Let’s do ‘Dividends 101’ first, just in case there are some who are wondering ‘what exactly are dividends?’ A dividend is a distribution of real money that is made by a company to the owners of shares of common stock of that company. The company makes sure that you, because you have an ownership stake in the company, get paid some actual cash from time to time. Why do dividends matter? They just do. Oh … you don’t believe me? Well, for one thing they are a real good indicator of a company’s commitment to handling the money responsibly. If the company pays a good, growing, and reliable dividend, it says volumes about management’s commitment to handling the money effectively. This matters to me because, as an investor (owner), I want management to be doing its best to benefit me. Furthermore, probably my primary goal as an investor/owner is to make financial preparations for the future.
One of the attributes of our humanity is our unique ability to make reasoned plans for the future. Ok, I’ll concede that some animals possess an instinct to hoard supplies for the winter, but I’ll take the position that that is different. For the most part, people plan for the future, often in exhausting detail, trying to anticipate the gamut of worst-case and best-case scenarios. Such planning is mostly a constructive, healthy exercise, although it can sometimes become unhealthy and manifest as chronic worrying or even paranoia. Let’s agree that sensible planning for the future is largely a good thing, and that it is an acceptable part of a balanced life. Let us also take the counterpoint that refusing to do so is, by and large, foolish.
When it comes down to it, our lives may be characterized as one dauntingly complex, but fascinating, exercise of planning, preparing, and working toward the future. We want to look forward with hope toward accomplishing things that are meaningful; we want to look back with satisfaction at having realized some successes. Unavoidably, living well requires resources of many types. Any culture and its associated economy impose upon us a need for money, both as a means to acquire other resources and as a resource proxy. I express this at the risk of seeming overly materialistic and perhaps in conflict with biblical teachings to ‘live by faith.’ Allow me to take the position that I can both strive to live by faith and to exercise biblical stewardship. The two concepts are by no means mutually exclusive. They are both, in fact, part of a balanced godly life.
OK, now that we have that settled (maybe), we’ll get on with the subject of planning and managing our finances. We’ll assume that however you dispense the results of that practice is between you and God. We will also assume that you will be doing a good job of this (financial management that is) and ultimately be facing the issue of using your plentitude righteously.
Given that preamble, let me now describe my approach to the task of managing/investing my finances. Although I am now retired (spell that ‘unemployed’), let me say that I am persuaded that if I were just starting out in life I would be engaging in a start-up version of this same strategy.
Dividends are at the core of my strategy. The reasons are many:
- Dividends are bankable, real, money.
- Dividends are evidence of management commitment to doing right by the shareholders.
- Dividends are evidence of management’s commitment to conducting its financial affairs properly.
- A company with a strong dividend policy is more constrained to expend its accumulated earnings responsibly. This infers wise expenditures on growing the business, on stock buybacks, or on dividend distributions.
- The valuations of companies that are committed to dividends are historically less affected by the mood swings of the capital market. Strong dividend companies are more prone to maintain market value in the face of market crisis.
- I measure the success of my portfolio in terms of a growing dividend income stream rather than in terms of the liquidation value of the portfolio at any given time.
- Dividends are tax friendly.
- Good dividend companies will historically grow their payouts year by year. This means two boosts to the compounded growth of the dividend income I seek.
As I mentioned in an earlier post, I am persuaded to look at the ‘Stock Market’ as an opportunity for business ownership. I want to own really good businesses to make money. That’s the long and the short of it. My ownership stake in the several businesses in my portfolio is an important source of income. The two elementary ways in which I can realize income from my investments are 1) by trading stocks (buying and selling) and/or 2) by collecting dividends. I must quickly make the distinction that I am not what you might describe as a ‘trader’. Trading has its place, but only as it enables management of my portfolio.
Trading profitably (as an investment strategy) is not so easy to do, as proven by many studies that confirm that attempting to become rich by trading is an exercise in futility. Oh, yes, and then there are taxes. There are short-term capital gains taxes and there are long-term capital gains taxes (a significant consideration unless you are working within a tax sheltered account). And one thing more, the transaction costs. The broker who facilitates your buys and sells doesn’t work for free you know.
Mr. Market, being rather manic depressive, is really not very good at setting a price for a given stock. At any given time, the price may exceed what I paid or it may be less than what I paid. When the market is offering something more than I paid I can make a little money, but only if I sell the stock. If I don’t sell I really haven’t captured any profit, and the market price may not be as good to me tomorrow. If the market price declines then I’m setting on a paper loss and must wait for price recovery (unless I sell and lock in my loss, not a pleasant result). If I do sell at a profit then I need to do something with the money I have in hand as a consequence (original $$ + capital gains $$). This means that I need to find another opportunity to “buy low and sell high”. Conclusion: this use of trading is gambling (I don’t gamble).
As I said, trading does have its place, primarily as a tool for managing my portfolio. I want to buy the companies I wish to own at reasonable/bargain prices. This means that I need to know which company I want to own and why. It also means that I want to buy when the price is low relative to how it can be valued by nominal market consensus (since Mr. Market is emotionally unstable, this consensus can go haywire quite often). In any event, if I make it a practice to buy on these terms habitually, the odds favor my making money rather than losing money. This is the concept of ‘margin of safety’, which has a time tested pedigree. You violate it at your own risk.
There are times when I wish to reduce my holdings in a particular company in order to adjust my portfolio. This is another circumstance where I might wish to trade. I might sell off one position to raise cash to buy something that is more attractive for my portfolio. I might judge that overall a particular company has become too large a part of my portfolio (focused risk). Possibly things have changed for a given company such that it no longer meets my criteria for ownership. Also, the ‘margin of safety’ for a stock may have dissipated to the extent that I judge continued ownership to be too risky. In the end, as in any enterprise, the direction you take is determined by the composited picture of cost, benefit and risk impact on the portfolio. Suffice to say that portfolio management skill is of primary importance.
Ok, now let’s continue with ‘Dividends 101’. As mentioned earlier, I am looking for reliable, real, income as a benefit of my business ownership. I want to own businesses that hold the most promise of rewarding my ownership. Furthermore, I want to be able, in many cases, to reinvest the dividends to increase my dividend paying share counts. I want to be able to do this with little or no transaction expense (this expense is sometimes referred to as ‘friction’). I am persuaded that this is a time proven strategy for compounded growth of both the value of my portfolio and of the dividends being paid to me. I want this growth rate to exceed the rate of inflation as much as possible. This is not a get rich quick strategy, but it is a conservative strategy for getting very rich slowly and inevitably. Studies show that pursuing this strategy consistently for at least a couple of decades inevitably leads to very satisfactory results.
Let’s use an example here: Right now, Walmart Inc. (ticker symbol: WMT) is committing to $1.92 of dividends annually for each share of its common stock. Right now, I can buy one share of WMT for $74.58 and become entitled to that $1.92 of annual dividend income. Hmmm … that means that I can earn 2.57% on what it cost me to buy one share of WMT. When you divide the amount of dividend by what it cost you to buy that share your result (expressed as a percentage) is defined as ‘dividend yield’. Some other points to throw into the discussion here:
- I like companies that increase the dividend a significant amount each year (dividend growth). There are a certain group of really good companies that historically show a strong commitment to dividend growth. I really favor these companies. ‘Dividend growth’ puts my compounding strategy on steroids.
- When I’m able to buy shares of one of these favored companies at a bargain price, guess what, I get a better dividend yield and I also reduce my risk of losing money as an owner of that stock.
- By and large most companies pay out their dividend quarterly. That means that, for example, if the company is paying an annual dividend of $2.00 per share it will be distributing $0.50 per share every 3 months.
Let us now outline what I recommend as a prudent, conservative, getting-started strategy that offers a sound expectation of satisfactory long-term results. Remember, your objective here is to build a portfolio that will, with the passage of a couple of decades, have grown into something significant and that will give you accelerating growth year after year. Visualize a runaway train on a steady slope as a good analogy; what’s happening at first doesn’t look like much, but there comes a point at which it is really hard to stop. With that picture in mind consider the following:
- Start by opening a Roth IRA. When I got started, the Roth option was not available, but, given the opportunity to start over, I would definitely focus on a Roth IRA since you fund it with after-tax money and later you don’t need to deal with such sticky issues as paying taxes on the distributions or, uhg, ‘required minimum distributions’ (RMDs). RMDs are imposed after age 70 ½ by our beloved IRS and believe it or not you are statistically likely to become this old (and rich if you follow this strategy).
- Consistently, habitually, contribute new money to your portfolio. If you are able to make it a priority to maximize your annual IRA contributions (currently $5,500 per year) you could have a very respectable starting portfolio in 5 years or so.
- Target an ultimate portfolio of 20 to 30 excellent companies. However, an early target might be perhaps 10 really good portfolio-core companies.
- In the early phase of this program, I’d suggest that new money should be held for buys in $500 increments in order to keep transaction costs minimal as a percentage of the total. As you settle into habitual saving with increasing income, you might want to ramp up to at least $1,000 increments.
- Build your portfolio with companies that offer a dividend reinvestment program (DRIP). Work with a broker than places no restrictions on DRIP participation (e.g., I use Charles. Schwab Co., there is no limit on the number of DRIP companies in my portfolio and they enable accumulation of fractional shares). Since this strategy actually requires very little trading, I find that I would rather avoid the constraints on DRIPing that are imposed by a ‘discount’ broker in favor of the greater flexibility I’ve experienced when paying slightly more with Schwab. Perhaps the fine points of a DRIP strategy could be covered in a future blog post.
- Rinse and repeat year by year. If you were to follow this discipline for 10 or more years you could eventually find that your yearly portfolio growth from DRIP exceeds the growth attributable to the new money contributions you are making.
The following quote is attributed to Albert Einstein, a pretty bright fellow:
“compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
I’m sure that you, dear readers, understand the point that the ‘compounding’ of dividends works to your benefit as surely as the compounding of ‘interest.’
Here’s an article that builds on what I’ve been sharing here: My DGI Plan: How I Keep Investing Simple.
Some of the things alluded to in this article may not be familiar to you at this point, but are easily understood by spending a little research time on http://seekingalpha.com.
Of course, if you are one of my ‘Grands,’ I will always make time for ‘one-on-one’ to work out the details.