The concept is relatively simple and involves a few easy to follow rules:
1) Accumulate a certain amount of money
2) Invest that money regularly in quality companies that pay a dividend
3) When the dividends from these income stocks exceed your expenses you are financially independent
I rarely discuss accumulating money on this site. I assume that individuals reading this article have the means to figure out means to accumulate a certain level of capital. The goal of this article is to discuss specific strategies, which will assist in investing that money until the goal of financial independence is achieved.
The goal of the dividend investor is to have a portfolio, which throws off a sufficient amount of cash to pay for their expenses. Dividends are a more stable source of returns than capital gains, which makes them an ideal source of income for retirees. While stocks are said to deliver long-term returns of 10% per year, it is not uncommon for investors to experience severe losses, followed by strong bullish moves. This roller coaster ride makes relying on total returns a very risky proposition for retired investors.
Assume that you have saved enough to have a portfolio worth $500,000, yielding 4% and growing distributions at 6% annually. This portfolio generates $20,000 in annual dividend income. If the income needs of the investor are $20,000/year, then they can easily retire. If income grows at 6% per year, the retiree will generate $21,200.
With dividends, retired investors know exactly when to expect a return on their investment. This makes planning for retirement expenses much easier. In addition, dividend payments do not fluctuate as much as the prices of common stocks. As a result, investors in dividend paying stocks receive a form of income which is stable, reliable and is deposited in your account at predictable intervals of time. In addition, because dividend stocks represent ownership in actual businesses, they can afford to raise distributions at or above the rate of inflation by simply passing on rising costs to consumers. This provides an inflation adjusted stream of income for retirees.
Dividends can get cut however. To minimize this risk, investors need to be diversified and only purchase the right stocks after rigorous screening criteria. Investors need to have a diversified income portfolio consisting of at least 30 individual stocks from as many sectors and countries as possible, without sacrificing quality of the positions of course. Investors also need to purchase stocks which are priced attractively and have the right competitive advantages to ensure their business model will keep delivering in the future. Even if a dividend cut occurs, investors should act quickly and replace this stock with another candidate, in order to minimize any further downside risk to that share of their portfolio dividend income. Chasing yield and focusing only on the highest yielding sectors will certainly lead to problems for yield chasing gamblers.
Accumulating dividend stocks is a long term process. The type of stocks I tend to invest in have wide moats, long histories of dividend increases, attractive valuations and multi-national operations. Four such examples include:
Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. This dividend aristocrat has raised distributions for 40 years in a row and has a ten year dividend growth rate of 8.70%/year. Yield: 3.10% (analysis)
Johnson & Johnson (JNJ) engages in the research, development, manufacture, and sale of various products in the health care field worldwide. This dividend aristocrat has raised distributions for 50 years in a row and has a ten year dividend growth rate of 12.40%/year. Yield: 3.60% (analysis)
McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. This dividend aristocrat has raised distributions for 35 years in a row and has a ten year dividend growth rate of 27.40%/year. Yield: 3.10% (analysis)
PepsiCo, Inc. (PEP) engages in the manufacture and sale of snacks, carbonated and non-carbonated beverages, dairy products, and other foods worldwide. It operates in four divisions: PepsiCo Americas Foods (PAF); PepsiCo Americas Beverages (PAB); PepsiCo Europe; and PepsiCo Asia, Middle East, and Africa (AMEA). This dividend aristocrat has raised distributions for 40 years in a row and has a ten year dividend growth rate of 13.30%/year. Yield: 3.10% (analysis)
Full Disclosure: Long all stocks listed above
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