total portfolio.
The Champions, Contenders and Challengers list is a good starting point for an idea list and most of my holdings are or were once in this list. I do have a few companies that have frozen dividend increases and are not on the list any more but I’m still holding them. There are also a few others I hold that aren’t on the list but this is the minority.
I don’t have equal ownership across all companies in my portfolio. I currently hold 43 companies and the top 10 make up 50% of the portfolio but within all are within 3.5% – 6.5% each of the portfolio. I did an industry tag based on your question and it’s clear that I’m overweight on consumer staples (with strong brand names) at 29% of my portfolio. Following this Healthcare and Oil & Gas make up 11% each, Financials 10%, Consumer discretionary 8%, Tobacco 6.5%, Industrials 6%, REIT’s 6%, Technology 4.5%, Mining 3%, Telecom 2%, Transportation 1%, Utilities <1%.
The top 10 individual stocks I hold by weighting are: MCD, V, KO, JNJ, DEO, AMNF, IBM, DIS, KMI and OHI. I'm sure you are familiar with most of them. Some of the other smaller positions I have may build up depending on the valuations and the priority I have for allocating capital. I'm pretty happy with my holdings and sleep well at night. There will be some pruning here and there but generally I have historically only looked at selling 1-2 companies per year if there is something else that is more compelling out there.
I hope that answers all of your questions.
-Mike
In my answer above I made a typo – MCD not MDC….
Thanks Mike,
That was very helpful.
One more follow up. Could you pick a couple stocks you bought that are probably not very well know and give the reason why you decided to purchase a stock like that versus a ubiquitous product like KO?
Apex – I’m trying to send you a response, but my comment doesn’t seem to get through.
Hi Apex,
Well KO is a good stock if the price is right. With the recent sell off KO got down to below $39 and buying there is no brainer territory in my opinion, given the strength of the brand and ubiquity of the product. At higher prices like in the $50’s it is less desirable.
So I’ll two companies that I bought that you may have never of heard of, one is Westrock (WRK), a maker of corrugated and consumer packaging, a trend that plays nicely to the increase in internet shopping and home deliveries. I did my own independent analysis of the company but also found this article by Jason Fieber who also does a good write up on the company:
I can’t post a link here but do a search on google for “Undervalued dividend growth stock of the week Westrock” and you will find it.
By the way, this is a free weekly series that Jason (of the website http://www.mrfreeat33.com) puts out and some of the ideas presented here are pretty compelling and worth further exploration. I view WRK as a solid industrial that is still undervalued.
Another company that I bought a full position in is Armanino Foods of Distinction (AMNF) – the make frozen Italian food and are based out of California. It’s a small company with a market cap of only $75M so there is small company risk present there, however I’m a happy shareholder. They are, in my opinion, also undervalued with a 4.5% yield. The recent stats I wrote up for them looking at their numbers indicate: 8% compound sales growth the past 10 years, 26% compound EPS growth, 28%. Operational cash flow per share growth. Both EPS and cash flow have benefited from improved margins as they could automate and scale their production factory, they also benefited greatly from the corporate tax cut. They have a 13% compound book value per share growth (current book value or shareholder equity is $0.38 per share). The company has zero long term debt.
A good price with a large margin of safety (25% below fair value) using the calculation spreadsheet that I use (From Phil Towne’s Payback Time book) is $2.70 and the stock is currently trading at $2.34. If I didn’t have a full position, I’d be buying more. Come to think of it, I may just do that. This is a company that reminds me of See’s Candies that Buffett bought for $30M some 40 years ago. Buffett mentioned that that company returned more than $1B of capital to Berkshire since he bought it. This is not a stock recommendation, do your own due diligence, but these are the type of companies I like to hold in a diversified portfolio to put the forces of compounding to work for you over the course of your life.
They sold off hard since part of their business was selling to restaurants in addition to direct to consumer. In the long run, I believe they will continue to do well.
-Mike
Thanks again Mike. It’s helpful to see the gears behind the machine.
Why underweight utilities?
Utilities are slow growers since their area of coverage is normally somewhat fixed and their ability to raise prices is regulated. On the other hand, their market is somewhat protected.
I would be buying utilities if the yields are attractive enough and perhaps over time I’ll start to build a portfolio of utilities. The short version of the story is that I’ve found more attractive opportunities elsewhere. Since my journey is planned to be a life long investor, I believe the time will come around eventually when these are a lot more compelling.
-Mike
Joe,
Interestingly enough, I started to pick up some utilities in the past months (DUK, POR) as their valuations started to come down. The weight is now about 2% of my portfolio and I will probably add another 1-2% over time.
I didn’t have that opportunity earlier.
-Mike
I’m almost 75 and therefore taking annual RMD’s. One strategy I’m using is to transfer stocks, which are down by the largest percentage, from my regular IRA to my Roth IRA. This should allow them to now grow tax free and also satisfies my RMD for 2020. There will of course be taxes due on the conversions but the transfers are now worth probably 40% less than a month ago. So I’m betting on only transferring (and paying tax on) $6,000 but later increasing back to $10,000 as the market recovers. Also, another strategy the author mentioned was buying in pieces to establish a full position. This is an excellent strategy plus with zero commissions it doesn’t cost a fortune in fees.
“and also satisfies my RMD for 2020”
Where did you get the information that a conversion could qualify as an RMD?
https://money.com/retirement-required-minimum-distribution-roth/
Or do you still have wage income and are thus taking an RMD and then contributing to a Roth and repurchasing the stocks that are sold in the IRA? if so you can actually contribute $7,000 since you are old enough for catch-up contributions.
Vanguard has applied all of these conversions to my 2020 RMD.
I don’t have enough details about exactly what is going on here or exactly how Vanguard is treating this but if we are actually both talking about the same thing then what you describe is not allowed. You can google “can a conversion satisfy rmd” to find multiple articles talking about it.
I would try to get clarification from Vanguard on what they are reporting because a mistake here results in a huge penalty on the order of loss of 50% of the affected funds.
I didn’t know that a conversion can be applies as an RMD. I’ll have to cross that bridge when I get to it as I’m still in my mid 40’s. If it works without any penalties that sounds like a great strategy.
-Mike
Any thoughts on how the market prices in dividends and effect that has on overall return for a given equity position? I’ve heard that shares that pay dividends underperform the market because part of their upside shows up as dividends rather than share price appreciation. True?
That’s a good question, Tom. So in theory what happens is that the day the company goes ex-dividend, the stock price drops by the exact same amount of the dividend when the trading day starts. So the strategy to buy the dividend before the ex-div date and sell it after it is paid is not really a great one. In practice the stock price fluctuates like any other day and you may not be able to observe this difference as easily as you may think.
On your question on underperformance, that is not necessarily true. Research shows that companies that regularly grow their profits and dividends strongly outperform the rest of the market. While the strategy of finding companies of track records of this is backward looking, you are also carefully examining this and making judgement if the business model is likely to be sustainable – this is part of thinking like an owner. Companies that cut their dividend and have lowered guidance on earnings will certainly underperform the market.
-Mike
How does buying a dividend stock ETF such as VIG compare? Lower returns, but less work?
I haven’t researched the holdings of VIG. But generally you will find it’s less steps involved but you will lose the ability to control how you set up and grow your holdings. Part of this is that you learn a lot more just by starting the process and depending how you are wired, it can be pretty gratifying. We tend to have interest in things that offer us incentives and this is a case with the more you do it the better you become over time. The expense ratio of VIG will be low so if you can’t be bothered to find and buy individual stocks then by all means by the appropriate fund that meets your objectives.
-Mike
Mike H, I saw your comment on a previous dividend stock investing post regarding performance:
https://esimoney.com/dividend-stock-investing-as-a-source-of-passive-income/#comment-68335
Is this something that takes time to build up? Or would I have seen the same 2019 yield as you did had I bought the same 3M portfolio of dividend stocks at the start of 2019?
I’m very lazy and the bulk of my portfolio is just VTI/VXUS/BND. I’m dollar cost averaging some cash I’ve been holding back into my portfolio right now.
But I’m contemplating setting aside a portion for dividend stock investing. How many stocks are in your current dividend stock portfolio? Would just buying an ETF like VIG give me similar results? Like I said, I’m lazy.
Hi EW,
Thanks for the comment. I have 43 stocks in my portfolio. I think that this is best done if you take time to build up the masterpiece of a full portfolio over a period of years. The main reason for this is that not all sectors are undervalued at the same time so ideally you want to build exposure to the undervalued sectors and move to new companies and sectors as new opportunities arise. So someone starting now may build into tobacco, oil & gas, financials and REIT’s and move into other sectors later as valuations are more compelling. For example WMT (Wal mart) is a nice company but it is at all time highs right now. A good time to buy WMT was about 2.5 years ago when they were beaten down by perceptions that AMZN would put them out of business. They surfaced on my watch list but I found another opportunity that looked more attractive at the time. Normally with this approach there are more opportunities than capital available and there is no penalty for missing one that got away. You can always get around to it later.
The other big psychological benefit to me with doing this over time is that it is pretty inevitable that on some days you will be ‘under water’ on specific stocks with their share price being lower than when you bought in. Over time you will see that the dividends paid and the retained earnings of the company used to grow it will make this less and less of an effect. So if you were to put the entire $3M (let’s say) into a portfolio on day 1 then I’m 100% sure that you will see it be worth less and the temptation to sell it all and give up will be very natural. That’s why I said at the outset that it is a strategy for those with extra cash on hand and that one needs to think about their investing objectives.
You can buy an ETF by all means if this is too much effort. The effort is pretty much front loaded so one objective may be to buy 5 stocks this year with a portion of your surplus capital and see how it goes. Either way is fine, I just wanted to help people who may be interested in buying specific dividend stocks. In my case, I really enjoy having my own ETF, for all practical purposes.
-Mike
I use a similar strategy in an attempt to buy low, sell high but not just for dividend stocks. I balance and re-balance my portfolio with new cash (from W-2 income) and buy what sectors/companies/regions look low. And when I’m fully balanced, I simply buy the market via a total market ETF like VTSAX.
Looking back, I’m not saying this strategy is any better than the lazy one. I’ve casually looked back to see whether I’ve done any better trying to “time” sectors/companies/regions and my gut feel based on eyeballing my returns over 10+ years is that I’m doing close to the same as simply buying a low cost, diversified ETF. So I don’t think my returns are much better than MI177 who basically only buys VTSAX. But I’m having fun so I don’t mind.
Lazy is good. Fidelity did a study and found that client with the best returns had accounts that were forgotten or held by dead people.
Outstanding article ! Thank You Sir !
Thanks, VM! It’s my pleasure, and I’m glad you liked it.
Good thoughts on a simple, systematic approach to evaluating dividend paying stocks for investment. Some reactions (not that anyone cares):
– Most if not all of these company evaluation techniques can apply to any stock, not just dividend stocks. If you’re into the buy-and-hold stock strategy (I am), then thinking like an owner, evaluating based on fact based, audit-able criteria, know what your goals are, etc. applies whether the investments are dividend, growth, value, small cap, reits or any other mainstream equity investment instrument. I don’t see any of these steps as being unique or exclusive to just dividend stocks.
– You can easily create a simple formula to systematically sell your positions to create cash flow that is very similar to dividend payouts. I don’t like getting locked into quarterly dividends that are taxed as ordinary income. I’d rather take cash when I need it. And if I have a sufficiently diversified set of individual stocks, ETFs, equity funds, bonds funds (I don’t buy individual bonds), reits, etc., then using a fixed rule to periodically sell to generate cash isn’t that tough. IMO, this isn’t much harder than buying dividend stocks. There is risk either way. Dividends are cut during bad times and there is plenty of evidence these stocks aren’t any safer than the market at large at generating steady cash flow (e.g. efficient market theory). As long as you’re disciplined and consistent in your selling tactics, you get the same cash flow as dividend stocks, better cash management flexibility and a larger pool of investment options without sacrificing returns.
The dividend taxation optimization argument used to be true, but is actually out of date by almost 20 years. Today most dividends are not taxed as ordinary income, they are taxed the same as capital gains.
It is true that prior to 2003 all dividends were taxed as ordinary income. In 2003 a new category of dividends was created called a qualified dividend. Except for REIT dividends which are considered income and thus ineligible to receive the qualified status, almost all other stock dividends are what is considered a qualified dividend which receive capital gains tax treatment.
In order to be a qualified dividend the stock has to be held for 1 year which is the same requirement needed for a stock sale to be treated as a long term capital gain for tax purposes. As such, there is no real tax benefit to the stock sale strategy over the dividend strategy.
I need to make a slight correction to an assumption about holding period that I had not verified (I don’t currently own any individual stocks so I don’t have personal experience with qualified dividends and holding periods so I was going off of memory which was incorrect. I should have verified the details before I posted). The holding period for dividends to qualify is actually only 60 days and it includes the days after the dividend is paid. This is effectively designed to stop dividend harvesting where someone buys and sells a stock just to capture the dividend. Thus the very first dividend on a long term hold is qualified and gets capital gains tax treatment making stock dividends other than REITs tax optimal from the very first dividend payment.
Thanks, Apex. I was going to correct you but you already did. It’s 60 days of holding a purchased security before the dividend is paid that makes it qualified, as I understand it.
When you get your broker statements at the end of the tax year, they will list out what is qualified and what is not. If there are any errors you need to contact them as that is what is furnished to the IRS and the returns that are filed should be matching with these numbers.
-Mike
It looks like it is any 60 days around the ex-dividend date so that would include the 60 days after the dividend is paid too. This would make sense if their goal was to stop dividend harvesting as long as you hold the stock for 60 days before selling the stock even if you purchased it 1 day before the dividend and held for 60 days.
https://www.investopedia.com/ask/answers/072915/when-does-holding-period-stock-dividend-start.asp
Hi Phillip,
You are exactly correct that this analysis can be used to evaluate all types of stocks. I can tell you I love the growth characteristics of companies like GOOG and BRK-A even though they don’t pay a dividend and may look to buy those at some point in time.
The reason I chose my strategy is that I would like to receive some of the retained earnings now in the form of a dividend and use this surplus cash to reinvest in the best opportunities that I see in the market. You can’t do that if the company doesn’t pay a dividend. Companies that stock pile cash will need to eventually do something with it and there is always a risk of a white elephant project or division or an expensive acquisition (though this could also happen with a dividend payer, they tend to be a little more capital constrained and disciplined to this). As for selling and creating synthetic income that way to live off and reinvest, then you are at the mercies of the the valuation of the market. That strategy is pretty stressful in a prolonged bear market where you have to sell a greater percentage of your holdings then you had planned due to lower market valuations.
On the tax rate, I can tell you that it is lower than you might think. Last year, I am seeing that my qualified dividends were just above $90K with the rest being either a return of capital (can happen with REIT’s and some energy companies) or non-qualified income. As someone who works overseas as a consultant with my net income being below the foreign earned income tax threshold and supporting a family of four, the federal tax impact on this dividend income is near zero. That will change as dividend income grows dramatically but it will still be a far lower tax rate than earned income under current law.
There are many paths to earning investment returns in the market and I hope this better explains the positive with dividend growth investing if done with some level of care by someone who has personally done this over several years.
-Mike
Thanks for clarifying. I love learning from the comments as much as the article. I assumed my qualified dividends were from my mutual funds and maybe ETFs whereas I assumed the professionals knew how to better tax manage. I didn’t realize the laws changed in 2003 for individual stocks. At any rate, I still like the option of using my dry powder cash instead of being “forced” to take a dividend when I’d rather hold on to a position (or pay the tax and then reinvest the dividend). But we are probably splitting hairs at this point.
For now, I do like growth/tech stocks (I’m over-weighted in tech since they tend to not payout as much in dividends and are generally performing well as a sector) and I do buy individual stocks that I think are undervalued but usually don’t pay much or any dividends (my gambling money). We still generate excess cash from W-2 income and are probably paying the highest tax rates in our lifetime now so I have to admit I have tunnel vision. Once we FIRE our perspective may change regarding dividend stocks as I agree cash dividends from these stocks are more predictable and may provide more piece of mind and simplicity.
Mike – Thanks for doing this, it’s really great info. I’m a little late to the party but have a couple quick questions – Wondering if you put any/much thought into the future of the business and how that goes into your buy decision? Most of your metrics are backward facing and could lead to purchasing businesses that are slowly falling out of favor. Also, have you ever missed out on a business because the valuation never got to a point that you liked, but in retrospect you should have just bought? I’m still in growth/trend mode (therefore overweight in tech) and some of the best companies I’ve purchased would have been considered overvalued by most.
Hi Josh,
So I absolutely try to think about of the future of the business. You buy for what the business will do not where it’s been. However an established business would have carved out competitive strengths in a market landscape so the thinking is would they be able to do this or not? So commodity products with a strong brand attached to it can be a predictor of consumer habits and the sustaining of those habits will be part of the business case for the business to be able to sustain. Not all companies can rely on the strength of their brand, for example Kraft Heinz (KHC) has some great brands but they are being picked off by key in store brands like Kirkland in Costco.
And for your other question, I probably did miss out on businesses with high valuations but I did buy both Nike and Visa and they were both sporting high valuations and I did well with both of them. The rule here is that if the company can sustain high growth rates for a few years they can burn off this valuation. But it’s always a trade-off. Will super sized companies like Amazon or Facebook start to slow down their monster revenue growth rates? Eventually they will have to since the world is only so big and once you get to extremely large numbers it becomes hard to have high rates of growth. When that happens the P/E normally reverts to a mature company as the market consensus realizes this and then in that case you may be looking at a share price drop that matches the burn off in valuation. If the company is not sharing any earnings via dividends you may find that it didn’t work out that well. That’s been proven wrong these past few years but that doesn’t help you forecast what will happen in the future.
-Mike
Set aside for future reference only . . . for now, just a brokerage account with the choicest ‘vanity’ stocks, reinvested. When I have nothing but time, then, not much more to be done.
MikeH, thanks so much for all this great info on dividend investing. Out of curiosity, how much did you invest in your dividend portfolio to get to the $130k in dividend income it is throwing off today?
Hi MI192,
Sorry for the delay in responding. I’ve invested close to $3M including reinvested dividends and capital gains from any positions sold.
Good luck in your own journey.
-Mike