I have been writing about dividend investing since early 2008. I started this site in order to write down ideas on dividend investing, keep myself motivated, and make myself to do some work before putting money in dividend paying businesses.
There were not a lot of dividend investing sites back then besides mine, and only Dividends4life and The Dividend Guy are still active. The rest just dropped out, because writing about investing is time consuming. Recently, we have a lot of websites that keep on discussing personal stories of the authors, including details like their monthly income, expenses etc. Some dividend authors like Dividend Mantra have gone as far as coming out into the national spotlight.
You would never see this on the Dividend Growth Investor website however. What you would see is information related to my dividend investing strategy, dividend stock analyses, portfolio management and dividend increases. This example type of information, is really all the information you really need to succeed in the game, if you put in the effort. Actually, your effort might be the most important ingredient you need to succeed with dividend investing, now that I think about it.
The reason why I am anonymous and share little detail about myself, is because this is not and should not be important to you. I have observed how when I mention something specific about my investing, I always notice that someone is focusing on the things that should matter the least to them. This is because it is all very relative - to a cashier working at Wal-Mart, saving $5000/year might look like an impossible task, whereas a highly-compensated lawyer might just ignore anything that mentions less than $50,000. For example, an article I posted about the power of dividend reinvestment garnered some of useless comments stating that someone in their 20s cannot save $3000/month. Another article I wrote about investing in a Roth IRA generated comments that investing $200 at a time is not worth the effort. The reality is that it does not matter how much you put into your strategy, because all it matters is that you have a strategy, and you execute it consistently with the amount of capital you have at your disposal. It should not matter if you put $200/month or $3000/month in dividend paying stocks, or whether you are 25 or 65 years old. What matters is that you put some money to work when you find attractive dividend payers at reasonable prices.
I believe that dividend investing is a perfectly democratic way to earn passive income. In order to be successful, it does not matter what your age, gender, or nationality truly is. You do not have to play office politics, or focus on things that do not interest you. You do need to put in some work into it however, in order to learn how to screen for stocks, analyze companies, and build diversified portfolios over time. You also need to have an open mind, and not be subject to prejudices. This is where most investors usually struggle, because if you make up your mind in advance, then it is very hard to make the right decision, even when the data tells you what the correct answer is.
What I am trying to say is that dividend growth investing is a strategy which is bigger than a single individual. You can be successful using it, whether you put $200 or $20,000/month, and whether you are in your 20s or 60s. The core concept applies for all scenarios. Dividend growth investing is all about finding a quality company at a cheap price, which can increase earnings in order to pay growing dividends. You also want to focus on a company whose dividends are sustainable, which lowers the risk of a dividend cut. Growing dividends are important, because they allow you to maintain purchasing power of your dividend income, without having to add more capital or having to reinvest a portion of distributions back.
If you are a 50 – 60 something year old, you still need to plan at least for a 20 – 30 year retirement. As a result, focusing on a stream of income that maintains purchasing power and is sustainable should be more important than chasing the highest yield available. For a 30 something year old, you have a slightly longer period to focus on, but you should still make your investments in a way that translates into a sustainable and growing stream of dividend income for decades. For both scenarios, income investors would likely see a $1000 purchase of a stock like Exxon Mobil (XOM) as a source of $30 in annual dividend checks that will grow at or above the rate of inflation. Assuming a 7% annual growth, this income likely will double every decade.
In both age group scenarios, you are interested in purchasing assets that can provide you and your heirs with a growing and sustainable stream of income for decades to come. I am getting my inspiration behind this thesis after looking at trust funds set up to benefit people, their children and grandchildren and favorite non-profits. You never know in advance whether the 50 year old will live 50 more years, or whether the 20 year old would die in 10 years. This is why your strategy for each age group might be remarkably similar.
Of course, the fruits of dividend investing are going to go those who take the time to study it patiently, devote time to better their skill over time and effort, and build expertise over time. Just like compound interest, knowledge does accumulate over time. And, as you build you knowledge and your portfolio over time, it blends into a powerful symbiosis that turbocharges your potential. This is because as you gain scale in your investments over time through patience, smart work, perseverance and a little dose of luck, you will be able to devote more time to your investment interests. In other words, if you manage to retire using dividend investing, then you would have the time to learn more about it.
In summary, I do not think it should matter to you who I am, where I live, what my background is, or how much money I have (or make). The thing that matters is that I have a desire to follow a dividend retirement strategy, and consistently save and invest in income producing securities until the income from these investments is enough for me to retire on. This type of thinking could be applied to everyone that wishes to attain financial independence using dividend investing. My goal is not to make everyone a clone of my DGI strategy, but to provide readers with the analytical tools, frameworks and models, that would provide them with the foundation behind their future success. If you have the tools of the trade, you can paint your own masterpiece. If you choose to focus on irrelevant facts however, and draw wrong conclusions, then you will not be really helping yourself out in your investing journey.
Relevant Articles:
- Living off dividends in retirement
- Common Misconceptions about Dividend Growth Investing
- Why most dividend investors never succeed
- How to accumulate your nest egg
- Dividend Investing – Science versus Intuition
This article was featured in the Carnival of Wealth
Wednesday, October 30, 2013
Monday, October 28, 2013
Nine Dividend Paying Stocks I Accumulated in the Past Month
My 2013 Roth IRA experiment continued on, with the purchase of nine additional dividend paying stocks. With this experiment, I am trying to prove that it is possible to create a diversified dividend portfolio even if you only had a few thousand dollars to invest, by holding great businesses for the long term. I am also proving a point that almost anyone can start investing in dividend paying stocks, and not have to pay high commissions in the process. With my Sharebuilder account, I am going to essentially end up paying slightly less than 0.50% of total contributions. ($24 in commissions to invest $5,500). Another goal for this experiment is that investors who are just starting out should not be discouraged from investing and should not despise the days of small beginnings.
While the original ten securities were purchased in one transaction in early September, for the second month I tried to space it out a few times a week. The goal of building a portfolio is to build it over time and slowly. It should not matter if you are investing $5.5 million or $5,500 – the principle of accumulating attractive dividend paying stocks over time, and building a portfolio of quality companies is the same in both situations.
The companies I invested in over the past month include:
Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The company was beaten down by negative comments from an analyst whose motives seem highly questionable. I viewed this as an opportunity to acquire shares in a business that owns general partner interests and holds units in two master limited partnerships – Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB). Because of the general partner arrangement, I expect Kinder Morgan Inc to be able to grow dividends by 9 – 10%/year for the foreseeable future. Add in to that the high current yield of 4.60% and the fact that its CEO has almost all of their net worth in the stock, and I think I have a winner.
Altria Group, Inc. (MO), through its subsidiaries, engages in the manufacture and sale of cigarettes, smokeless products, and wine in the United States and internationally. I found this domestic tobacco stocks to be cheap at 16.60 times earnings and yielding 5.40%. The company has been able to grow dividends by 10.60%/year since it spun-off Phillip Morris International (PM) in 2008. While number of smokers declines every year, the prices per pack increase. This leads to growing profits in an industry that squeezes out efficiencies and cannot spend money to advertise its products. Hence it is tough for new entrants into the market, leading to hefty returns for shareholders. Check my analysis of Altria for more details.
International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. The company was much cheaper at times earnings than competitors like Accenture (ACN) although its yield is low at about 2%. This dividend achiever has managed to boost distributions for years in a row. The good client relationships are generating rising profits, which are expected to reach $20/share by 2015. I bought the stock twice for the ROTH portfolio.In addition, I also added to my existing IBM position in taxable accounts. One was before the dip two weeks ago, and the other time was after it. Check my analysis of IBM for more details.
BP p.l.c. (BP) provides fuel for transportation, energy for heat and light, lubricants to engines, and petrochemicals products. is one of the most underloved oil companies out there. It is trading at a forward P/E of 9.70 and with one of the highest current yields of 5%. The company has only raised dividends since the cut in 2010, and everyone is scared that the Gulf of Mexico incident in 2010 might bankrupt it. I think those fears are irrational, and I also initiated a position in my taxable accounts as well.
Vodafone Group Public Limited Company (VOD) provides mobile telecommunication services worldwide. Vodafone is selling its 45% stake in Verizon Wireless to Verizon for $130 billion. Currently, Vodafones entire market capitalization is approximately $170 billion. While investors will receive some cash consideration and stock in Verizon wireless after the sale is completed in 2014, I believe that the remaining business for Vodafone is still very undervalued. Given the status of a dividend achiever, attractive valuation at 14.50 times earnings, and the high yield of 5.60%, I like the company. I also believe that the company has a lot of potential. Once Europe gets it mess together, Vodafone might really shine in your portfolio. Check my analysis of Vodafone.
General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. I initiated a position in General Mills, which had good valuation at the time. I like the revenue and earnings stability of food companies, and the almost complete lack of exposure to the cyclical whims of the economy. Companies like General Mills have strong brands that consumers purchase repeatedly throughout the course of the year. It is not surprising that even if the economy does not do well, people still need to eat. This dividend achiever has raised distributions for a decade, yields 3.10% and trades at 17.20 forward earnings. Check my analysis of General Mills.
I also bought shares in Kellogg (K) for the Roth IRA portfolio, using the same logic that I used for General Mills. Food staples usually grow at a steady rate, have quality brands, and manage to reward shareholders with rising dividends over time. I was particularly attracted by Kellogg, because the earnings figures in most financial databases do not show the true earnings power of the company. My Yahoo finance screen shows that Kellogg is trading at 23.90 times earnings. Therefore, a lot of investors are likely ignoring this stock, because they think it is too expensive. However, the company is expected to earn $3.77/share in 2013. At current prices, this translates to a P/E of 16.60.
Unilever PLC (UL) operates as a fast-moving consumer goods company in Asia, Africa, the Middle East, Turkey, Europe, and the Americas. I used the dip early in the month to acquire some more consumer staples in the Roth Portfolio. Unilever is a good candidate for a long-term buy and forget holding, because of the broad diversity of staples it offers on a global scale. I like the steady growth in earnings, distributions, although I would prefer P/E ratios below 16- 17 for companies like Unilever. This international dividend achiever has rewarded shareholders with rising dividends for 14 years in a row. When looking at international stocks, one needs to look at dividend growth in local currency, not US dollars. The company is under the radar, as David Fish has erroneously removed it from his list, probably because of his focus on US dollar dividends, not in their value in Euros. Currently, it trades at a P/E of 19 and yields 3.50%. Check my analysis of Unilever.
Clorox (CLX)is the purchase in the Roth, which is the most questionable one. I like the company a lot, its history of raising dividends for 36 years in a row, and the ten year dividend growth at 11.30%/year. Unfortunately, the stock is trading at the very high points of the acceptable entry valuation I am willing to pay for a dividend paying stock. I would much rather pay 15 times earnings for this stock, like I did when I accumulated my position in the company in taxable accounts over the past five years. However, I believe that a quality business like Clorox can churn out an ever rising stream of earnings, that would result in rising dividends to me for decades to come. The stock is trading at 19.40 times forward earnings, and yields 3.30%. Check my analysis of Clorox.
I plan on doing a few more trades by the end of November, after which I won’t make any contributions to this account until sometime in 2014.
This is just an illustration of what one can do even with small amounts of money. It is not a recommendation to buy these stocks however. I also invest my funds in slightly different lots, typically at $2,000/position these days. However, when I started building my dividend portfolios, my position size was $100/stock. If I can cover 50 – 60% of expenses with dividend paying stocks, so can you!
Full Disclosure: Long all companies listed in this article. (except ACN and EPB)
Relevant Articles:
- Ten Dividend Paying Stocks I purchased in September
- Two dividend payers I recently purchased for my taxable accounts
- Undervalued Dividend Stocks I purchased in the past week
- My Retirement Strategy for Tax-Free Income
- Check the Complete Article Archive
While the original ten securities were purchased in one transaction in early September, for the second month I tried to space it out a few times a week. The goal of building a portfolio is to build it over time and slowly. It should not matter if you are investing $5.5 million or $5,500 – the principle of accumulating attractive dividend paying stocks over time, and building a portfolio of quality companies is the same in both situations.
The companies I invested in over the past month include:
Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The company was beaten down by negative comments from an analyst whose motives seem highly questionable. I viewed this as an opportunity to acquire shares in a business that owns general partner interests and holds units in two master limited partnerships – Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB). Because of the general partner arrangement, I expect Kinder Morgan Inc to be able to grow dividends by 9 – 10%/year for the foreseeable future. Add in to that the high current yield of 4.60% and the fact that its CEO has almost all of their net worth in the stock, and I think I have a winner.
Altria Group, Inc. (MO), through its subsidiaries, engages in the manufacture and sale of cigarettes, smokeless products, and wine in the United States and internationally. I found this domestic tobacco stocks to be cheap at 16.60 times earnings and yielding 5.40%. The company has been able to grow dividends by 10.60%/year since it spun-off Phillip Morris International (PM) in 2008. While number of smokers declines every year, the prices per pack increase. This leads to growing profits in an industry that squeezes out efficiencies and cannot spend money to advertise its products. Hence it is tough for new entrants into the market, leading to hefty returns for shareholders. Check my analysis of Altria for more details.
International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. The company was much cheaper at times earnings than competitors like Accenture (ACN) although its yield is low at about 2%. This dividend achiever has managed to boost distributions for years in a row. The good client relationships are generating rising profits, which are expected to reach $20/share by 2015. I bought the stock twice for the ROTH portfolio.In addition, I also added to my existing IBM position in taxable accounts. One was before the dip two weeks ago, and the other time was after it. Check my analysis of IBM for more details.
BP p.l.c. (BP) provides fuel for transportation, energy for heat and light, lubricants to engines, and petrochemicals products. is one of the most underloved oil companies out there. It is trading at a forward P/E of 9.70 and with one of the highest current yields of 5%. The company has only raised dividends since the cut in 2010, and everyone is scared that the Gulf of Mexico incident in 2010 might bankrupt it. I think those fears are irrational, and I also initiated a position in my taxable accounts as well.
Vodafone Group Public Limited Company (VOD) provides mobile telecommunication services worldwide. Vodafone is selling its 45% stake in Verizon Wireless to Verizon for $130 billion. Currently, Vodafones entire market capitalization is approximately $170 billion. While investors will receive some cash consideration and stock in Verizon wireless after the sale is completed in 2014, I believe that the remaining business for Vodafone is still very undervalued. Given the status of a dividend achiever, attractive valuation at 14.50 times earnings, and the high yield of 5.60%, I like the company. I also believe that the company has a lot of potential. Once Europe gets it mess together, Vodafone might really shine in your portfolio. Check my analysis of Vodafone.
General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. I initiated a position in General Mills, which had good valuation at the time. I like the revenue and earnings stability of food companies, and the almost complete lack of exposure to the cyclical whims of the economy. Companies like General Mills have strong brands that consumers purchase repeatedly throughout the course of the year. It is not surprising that even if the economy does not do well, people still need to eat. This dividend achiever has raised distributions for a decade, yields 3.10% and trades at 17.20 forward earnings. Check my analysis of General Mills.
I also bought shares in Kellogg (K) for the Roth IRA portfolio, using the same logic that I used for General Mills. Food staples usually grow at a steady rate, have quality brands, and manage to reward shareholders with rising dividends over time. I was particularly attracted by Kellogg, because the earnings figures in most financial databases do not show the true earnings power of the company. My Yahoo finance screen shows that Kellogg is trading at 23.90 times earnings. Therefore, a lot of investors are likely ignoring this stock, because they think it is too expensive. However, the company is expected to earn $3.77/share in 2013. At current prices, this translates to a P/E of 16.60.
Unilever PLC (UL) operates as a fast-moving consumer goods company in Asia, Africa, the Middle East, Turkey, Europe, and the Americas. I used the dip early in the month to acquire some more consumer staples in the Roth Portfolio. Unilever is a good candidate for a long-term buy and forget holding, because of the broad diversity of staples it offers on a global scale. I like the steady growth in earnings, distributions, although I would prefer P/E ratios below 16- 17 for companies like Unilever. This international dividend achiever has rewarded shareholders with rising dividends for 14 years in a row. When looking at international stocks, one needs to look at dividend growth in local currency, not US dollars. The company is under the radar, as David Fish has erroneously removed it from his list, probably because of his focus on US dollar dividends, not in their value in Euros. Currently, it trades at a P/E of 19 and yields 3.50%. Check my analysis of Unilever.
Clorox (CLX)is the purchase in the Roth, which is the most questionable one. I like the company a lot, its history of raising dividends for 36 years in a row, and the ten year dividend growth at 11.30%/year. Unfortunately, the stock is trading at the very high points of the acceptable entry valuation I am willing to pay for a dividend paying stock. I would much rather pay 15 times earnings for this stock, like I did when I accumulated my position in the company in taxable accounts over the past five years. However, I believe that a quality business like Clorox can churn out an ever rising stream of earnings, that would result in rising dividends to me for decades to come. The stock is trading at 19.40 times forward earnings, and yields 3.30%. Check my analysis of Clorox.
I plan on doing a few more trades by the end of November, after which I won’t make any contributions to this account until sometime in 2014.
This is just an illustration of what one can do even with small amounts of money. It is not a recommendation to buy these stocks however. I also invest my funds in slightly different lots, typically at $2,000/position these days. However, when I started building my dividend portfolios, my position size was $100/stock. If I can cover 50 – 60% of expenses with dividend paying stocks, so can you!
Full Disclosure: Long all companies listed in this article. (except ACN and EPB)
Relevant Articles:
- Ten Dividend Paying Stocks I purchased in September
- Two dividend payers I recently purchased for my taxable accounts
- Undervalued Dividend Stocks I purchased in the past week
- My Retirement Strategy for Tax-Free Income
- Check the Complete Article Archive
Friday, October 25, 2013
My Retirement Strategy for Tax-Free Income
This is the last article on taxes for the week. Hopefully you enjoyed articles one, two, three and now four. Please make sure to read the other three articles, before checking this one, because it is a continuation of them all.
In my retirement strategy, I currently have the bulk of my funds in taxable brokerage accounts. They are producing approximately enough dividend income to cover 50 - 60% of my annual expenses. As I am maxing out 401 (k), Sep IRA and Roth IRAcontributions this year, this leaves less to be put towards my taxable dividend portfolios. The tax savings are more than worth it however. If I were a fan of Early Retirement Extreme and worked for 4 years, while saving $17,500/year in a 401 (K), the tax benefits would be equivalent to me working over one whole year. I would end up with a total of $17,500 in savings in a taxable account merely because of my marginal tax rate of 25%. This is in addition to having the contributions for four years in the 401 (k).
I expect to be able to not have to work in a traditional job environment by the end of 2018. By this time, my dividend income would likely be covering 100% of my expenses. This is because I expect dividend growth of 6 – 7% in my dividend portfolio, which continues to be reinvested in dividend paying stocks whose average yield is somewhere in the 3% - 4% range. Currently, it covers approximately 50 – 60% of expenses.
I am also expecting that I would earn some money on the side in a 1099 capacity after my retirement date, although I am not counting on it. Of course, if I have all the free time in the world, chances are I could write a book on dividend investing, start a stock picking paid service, create and run a low cost dividend mutual fund or start a TV show on dividend investing ( to name a few possible items). Or I could get really bored and start advising persons on financial and tax matters for a fee. This extra income however, would not be spent but merely end up accumulating. Since I would consider myself retired, and already have dividends covering my income, this would mean that some of my assets would need to be put in a tax deferred account today. Otherwise, I would be drowning in cash, and would be paying too much to the tax person for years. For example, if I make $24,000 in annual dividend income, and $24,000 in contracting income, but only need $24,000 to live on, I am essentially earning too much. If I made the dividends in a tax-deferred account, I could therefore choose to withdraw them as I please (or as I need the money to live on). It doesn’t make sense to pay taxes for dividend income I am not using, especially if it is in a taxable account. In a tax-deferred account, the money will compound tax-free for decades.
Therefore, the optimistic scenario is that I max out contributions and keep the 401 (k), Sep IRA and Roth IRA to compound tax-free for several decades. If I do not make too much money from dividends and side hustles once I retire, but enough to live on, I would start rolling over portions of my 401 (k) into a Roth IRA. I would try not to pay more than a 15% tax on that rollover. I expect that within 3 – 4 years after retirement, I should be able complete the conversion process. After that, I might also consider rolling any IRA and Sep IRA accounts over to Roth, depending on balances and my tax situation.
However, if I end up making too much from my dividend stocks and side hustles, I would likely have to simply roll those 401 (k) amounts into a regular IRA, and slowly convert it into a portfolio of dividend paying stocks. I expect it to compound tax-free for several decades, until I reach the age of 70.50 years old and have to take required minimum distributions. Since I have several decades before I hit that age, this could potentially be a large tax hit. Of course, I would much rather use any trick under my sleeve to accumulate as much cash as I can to generate as much dividend income, in order to achieve my goals of retiring early. The trade-offs are well worth it.
This is because it is much better to accumulate $17,500 in a 401 (k) in a single year, rather than accumulate only $13,125 in a taxable account for the year. In addition, I am somewhat protected from increases in tax rates on the amounts that would stay inside tax-deferred accounts. If tax rates on dividends and capital gains increased to match ordinary income rates, this could be bad for retired dividend investors. Of course, I do not know where tax rates are going to be 30 – 40 years from now, which is why I try to diversify against the risk of higher taxes by shifting some of my assets to tax deferred types of accounts.
Last but not least, I fully expect my taxable accounts to be able to cover my expenses in 4 - 5 years based on current levels, and projections for reinvestment at yields of 3 - 4 % and dividend growth of 6 - 7 %/year. The excess is going to tax deferred accounts ( 401K, Sep IRA and Roth IRA), which would likely be able to cover somewhere between 25% - 33% of expenses above 100%. This would be the reserve account in case my dividend income does not grow at or above the rate of inflation or if I experience too many dividend cuts for whatever reason. Another reason for the reserve is that I might end up spending more than I initially projected. Since I am hoping not to have to touch this "reserve fund" unless something unexpected happens, it is much better to be in a tax-deferred account, and it won't generate tax liabilities on income i don't need.
After reading all four articles on tax deferred accounts, I hope you learned the general overview of options available to you outside of taxable accounts. I also hope my take was helpful.
Addendum: My retirement strategy for tax-free income explained more thoroughly
My goal in retirement is to essentially live off dividends (qualified dividends) and pay no taxes in retirement. Using 2015 rates, a couple that is married and filing jointly will not pay any federal taxes if they earn less than $95,500 in qualified dividend income. This exercise assumes that the couple has no other source of income.
The couple will have a standard deduction of $12,600, and the personal exemptions will be $8000 ( $4000 per person), for a total of $20,600. In order to avoid paying taxes on qualified dividend income, the couple needs to make sure that they stay in the 15% marginal tax bracket. The highest income per that bracket for 2015 is $74,900. Therefore, adding $74,900 to $20,600 gets us up to $95,500.
My strategy for tax-free income is to live off qualified dividends and not pay any taxes in the process. However, I also expect to convert 401 (k) and IRA balances into Roth slowly. You can recall that I get a 25% - 30% deduction for putting money in 401 (k) and IRA today. My goal is to convert that amount in 401 (k) and IRA slowly into a Roth IRA when I retire, and to pay no taxes in the process.
How is that possible?
Let’s assume that a married couple files taxes jointly and has no other income than $74,000 in annual qualified dividends. This means they will pay no taxes on that qualified dividend income. However, if they rolled over $20,600 from an old 401 (k) into a Roth IRA, they will pay zero taxes on the conversion.
This is possible, because a 401 (k) to Roth IRA conversion creates ordinary taxable income. However, ordinary taxable income that is lower than the sum total of the standard deduction and personal exemptions creates a taxable liability of zero. The sum total of the standard deduction and personal exemptions for a married couple comes out to $20,600 for 2015. And of course, since the sum of the $20,600 IRA conversion and the $74,000 in qualified dividend income is less than $95,500, the total income stream will be tax-free at the Federal level.
Therefore, if the couple has a 401 (k) with $100,000 in it, they can expect to convert it into a Roth IRA within 5 years or so and pay no taxes in the process. This is a pretty sweet deal, because the couple likely received hefty tax breaks in saving the money into a 401 (k) in the first place. However, they converted it into a Roth IRA, which means that any future distributions from this Roth IRA will be tax-free. This is the type of deal where you get your cake and you eat it too, which is very appealing to the Dividend Growth Investor.
And to add another thing for you to think about, it is important to complete these 401 (k) to Roth IRA conversions before you start claiming Social Security benefits. This is because the addition of Social Security Benefits will increase ordinary taxable income, and could lead to paying some tax on the 401 (k)/IRA to Roth IRA conversion. In addition, it is really important that the conversion of a 401 (k)/IRA to Roth IRA occurs prior to the age of 70 and a half years, in order to avoid having to make required minimum distributions (RMD). Those Required Minimum Distributions from a 401 (k) or IRA are subject to ordinary income taxes. If you have already completed the conversion to a Roth IRA prior to the age of 70 and a half, you will not have to make required minimum distributions. This is why tax planning is so important - it can add more money for the investor, speed up the process of asset accumulation, and reduce tax expenses in retirement.
Full Disclosure: None
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend investing
- Is Dividend Mantra Wrong on Taxes?
- How to Retire Early With Tax-Advantaged Accounts
- Do not despise the days of small beginnings
- Price is what you pay, value is what you get
This article was featured on the Carnival of Wealth
In my retirement strategy, I currently have the bulk of my funds in taxable brokerage accounts. They are producing approximately enough dividend income to cover 50 - 60% of my annual expenses. As I am maxing out 401 (k), Sep IRA and Roth IRAcontributions this year, this leaves less to be put towards my taxable dividend portfolios. The tax savings are more than worth it however. If I were a fan of Early Retirement Extreme and worked for 4 years, while saving $17,500/year in a 401 (K), the tax benefits would be equivalent to me working over one whole year. I would end up with a total of $17,500 in savings in a taxable account merely because of my marginal tax rate of 25%. This is in addition to having the contributions for four years in the 401 (k).
I expect to be able to not have to work in a traditional job environment by the end of 2018. By this time, my dividend income would likely be covering 100% of my expenses. This is because I expect dividend growth of 6 – 7% in my dividend portfolio, which continues to be reinvested in dividend paying stocks whose average yield is somewhere in the 3% - 4% range. Currently, it covers approximately 50 – 60% of expenses.
I am also expecting that I would earn some money on the side in a 1099 capacity after my retirement date, although I am not counting on it. Of course, if I have all the free time in the world, chances are I could write a book on dividend investing, start a stock picking paid service, create and run a low cost dividend mutual fund or start a TV show on dividend investing ( to name a few possible items). Or I could get really bored and start advising persons on financial and tax matters for a fee. This extra income however, would not be spent but merely end up accumulating. Since I would consider myself retired, and already have dividends covering my income, this would mean that some of my assets would need to be put in a tax deferred account today. Otherwise, I would be drowning in cash, and would be paying too much to the tax person for years. For example, if I make $24,000 in annual dividend income, and $24,000 in contracting income, but only need $24,000 to live on, I am essentially earning too much. If I made the dividends in a tax-deferred account, I could therefore choose to withdraw them as I please (or as I need the money to live on). It doesn’t make sense to pay taxes for dividend income I am not using, especially if it is in a taxable account. In a tax-deferred account, the money will compound tax-free for decades.
Therefore, the optimistic scenario is that I max out contributions and keep the 401 (k), Sep IRA and Roth IRA to compound tax-free for several decades. If I do not make too much money from dividends and side hustles once I retire, but enough to live on, I would start rolling over portions of my 401 (k) into a Roth IRA. I would try not to pay more than a 15% tax on that rollover. I expect that within 3 – 4 years after retirement, I should be able complete the conversion process. After that, I might also consider rolling any IRA and Sep IRA accounts over to Roth, depending on balances and my tax situation.
However, if I end up making too much from my dividend stocks and side hustles, I would likely have to simply roll those 401 (k) amounts into a regular IRA, and slowly convert it into a portfolio of dividend paying stocks. I expect it to compound tax-free for several decades, until I reach the age of 70.50 years old and have to take required minimum distributions. Since I have several decades before I hit that age, this could potentially be a large tax hit. Of course, I would much rather use any trick under my sleeve to accumulate as much cash as I can to generate as much dividend income, in order to achieve my goals of retiring early. The trade-offs are well worth it.
This is because it is much better to accumulate $17,500 in a 401 (k) in a single year, rather than accumulate only $13,125 in a taxable account for the year. In addition, I am somewhat protected from increases in tax rates on the amounts that would stay inside tax-deferred accounts. If tax rates on dividends and capital gains increased to match ordinary income rates, this could be bad for retired dividend investors. Of course, I do not know where tax rates are going to be 30 – 40 years from now, which is why I try to diversify against the risk of higher taxes by shifting some of my assets to tax deferred types of accounts.
Last but not least, I fully expect my taxable accounts to be able to cover my expenses in 4 - 5 years based on current levels, and projections for reinvestment at yields of 3 - 4 % and dividend growth of 6 - 7 %/year. The excess is going to tax deferred accounts ( 401K, Sep IRA and Roth IRA), which would likely be able to cover somewhere between 25% - 33% of expenses above 100%. This would be the reserve account in case my dividend income does not grow at or above the rate of inflation or if I experience too many dividend cuts for whatever reason. Another reason for the reserve is that I might end up spending more than I initially projected. Since I am hoping not to have to touch this "reserve fund" unless something unexpected happens, it is much better to be in a tax-deferred account, and it won't generate tax liabilities on income i don't need.
After reading all four articles on tax deferred accounts, I hope you learned the general overview of options available to you outside of taxable accounts. I also hope my take was helpful.
Addendum: My retirement strategy for tax-free income explained more thoroughly
My goal in retirement is to essentially live off dividends (qualified dividends) and pay no taxes in retirement. Using 2015 rates, a couple that is married and filing jointly will not pay any federal taxes if they earn less than $95,500 in qualified dividend income. This exercise assumes that the couple has no other source of income.
The couple will have a standard deduction of $12,600, and the personal exemptions will be $8000 ( $4000 per person), for a total of $20,600. In order to avoid paying taxes on qualified dividend income, the couple needs to make sure that they stay in the 15% marginal tax bracket. The highest income per that bracket for 2015 is $74,900. Therefore, adding $74,900 to $20,600 gets us up to $95,500.
My strategy for tax-free income is to live off qualified dividends and not pay any taxes in the process. However, I also expect to convert 401 (k) and IRA balances into Roth slowly. You can recall that I get a 25% - 30% deduction for putting money in 401 (k) and IRA today. My goal is to convert that amount in 401 (k) and IRA slowly into a Roth IRA when I retire, and to pay no taxes in the process.
How is that possible?
Let’s assume that a married couple files taxes jointly and has no other income than $74,000 in annual qualified dividends. This means they will pay no taxes on that qualified dividend income. However, if they rolled over $20,600 from an old 401 (k) into a Roth IRA, they will pay zero taxes on the conversion.
This is possible, because a 401 (k) to Roth IRA conversion creates ordinary taxable income. However, ordinary taxable income that is lower than the sum total of the standard deduction and personal exemptions creates a taxable liability of zero. The sum total of the standard deduction and personal exemptions for a married couple comes out to $20,600 for 2015. And of course, since the sum of the $20,600 IRA conversion and the $74,000 in qualified dividend income is less than $95,500, the total income stream will be tax-free at the Federal level.
Therefore, if the couple has a 401 (k) with $100,000 in it, they can expect to convert it into a Roth IRA within 5 years or so and pay no taxes in the process. This is a pretty sweet deal, because the couple likely received hefty tax breaks in saving the money into a 401 (k) in the first place. However, they converted it into a Roth IRA, which means that any future distributions from this Roth IRA will be tax-free. This is the type of deal where you get your cake and you eat it too, which is very appealing to the Dividend Growth Investor.
And to add another thing for you to think about, it is important to complete these 401 (k) to Roth IRA conversions before you start claiming Social Security benefits. This is because the addition of Social Security Benefits will increase ordinary taxable income, and could lead to paying some tax on the 401 (k)/IRA to Roth IRA conversion. In addition, it is really important that the conversion of a 401 (k)/IRA to Roth IRA occurs prior to the age of 70 and a half years, in order to avoid having to make required minimum distributions (RMD). Those Required Minimum Distributions from a 401 (k) or IRA are subject to ordinary income taxes. If you have already completed the conversion to a Roth IRA prior to the age of 70 and a half, you will not have to make required minimum distributions. This is why tax planning is so important - it can add more money for the investor, speed up the process of asset accumulation, and reduce tax expenses in retirement.
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend investing
- Is Dividend Mantra Wrong on Taxes?
- How to Retire Early With Tax-Advantaged Accounts
- Do not despise the days of small beginnings
- Price is what you pay, value is what you get
This article was featured on the Carnival of Wealth
Thursday, October 24, 2013
How to Retire Early With Tax-Advantaged Accounts
This is the third article on my series on how to retire early with tax-advantaged accounts. Be sure to check the first article and the second article, before reading this one, as it is a continuation of my ideas already presented there. Stay tuned for the fourth article later on this week.
With 401 (k) accounts, you can withdraw money penalty-free after the age of 55, penalty free. With IRA and Roth IRA accounts, you can withdraw money penalty-free after the age of 59.5 years. You can withdraw only contributions but not earnings from Roth IRA without penalty before the age of 59.50 years. Otherwise, a 10% penalty applies, unless Substantially Equal Periodic Payments (SEPP) are selected.
If you choose to retire early, but you have found an accidental income source that pays for your bills, you might decide that you can simply leave your tax-deferred accounts there to grow tax free for decades. This would be interrupted by age 70.5, when you would have to pay required minimum distributions for 401 (k) and IRA's, which increase as you age. As a result, it might make sense to roll-over some of that 401 (k) or IRA money into a Roth IRA. When you do that, you might have to pay ordinary income taxes on the amounts you convert to a Roth IRA. You can also, convert just a portion of your 401 (k) or IRA balance over to a Roth IRA, in order to minimize the tax hit.
For example, lets assume you needed $24,000 to live on annually, and you manage to somehow earn that in your retirement years from side-gigs. Let's assume that you have $50,000 in your 401 (k) plan. If all else is equal, you can essentially convert approximately $12,500 from your 401 (k) into a Roth IRA for four years in a row, and end up paying a 15% marginal tax rate on the conversion amount. The distributions from your Roth IRA will grow tax-free for as long as you live, and you would never have to withdraw them. Once you are eligible to withdraw them however after the age of 59.5 years old, the distributions would be tax free.
This means that if you contributed to a 401 (k) or a tax deductible IRA and you were paying more than a 25% tax at the Federal level, it would be very beneficial to convert to a Roth IRA, especially if you can pay a tax rate that is much lower than 25% on the conversion. Your money will grow tax free in the Roth, you would have the option to buy US securities traded on NYSE, Nasdaq or Amex, and your distributions would be essentially tax free when you are eligible to withdraw them.
There is also an exception related to Roth IRA accounts, when you made a conversion from a regular IRA or a 401 (k) and paid taxes on the converted amount. You can essentially withdraw the amount of the contribution you made to the Roth at the time of conversion after five years from the conversion. For example, if you converted a $1000 IRA into a Roth in 2000, you can withdraw that $1000 tax-free in 2006.
With a Roth IRA, you can essentially put up to $5,500 per year, if you are under the age of 50. This money grows tax-free for decades, and you never have to distribute it. When you are eligible to distribute all the money from the Roth ( typically after you are 59.5 years old), you won’t owe any taxes on it. There is also this nice little thing about Roth IRA’s, where you can withdraw your contributions, but not earnings, prior to age of 59.50 years old, without paying any penalties. The real issue with regular Roth IRA’s is that it would take at least 10 – 15 years, before you can accumulate $100,000 in your account. Therefore, the way to attain critical mass with this account is through a rollover of a 401 (k), regular IRA or through a long period of contributing.
Check my last article on the topic.
Full Disclosure: None
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend Investments
- Is Dividend Mantra Wrong on Taxes?
- Roth IRA’s for Dividend Investors
- Six Dividend Paying Stocks I Purchased for my IRA
With 401 (k) accounts, you can withdraw money penalty-free after the age of 55, penalty free. With IRA and Roth IRA accounts, you can withdraw money penalty-free after the age of 59.5 years. You can withdraw only contributions but not earnings from Roth IRA without penalty before the age of 59.50 years. Otherwise, a 10% penalty applies, unless Substantially Equal Periodic Payments (SEPP) are selected.
If you choose to retire early, but you have found an accidental income source that pays for your bills, you might decide that you can simply leave your tax-deferred accounts there to grow tax free for decades. This would be interrupted by age 70.5, when you would have to pay required minimum distributions for 401 (k) and IRA's, which increase as you age. As a result, it might make sense to roll-over some of that 401 (k) or IRA money into a Roth IRA. When you do that, you might have to pay ordinary income taxes on the amounts you convert to a Roth IRA. You can also, convert just a portion of your 401 (k) or IRA balance over to a Roth IRA, in order to minimize the tax hit.
For example, lets assume you needed $24,000 to live on annually, and you manage to somehow earn that in your retirement years from side-gigs. Let's assume that you have $50,000 in your 401 (k) plan. If all else is equal, you can essentially convert approximately $12,500 from your 401 (k) into a Roth IRA for four years in a row, and end up paying a 15% marginal tax rate on the conversion amount. The distributions from your Roth IRA will grow tax-free for as long as you live, and you would never have to withdraw them. Once you are eligible to withdraw them however after the age of 59.5 years old, the distributions would be tax free.
This means that if you contributed to a 401 (k) or a tax deductible IRA and you were paying more than a 25% tax at the Federal level, it would be very beneficial to convert to a Roth IRA, especially if you can pay a tax rate that is much lower than 25% on the conversion. Your money will grow tax free in the Roth, you would have the option to buy US securities traded on NYSE, Nasdaq or Amex, and your distributions would be essentially tax free when you are eligible to withdraw them.
There is also an exception related to Roth IRA accounts, when you made a conversion from a regular IRA or a 401 (k) and paid taxes on the converted amount. You can essentially withdraw the amount of the contribution you made to the Roth at the time of conversion after five years from the conversion. For example, if you converted a $1000 IRA into a Roth in 2000, you can withdraw that $1000 tax-free in 2006.
With a Roth IRA, you can essentially put up to $5,500 per year, if you are under the age of 50. This money grows tax-free for decades, and you never have to distribute it. When you are eligible to distribute all the money from the Roth ( typically after you are 59.5 years old), you won’t owe any taxes on it. There is also this nice little thing about Roth IRA’s, where you can withdraw your contributions, but not earnings, prior to age of 59.50 years old, without paying any penalties. The real issue with regular Roth IRA’s is that it would take at least 10 – 15 years, before you can accumulate $100,000 in your account. Therefore, the way to attain critical mass with this account is through a rollover of a 401 (k), regular IRA or through a long period of contributing.
Check my last article on the topic.
Full Disclosure: None
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend Investments
- Is Dividend Mantra Wrong on Taxes?
- Roth IRA’s for Dividend Investors
- Six Dividend Paying Stocks I Purchased for my IRA
Wednesday, October 23, 2013
Is Dividend Mantra Wrong on Taxes?
This is the second article in my three-article series on deferring taxes in order to achieve early retirement. Please read my first article on the topic, as this one is a continuation of it.
The problem with my thesis is that $13,125 in a taxable account that yields 3% will generate $393.75 in annual dividend income that’s taxed at 15%. The net income is $334.69 if you collect the dividend income while you are working. If you do not have any taxable income, you would keep the whole $393.75 in dividend income, without paying any taxes. If the $17,500 that is invested in the 401 (k) will earn $525/year at 3%, that income will be tax deferred. However, if you wanted to access this amount before the age of 55 for 401 (k) and before the age of 59.5 if you converted to an IRA, you would pay a 10% early withdrawal penalty in addition to 25% if your taxable income is over $36,250. This translates into $354.37 in net dividend income if you paid taxes while you are working and you are younger than 55 years old. If you have zero taxable income however, you would only end up paying a 10% early withholding penalty, so would you end up with $472.50 in annual income to spend. As you can see, the savings add up really quickly in a tax deferred account. Those savings can result in higher distribution incomes for you to enjoy in your retirement.
Now, if at the time you retire you are over the age of 55 ( for 401K) or 59.5 (for IRA’s) or if you choose to do Substantially Equal Periodic Payments (Check Financial Samurai’s article on those), you can essentially avoid paying the 10% early withdrawal penalty. Therefore, for income under $10,000/year for singles, you would not owe any taxes whatsoever. If your taxable income is less than $36,250 for single individuals or under $72,500 for married individuals, you would pay 15% at current marginal tax rates. Therefore, if you are paying a 25% marginal tax rate today, and you expect to be earning less in your early retirement at say 10% or 15%, it makes perfect sense to use tax-deferred accounts to save. You would essentially be playing tax arbitrage, and be able to accumulate more investable assets to your name. More money on your name could potentially result in more income, when compared to a pure taxable investing only strategy with the same investments in focus.
The problem with my thesis is that 401 (k) plans are not available for all employees. In addition, 401 (k) plans are very restrictive about the types of investments you can make in them. In the case that 401 (k) plans are not available for you, you can put $5,500 in a tax- deductible IRA for singles or married taxpayers whose spouse is also not covered by a retirement plan at work. If you had managed to find a spouse who is covered by a retirement plan at work, you need to be making less than $178,000 in annual income. Otherwise, you cannot get a tax break by contributing in an IRA. With IRA’s you can put less than the amount of 401 (k) plans, but you have the option of investing in any security you want.
With 401 (k) plans, you might be stuck with high fee mutual funds, which could also be doing much worse than your plain vanilla index fund. Depending on the types of investments available in your 401 (k) plan, and the time you plan on holding on to that plan, it might not make sense to use this form of tax-advantaged savings. In most cases however, it might still make sense to do 401 (k) investing, even with a mutual fund where you pay 1% in annual management fees, mostly due to the steep tax savings you are making. It would especially make sense if you plan on rolling that 401 (k) money into an IRA within 5 years or so.
If your plan offers low cost index funds, it might be worth it to stick with them if you have only a few years prior to retirement. After you retire, you can convert this 401 (k) into an IRA, and buy the best dividend paying stocks.
Stay tuned for the third installment of this tax series tomorrow.
Full Disclosure: None
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend Investments
- Roth IRA’s for Dividend Investors
- Six Dividend Paying Stocks I Purchased for my IRA
- Twenty Dividend Stocks I Recently Purchased for my 401 (k) Rollover
- Eleven Dividend Paying Stocks I Purchased Last Week
The problem with my thesis is that $13,125 in a taxable account that yields 3% will generate $393.75 in annual dividend income that’s taxed at 15%. The net income is $334.69 if you collect the dividend income while you are working. If you do not have any taxable income, you would keep the whole $393.75 in dividend income, without paying any taxes. If the $17,500 that is invested in the 401 (k) will earn $525/year at 3%, that income will be tax deferred. However, if you wanted to access this amount before the age of 55 for 401 (k) and before the age of 59.5 if you converted to an IRA, you would pay a 10% early withdrawal penalty in addition to 25% if your taxable income is over $36,250. This translates into $354.37 in net dividend income if you paid taxes while you are working and you are younger than 55 years old. If you have zero taxable income however, you would only end up paying a 10% early withholding penalty, so would you end up with $472.50 in annual income to spend. As you can see, the savings add up really quickly in a tax deferred account. Those savings can result in higher distribution incomes for you to enjoy in your retirement.
Now, if at the time you retire you are over the age of 55 ( for 401K) or 59.5 (for IRA’s) or if you choose to do Substantially Equal Periodic Payments (Check Financial Samurai’s article on those), you can essentially avoid paying the 10% early withdrawal penalty. Therefore, for income under $10,000/year for singles, you would not owe any taxes whatsoever. If your taxable income is less than $36,250 for single individuals or under $72,500 for married individuals, you would pay 15% at current marginal tax rates. Therefore, if you are paying a 25% marginal tax rate today, and you expect to be earning less in your early retirement at say 10% or 15%, it makes perfect sense to use tax-deferred accounts to save. You would essentially be playing tax arbitrage, and be able to accumulate more investable assets to your name. More money on your name could potentially result in more income, when compared to a pure taxable investing only strategy with the same investments in focus.
The problem with my thesis is that 401 (k) plans are not available for all employees. In addition, 401 (k) plans are very restrictive about the types of investments you can make in them. In the case that 401 (k) plans are not available for you, you can put $5,500 in a tax- deductible IRA for singles or married taxpayers whose spouse is also not covered by a retirement plan at work. If you had managed to find a spouse who is covered by a retirement plan at work, you need to be making less than $178,000 in annual income. Otherwise, you cannot get a tax break by contributing in an IRA. With IRA’s you can put less than the amount of 401 (k) plans, but you have the option of investing in any security you want.
With 401 (k) plans, you might be stuck with high fee mutual funds, which could also be doing much worse than your plain vanilla index fund. Depending on the types of investments available in your 401 (k) plan, and the time you plan on holding on to that plan, it might not make sense to use this form of tax-advantaged savings. In most cases however, it might still make sense to do 401 (k) investing, even with a mutual fund where you pay 1% in annual management fees, mostly due to the steep tax savings you are making. It would especially make sense if you plan on rolling that 401 (k) money into an IRA within 5 years or so.
If your plan offers low cost index funds, it might be worth it to stick with them if you have only a few years prior to retirement. After you retire, you can convert this 401 (k) into an IRA, and buy the best dividend paying stocks.
Stay tuned for the third installment of this tax series tomorrow.
Full Disclosure: None
Relevant Articles:
- Why I Considered Tax-Advantaged Accounts for My Dividend Investments
- Roth IRA’s for Dividend Investors
- Six Dividend Paying Stocks I Purchased for my IRA
- Twenty Dividend Stocks I Recently Purchased for my 401 (k) Rollover
- Eleven Dividend Paying Stocks I Purchased Last Week
Tuesday, October 22, 2013
Why I Considered Tax-Advantaged Accounts for My Dividend Investments
Over the course of this week, I am going to discuss taxes on investments, and using tax deferred vehicles. This is the first article of a series of three articles on the subject that will appear this week. I am not a tax adviser, and the facts I have presented as well as conclusions are derived from my personal understanding of the tax code. Any examples are made up, and are not a recommendation to do anything. As everything else you read on this site, use it for entertainment or educational purposes.
One of my favorite sites on dividend investing is written by Jason Fieber from Dividend Mantra. This is an average person, with an average income, that manages to save a very high portion of his income and then invest it in dividend paying stocks. What makes him unique, is that he shares all of the numbers behind his income, expenses, savings and investments. One of the reasons why I like his site is because I personally share a lot of similarities with him – I save a very high amount of my income, I am close to his age group, and I keep putting my hard earned money in dividend growth stocks. Just like him, I plan on retiring early.
Over the past 2 months, Jason wrote an article on why he doesn’t invest in tax-advantaged accounts. His point was that because he invests in dividend paying stocks, and because he plans on retiring at the age of 40, tax-advantaged accounts such as 401 (k) and Roth IRA’s would not work for him. Dividend paying stocks provide a source of income, which is extremely tax efficient. This is because for qualified dividend income under $36,250 for single taxpayers and under $72,500 for married filing jointly taxpayers, the effective tax rates would be zero.
I used to think exactly like him until earlier this year. I rarely mentioned this on this site before, but I do plan to be able to retire at a fairly young age. In order to do so, I have been avoiding debt like the plague, and I have lived below my means, while trying to increase my income as much as possible in the process. As a result, since 2008, I have been accumulating cash and putting it to work into dividend paying stocks in taxable accounts. So far in 2013, I expect to be able to cover 50 - 60% of expenses with dividend paying stocks.
When I paid my taxes for 2012 however, I realized that the total amount I was paying to the Federal and State governments was the highest expense in my household budget. The expense easily exceeded my housing expenses, and my transportation expenses. As a result, I realized that while I was working extremely hard to minimize expenses and increase income, I had some serious leakage in terms of taxes. This is something that websites focusing on early retirement never really mention. I find it absolutely amazing that they never go there. I find it weird, because some people are willing to take sacrifices in making their own toothpaste, wait for buses in the rain, or forego paying for health insurance, or work over 50 hours/week at a job they detest, while having the largest expense in the form of income taxes to Federal, State and City governments.
In my case, this leakage meant that $30 of every $100 I made over a certain threshold went to taxes. This made it much more difficult to accumulate assets. In retrospect, since my income has been increasing over the past six years, I did not pay attention to this phenomenon. Now that I am planning on trying to be able to become financially independent in five years, I am trying to find innovative ways to increase income, keep as much as I can, since you can only cut costs so far. If I could somehow minimize the tax bite out of my earnings, I could be able to amass much more in assets, which could translate into higher levels of dividend income over time for me. After all, if I earned $70 after paying $30 in taxes, and put it into a dividend stock that pays a 3% yield, I would only earn $2.10 in annual dividend income. However, if I somehow legally avoided paying $30 in taxes, I would be left with $100. This could earn $3 in annual dividend income. This means that by trying to outsmart the tax person, I can end up with a 42% increase in income. If I were planning on retiring in 10 years, this tax efficient method could result in me shaving off 3 years from that journey. This could potentially mean I could retire in 7 years, rather than 10.
The solution was really easy. It is essentially something that any personal finance or investing blog has discussed at least once in their lifetime – use the tax-advantaged account to the maximum. In general, if you are a single taxpayer that has taxable income exceeding $36,250/year, you are paying a 25% marginal tax rate. If your taxable income is $53,750/year, you are essentially paying a 25% tax rate on the last $17,500 of income you make. However, if you put this money in a 401 (k) plan, you would have $17,500 to your name and you would be able to save $4,375 in annual tax expenditures. Furthermore, any gains in the investments in your 401 (k) would not be taxable, until you become 70.5 years old or until you start withdrawing these amounts.
If you spend $36,250/year, you would only be able to save $13,125 in taxable account, if your taxable income is $53,750 annually. I am ignoring FICA taxes for the purposes of calculation simplicity and because you have to pay them whether you allocate the money to a taxable or tax-deferred account. However, if you put $17,500 in a 401 (k), you would essentially end up with $17,500 to your name. If the assets you purchased yield 3%, you would essentially be earning much more in the second scenario.
Check my next article on taxes.
Full Disclosure: None
Relevant Articles:
- My dividend crossover point
- When can you retire on dividends?
- Dividend Investing Goals for 2013
- Will higher taxes bring dividend stocks down?
- Why I am not worried about the Fiscal Cliff and Dividend Tax Hikes?
One of my favorite sites on dividend investing is written by Jason Fieber from Dividend Mantra. This is an average person, with an average income, that manages to save a very high portion of his income and then invest it in dividend paying stocks. What makes him unique, is that he shares all of the numbers behind his income, expenses, savings and investments. One of the reasons why I like his site is because I personally share a lot of similarities with him – I save a very high amount of my income, I am close to his age group, and I keep putting my hard earned money in dividend growth stocks. Just like him, I plan on retiring early.
Over the past 2 months, Jason wrote an article on why he doesn’t invest in tax-advantaged accounts. His point was that because he invests in dividend paying stocks, and because he plans on retiring at the age of 40, tax-advantaged accounts such as 401 (k) and Roth IRA’s would not work for him. Dividend paying stocks provide a source of income, which is extremely tax efficient. This is because for qualified dividend income under $36,250 for single taxpayers and under $72,500 for married filing jointly taxpayers, the effective tax rates would be zero.
I used to think exactly like him until earlier this year. I rarely mentioned this on this site before, but I do plan to be able to retire at a fairly young age. In order to do so, I have been avoiding debt like the plague, and I have lived below my means, while trying to increase my income as much as possible in the process. As a result, since 2008, I have been accumulating cash and putting it to work into dividend paying stocks in taxable accounts. So far in 2013, I expect to be able to cover 50 - 60% of expenses with dividend paying stocks.
When I paid my taxes for 2012 however, I realized that the total amount I was paying to the Federal and State governments was the highest expense in my household budget. The expense easily exceeded my housing expenses, and my transportation expenses. As a result, I realized that while I was working extremely hard to minimize expenses and increase income, I had some serious leakage in terms of taxes. This is something that websites focusing on early retirement never really mention. I find it absolutely amazing that they never go there. I find it weird, because some people are willing to take sacrifices in making their own toothpaste, wait for buses in the rain, or forego paying for health insurance, or work over 50 hours/week at a job they detest, while having the largest expense in the form of income taxes to Federal, State and City governments.
In my case, this leakage meant that $30 of every $100 I made over a certain threshold went to taxes. This made it much more difficult to accumulate assets. In retrospect, since my income has been increasing over the past six years, I did not pay attention to this phenomenon. Now that I am planning on trying to be able to become financially independent in five years, I am trying to find innovative ways to increase income, keep as much as I can, since you can only cut costs so far. If I could somehow minimize the tax bite out of my earnings, I could be able to amass much more in assets, which could translate into higher levels of dividend income over time for me. After all, if I earned $70 after paying $30 in taxes, and put it into a dividend stock that pays a 3% yield, I would only earn $2.10 in annual dividend income. However, if I somehow legally avoided paying $30 in taxes, I would be left with $100. This could earn $3 in annual dividend income. This means that by trying to outsmart the tax person, I can end up with a 42% increase in income. If I were planning on retiring in 10 years, this tax efficient method could result in me shaving off 3 years from that journey. This could potentially mean I could retire in 7 years, rather than 10.
The solution was really easy. It is essentially something that any personal finance or investing blog has discussed at least once in their lifetime – use the tax-advantaged account to the maximum. In general, if you are a single taxpayer that has taxable income exceeding $36,250/year, you are paying a 25% marginal tax rate. If your taxable income is $53,750/year, you are essentially paying a 25% tax rate on the last $17,500 of income you make. However, if you put this money in a 401 (k) plan, you would have $17,500 to your name and you would be able to save $4,375 in annual tax expenditures. Furthermore, any gains in the investments in your 401 (k) would not be taxable, until you become 70.5 years old or until you start withdrawing these amounts.
If you spend $36,250/year, you would only be able to save $13,125 in taxable account, if your taxable income is $53,750 annually. I am ignoring FICA taxes for the purposes of calculation simplicity and because you have to pay them whether you allocate the money to a taxable or tax-deferred account. However, if you put $17,500 in a 401 (k), you would essentially end up with $17,500 to your name. If the assets you purchased yield 3%, you would essentially be earning much more in the second scenario.
Check my next article on taxes.
Full Disclosure: None
Relevant Articles:
- My dividend crossover point
- When can you retire on dividends?
- Dividend Investing Goals for 2013
- Will higher taxes bring dividend stocks down?
- Why I am not worried about the Fiscal Cliff and Dividend Tax Hikes?
Monday, October 21, 2013
Undervalued Dividend Stocks I purchased in the past week
In the past week I made a few stock purchases in my Roth IRA and for my taxable account. Today I am going to discuss the purchases I made in my taxable account.
I usually scan the list of dividend champions and achievers at least two times per month, in order to uncover quality that sells at cheap prices. I also have a list of stocks I own in Yahoo Finance, which I monitor each morning for headlines. Based on monitoring companies I owned with small allocations to my portfolio, and based on their relative valuation, I decided to add to them. The companies whose shares I acquired included International Business Machines (IBM) and American Realty Capital Properties (ARCP).
International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. This dividend achiever has managed to raise distributions for 18 years in a row.
Back on Thursday, I noticed that IBM stock was unduly punished to a 52 week low after supposedly missing analyst revenue growth expectations. The issue with IBM is that revenue has been growing very slowly over the past decade. However, as an investor in a business all I care about is the earnings per share that this business earns. This is because rising earnings per share provide the cornerstone behind future dividend growth. The thing I like about IBM is that its goal is to grow shareholder value, and not just chase meaningless revenues that would not translate into higher profits. As part of the company’s 2015 vision plan, it aims to earn $20/share by 2015. So far the company has been on track to achieve those goals.
IBM has also managed to consistently repurchase stock for 19 years in a row. It has reduce shares outstanding through its regular share repurchases from 2.34 billion at the end of 1994 to 1.10 billion by 2013. Further, this dividend achiever has increased distributions for 18 years in a row. Over the past decade, IBM has managed to increase dividends by 18.80%/year. If the stock price continues languishing for several years, that is good news for IBM shareholders, because that would mean that the dollars allocated for share repurchases would buy out a greater number of shares outstanding. One of the largest investors in IBM is Berkshire Hathaway (BRK.B), which is the holding company controlled by legendary investor Warren Buffett.
The stock has a low dividend above 2%, but is really cheap at 12 times 2012 earnings and 10.30 times forward 2013 earnings. Given the cheap valuation, and prospects for very good dividend growth, it is no surprise I added to my IBM position. Check my analysis of IBM.
American Realty Capital Properties, Inc. (ARCP) owns and acquires single tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment grade credit rated and other creditworthy tenants. I originally purchased shares of this REIT after selling my position in National Retail Properties early in the year.
This REIT has been public for less than two years. However, it has managed to raise its monthly dividends several times since going public in 2011. This indicates potential for shareholder friendly management. There are several things I look for in a REIT, as described in my REIT checklist.
The REIT has been rapidly expanding its portfolio of triple-net leased properties, and acquiring American Realty Capital Trust IV, a lot of other freestanding properties and is in the process of acquiring CapLease (LSE). This is a lot of M&A for one year, but it is all expected to be accretive to Funds from Operations per share. In fact, AFFO/share is expected to come at 1.14 – 1.18/share, which is substantially above the annual dividend of 94 cents/share. Based on forward valuation, this REIT is a steal at current prices.
In my checklist for REITs, I look for plans for growth, and American Realty Capital Properties does have the drive to reach the critical mass of Realty Income (O). It’s top 10 tenants account for less than one third of revenues, which are diversified across 48 states. It is surprising to find that the REIT has an almost 100% occupancy rate.
The one risk I see is that ARCP grows too quick too fast. This means that a company that grows too fast, might end up leveraging itself too much, and if the world throws it a curveball, it could derail plans for world domination. Typically when different companies are acquired or merged, there is the possibility for clash of cultures. I am not saying that this would happen, but one of the possible reasons for the cheap valuation on this REIT is that it still has a relatively unproven track record in comparison with Realty Income (O) or National Retail Properties (NNN).
That being said, it offers a yield of 7.30% that seems to be well covered from forward FFO/share. The distribution is paid monthly, and the tenant base seems pretty stable and respectable, which lowers the chance of occupancy declining.
Full disclosure: Long IBM, ARCP, O
Relevant Articles:
- Five Things to Look For in a Real Estate Investment Trust
- Are we in a REIT bubble?
- Warren Buffett’s Dividend Stock Strategy
- Dividends versus Share Buybacks/Stock repurchases
- Two dividend payers I recently purchased for my taxable accounts
I usually scan the list of dividend champions and achievers at least two times per month, in order to uncover quality that sells at cheap prices. I also have a list of stocks I own in Yahoo Finance, which I monitor each morning for headlines. Based on monitoring companies I owned with small allocations to my portfolio, and based on their relative valuation, I decided to add to them. The companies whose shares I acquired included International Business Machines (IBM) and American Realty Capital Properties (ARCP).
International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. This dividend achiever has managed to raise distributions for 18 years in a row.
Back on Thursday, I noticed that IBM stock was unduly punished to a 52 week low after supposedly missing analyst revenue growth expectations. The issue with IBM is that revenue has been growing very slowly over the past decade. However, as an investor in a business all I care about is the earnings per share that this business earns. This is because rising earnings per share provide the cornerstone behind future dividend growth. The thing I like about IBM is that its goal is to grow shareholder value, and not just chase meaningless revenues that would not translate into higher profits. As part of the company’s 2015 vision plan, it aims to earn $20/share by 2015. So far the company has been on track to achieve those goals.
IBM has also managed to consistently repurchase stock for 19 years in a row. It has reduce shares outstanding through its regular share repurchases from 2.34 billion at the end of 1994 to 1.10 billion by 2013. Further, this dividend achiever has increased distributions for 18 years in a row. Over the past decade, IBM has managed to increase dividends by 18.80%/year. If the stock price continues languishing for several years, that is good news for IBM shareholders, because that would mean that the dollars allocated for share repurchases would buy out a greater number of shares outstanding. One of the largest investors in IBM is Berkshire Hathaway (BRK.B), which is the holding company controlled by legendary investor Warren Buffett.
The stock has a low dividend above 2%, but is really cheap at 12 times 2012 earnings and 10.30 times forward 2013 earnings. Given the cheap valuation, and prospects for very good dividend growth, it is no surprise I added to my IBM position. Check my analysis of IBM.
American Realty Capital Properties, Inc. (ARCP) owns and acquires single tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment grade credit rated and other creditworthy tenants. I originally purchased shares of this REIT after selling my position in National Retail Properties early in the year.
This REIT has been public for less than two years. However, it has managed to raise its monthly dividends several times since going public in 2011. This indicates potential for shareholder friendly management. There are several things I look for in a REIT, as described in my REIT checklist.
The REIT has been rapidly expanding its portfolio of triple-net leased properties, and acquiring American Realty Capital Trust IV, a lot of other freestanding properties and is in the process of acquiring CapLease (LSE). This is a lot of M&A for one year, but it is all expected to be accretive to Funds from Operations per share. In fact, AFFO/share is expected to come at 1.14 – 1.18/share, which is substantially above the annual dividend of 94 cents/share. Based on forward valuation, this REIT is a steal at current prices.
In my checklist for REITs, I look for plans for growth, and American Realty Capital Properties does have the drive to reach the critical mass of Realty Income (O). It’s top 10 tenants account for less than one third of revenues, which are diversified across 48 states. It is surprising to find that the REIT has an almost 100% occupancy rate.
The one risk I see is that ARCP grows too quick too fast. This means that a company that grows too fast, might end up leveraging itself too much, and if the world throws it a curveball, it could derail plans for world domination. Typically when different companies are acquired or merged, there is the possibility for clash of cultures. I am not saying that this would happen, but one of the possible reasons for the cheap valuation on this REIT is that it still has a relatively unproven track record in comparison with Realty Income (O) or National Retail Properties (NNN).
That being said, it offers a yield of 7.30% that seems to be well covered from forward FFO/share. The distribution is paid monthly, and the tenant base seems pretty stable and respectable, which lowers the chance of occupancy declining.
Full disclosure: Long IBM, ARCP, O
Relevant Articles:
- Five Things to Look For in a Real Estate Investment Trust
- Are we in a REIT bubble?
- Warren Buffett’s Dividend Stock Strategy
- Dividends versus Share Buybacks/Stock repurchases
- Two dividend payers I recently purchased for my taxable accounts
Saturday, October 19, 2013
Weekly Articles on Income Investing: October 19, 2013
For your weekend reading enjoyment, I have highlighted a few interesting articles from the archives, which I find to be relevant today. The first five articles have been written and posted on this site, while the last five have been selected from other authors. I tend to post anywhere between three to four articles to my site every week. I usually try to write at least one or two articles that contain timeless information concerning dividend investing. This could include information about my strategy, or other pieces of information, which could be useful to dividend investors.
Below, I have highlighted a few articles posted on this site, which many readers have found interesting:
I read a lot about companies, and also read a lot of interesting articles from all over the web. A few that I really enjoyed over the past several months include:
- Dividend Investing Resources
- Dividend Champions Index – Five Year Total Return Performance
- S&P 8000 – The power of reinvested dividends in action
- Dividend Portfolios – concentrate or diversify?
- Five Things to Look For in a Real Estate Investment Trust
I read a lot about companies, and also read a lot of interesting articles from all over the web. A few that I really enjoyed over the past several months include:
Friday, October 18, 2013
Six Confident Dividend Increases Despite Government Turmoil
The past week was characterized by the possibility of default by the US government. Luckily, the debt ceiling debate and the possibility of US defaulting on its obligations has been postponed to early 2014. A few corporations I follow however, tend to have a more long-term view of the economy. They proved that by approving dividend increases to their shareholders. Typically, dividend growth companies that expect increases in earnings in the next two – five years tend to approve dividend increases to shareholders.
The companies that announced dividend increases so far this week include:
Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. The company raised its quarterly dividends by a whooping 57% to 22 cents/share. This marked the 41st consecutive annual dividend increase for this dividend aristocrat. In early 2013, it spun-off Abbvie (ABBV), which explains the reduction in dividend payments. Every shareholder of Abbott at 12/31/2012 received a share of Abbvie, which currently pay 40 cents/quarter. Before the spin-off, the legacy Abbott paid 51 cents/share in quarterly dividends. Therefore, I am glad I bought Abbott in late 2012, and stayed with it. My dividend income is essentially up by over 20% in this position alone. You can read more about my take on the spin-off here. The yield on Abbott Laboratories today is 2.40%.
Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. This MLP managed to raise distributions to $1.35/unit, which is an increase of 7% over the distributions paid this time in 2012. This dividend achiever has grown distributions for 17 years in a row. Over the past decade, KMP has managed to raise distributions by 7.50%/year. I have exposure to KMP through my investment in Kinder Morgan Management (KMR), which holds limited partner interests in the partnership. With KMR, I do not have to worry about K-1 filings, as distributions are received directly as partial shares, which are treated like non-taxable stock splits from a taxation standpoint. I also like the fact that KMR always trades at a discount to KMP, hence I am able to get the same exposure for a lower price. I like the consistency and length of distributions, and the yield of 6.70%. Check my analysis of Kinder Morgan Partners.
Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The general partner behind Kinder Morgan Partners and the El Paso Pipeline raised its quarterly dividends to 41 cents/share. This was a year over year increase of 14%. I expect Kinder Morgan to be able to grow dividends by 9 – 12%/year over the next several years, fueled by growth in distributable cash flows from the partnerships it manages. As a general partner, it earns 50% of incremental distributable cash flows from both Kinder Morgan Partners and El Paso Energy Pipeline. Since going public in 2011, it has not failed to disappoint investors with solid increases in dividends. Despite the fears that certain analysts are trying to create among investors, this is a solid company with a solid manager, whose wealth is tied into this entity. I like the yield of 4.70% and the solid growth prospects of the entity, which is why it is my largest holding as of 9/30.
Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, refined products, and petrochemicals in the United States and internationally. The partnership raised its quarterly distributions to 69 cents/unit, which is an increase of 6% over same time last year. The partnership is a dividend achiever, which has managed to boost distributions to loyal unit holders for fourteen years in a row. Over the past decade, it has managed to boost distributions by 6.70%/year. I made a controversial trade this year, where I sold 2/3 of my position in the partnership, and split the proceeds equally into Kinder Morgan Management (KMR), Kinder Morgan Inc (KMI) and ONEOK Partners (OKS). This was driven purely by the high valuation of EPD. In retrospect, I probably could have simply held on to Enterprise, which is a stable organization. However, even the best of us sometimes make mistakes and fail to stick to their long-term buy and hold nature. The new yield of 4.40% however is rather low, especially when Kinder Morgan Partners has slightly higher distributions growth and a much higher current yield. That being said, Enterprise is a good partnership to hold on to for the next decade, as it has some of the best distribution payout coverages in the MLP sector. Check my analysis of Enterprise Product Partners.
Omega Healthcare Investors, Inc. (OHI) operates as a real estate investment trust (REIT) in the United States. This REIT boosted quarterly distributions to 48 cents/share. The new dividend is 9.10% higher than the one paid in Q4 2012. This dividend achiever has raised distributions for ten years in a row. Over the past five years, it has managed to increase dividends by 9.40%/year. I purchased shares in the REIT in 2013, after selling my position in Universal Healthcare Realty Trust (UHT). When I analyzed this REIT a few months ago, I liked the opportunities for growth in FFO from its acquisitions strategy. I also like the fact that with Omega Healthcare I get not only a high current yield at 5.80%, but also the possibility for strong dividend growth.
Northwest Natural Gas Company (NWN) stores and distributes natural gas primarily in Oregon, Washington, and California. The company increased its quarterly dividends by 1% to 46 cents/share. This marked the 58th year of consecutive dividend increases for this dividend champion. Over the past decade, the company has managed to boost distributions by 3.60%/year. While I am a big fan of companies that can build a long streak of consecutive dividend increases, I am not a fan of anemic dividend increases simply for the sake of maintaining dividend growth streaks. If a company cannot grow dividends faster than inflation, and provide decent yields, I usually wait to enter during more advantageous times. I usually look for companies that have the capacity to grow earnings and grow dividends faster than inflation. Despite the high yield of 4.30%, I think this company is a hold at the very best.
Full Disclosure: Long KMR, ABT, ABBV, KMI, EPD, OKS, OHI
Relevant Articles:
- Should dividend investors hold on to Abbott (ABT) and Abbvie (ABBV) following the split?
- Abbott Laboratories: Quality Dividend Aristocrat for Long-Term Investors
- Five Things to Look For in a Real Estate Investment Trust
- The Dividend Kings List Keeps Expanding
- Dividend Aristocrats List
The companies that announced dividend increases so far this week include:
Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. The company raised its quarterly dividends by a whooping 57% to 22 cents/share. This marked the 41st consecutive annual dividend increase for this dividend aristocrat. In early 2013, it spun-off Abbvie (ABBV), which explains the reduction in dividend payments. Every shareholder of Abbott at 12/31/2012 received a share of Abbvie, which currently pay 40 cents/quarter. Before the spin-off, the legacy Abbott paid 51 cents/share in quarterly dividends. Therefore, I am glad I bought Abbott in late 2012, and stayed with it. My dividend income is essentially up by over 20% in this position alone. You can read more about my take on the spin-off here. The yield on Abbott Laboratories today is 2.40%.
Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. This MLP managed to raise distributions to $1.35/unit, which is an increase of 7% over the distributions paid this time in 2012. This dividend achiever has grown distributions for 17 years in a row. Over the past decade, KMP has managed to raise distributions by 7.50%/year. I have exposure to KMP through my investment in Kinder Morgan Management (KMR), which holds limited partner interests in the partnership. With KMR, I do not have to worry about K-1 filings, as distributions are received directly as partial shares, which are treated like non-taxable stock splits from a taxation standpoint. I also like the fact that KMR always trades at a discount to KMP, hence I am able to get the same exposure for a lower price. I like the consistency and length of distributions, and the yield of 6.70%. Check my analysis of Kinder Morgan Partners.
Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The general partner behind Kinder Morgan Partners and the El Paso Pipeline raised its quarterly dividends to 41 cents/share. This was a year over year increase of 14%. I expect Kinder Morgan to be able to grow dividends by 9 – 12%/year over the next several years, fueled by growth in distributable cash flows from the partnerships it manages. As a general partner, it earns 50% of incremental distributable cash flows from both Kinder Morgan Partners and El Paso Energy Pipeline. Since going public in 2011, it has not failed to disappoint investors with solid increases in dividends. Despite the fears that certain analysts are trying to create among investors, this is a solid company with a solid manager, whose wealth is tied into this entity. I like the yield of 4.70% and the solid growth prospects of the entity, which is why it is my largest holding as of 9/30.
Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, refined products, and petrochemicals in the United States and internationally. The partnership raised its quarterly distributions to 69 cents/unit, which is an increase of 6% over same time last year. The partnership is a dividend achiever, which has managed to boost distributions to loyal unit holders for fourteen years in a row. Over the past decade, it has managed to boost distributions by 6.70%/year. I made a controversial trade this year, where I sold 2/3 of my position in the partnership, and split the proceeds equally into Kinder Morgan Management (KMR), Kinder Morgan Inc (KMI) and ONEOK Partners (OKS). This was driven purely by the high valuation of EPD. In retrospect, I probably could have simply held on to Enterprise, which is a stable organization. However, even the best of us sometimes make mistakes and fail to stick to their long-term buy and hold nature. The new yield of 4.40% however is rather low, especially when Kinder Morgan Partners has slightly higher distributions growth and a much higher current yield. That being said, Enterprise is a good partnership to hold on to for the next decade, as it has some of the best distribution payout coverages in the MLP sector. Check my analysis of Enterprise Product Partners.
Omega Healthcare Investors, Inc. (OHI) operates as a real estate investment trust (REIT) in the United States. This REIT boosted quarterly distributions to 48 cents/share. The new dividend is 9.10% higher than the one paid in Q4 2012. This dividend achiever has raised distributions for ten years in a row. Over the past five years, it has managed to increase dividends by 9.40%/year. I purchased shares in the REIT in 2013, after selling my position in Universal Healthcare Realty Trust (UHT). When I analyzed this REIT a few months ago, I liked the opportunities for growth in FFO from its acquisitions strategy. I also like the fact that with Omega Healthcare I get not only a high current yield at 5.80%, but also the possibility for strong dividend growth.
Northwest Natural Gas Company (NWN) stores and distributes natural gas primarily in Oregon, Washington, and California. The company increased its quarterly dividends by 1% to 46 cents/share. This marked the 58th year of consecutive dividend increases for this dividend champion. Over the past decade, the company has managed to boost distributions by 3.60%/year. While I am a big fan of companies that can build a long streak of consecutive dividend increases, I am not a fan of anemic dividend increases simply for the sake of maintaining dividend growth streaks. If a company cannot grow dividends faster than inflation, and provide decent yields, I usually wait to enter during more advantageous times. I usually look for companies that have the capacity to grow earnings and grow dividends faster than inflation. Despite the high yield of 4.30%, I think this company is a hold at the very best.
Full Disclosure: Long KMR, ABT, ABBV, KMI, EPD, OKS, OHI
Relevant Articles:
- Should dividend investors hold on to Abbott (ABT) and Abbvie (ABBV) following the split?
- Abbott Laboratories: Quality Dividend Aristocrat for Long-Term Investors
- Five Things to Look For in a Real Estate Investment Trust
- The Dividend Kings List Keeps Expanding
- Dividend Aristocrats List
Wednesday, October 16, 2013
Should Dividend Investors be Defensive about these stocks?
Everyone knows that the US is running huge budget deficits. As a result, the US has a multi-trillion dollar debt load. Early on in 2013, we witnessed some automatic spending cuts by the Federal government, which affected government spending on defense. We are currently all witnessing the Debt Ceiling theater, which is the ultimate stupidity in the making. In addition, with the wars in Iraq and Afghanistan being close to complete, it looks like companies in the defense sector might have a tough time generating much in terms of earnings and dividend growth over the next decade.
Defense companies earn money from providing products and services for US government. If government pays them for research, and companies can use this knowledge, then this know-how could bolster prospects of earnings significantly over time. The relationship between inventions and profitability is not linear, as it takes time for an idea to come to market and reach a certain level of following, before generating profits. From a long-term perspective however, it could pay dividends for years to come.
The past decade had been tremendously profitable for defense companies such as Lockheed Martin (LMT), Raytheon (RTN), General Dynamics (GD) and Northrop Grumman (NOC). These companies enjoyed rising earnings that allowed them to bump up distributions to shareholders every year. Share prices increased as a result of the improved profitability at these corporations as well. Currently, a lot of these companies are looking attractively valued, and also have above average market yields. The question in the minds of many dividend investors is whether these companies are worth purchasing right now.
Lockheed Martin Corporation (LMT), a security and aerospace company, engages in the research, design, development, manufacture, integration, and sustainment of advanced technology systems and products for defense, civil, and commercial applications in the United States and internationally. The company derives over 80% of revenues from US government and US agencies. Approximately 18% is derived from sales to foreign governments. Lockheed Martin has raised dividends for 11 years in a row. Over the past decade, it has managed to boost distributions by 24.70%/year. The outstanding shares from decreased from 450 million in 2003 to 326 million in 2013. Analysts expect that this dividend achiever would earn $9.49/share in 2013 and $9.68/share by 2014. In contrast, it earned $8.36/share in 2012. Currently, the stock is attractively valued at 14.20 times earnings and yields 4.30%. Check my analysis of Lockheed Martin.
General Dynamics Corporation (GD), an aerospace and defense company, provides business aviation; combat vehicles, weapons systems, and munitions; military and commercial shipbuilding; and communications and information technology products and services worldwide. The company derives over 66% of revenues from US government. Approximately 13 percent of revenues are derived from international defense the remainder is from commercial customers. General Dynamics has raised dividends for 22 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 398 million in 2003 to 353 million in 2013. Analysts expect that this dividend achiever would earn $6.96/share in 2013 and $7.23/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 12.60 times forward 2013 earnings and yields 2.60%. Check my analysis of General Dynamics.
Raytheon Company (RTN), together with its subsidiaries, provides electronics, mission systems integration, and other capabilities in the areas of sensing, effects, and command, control, communications, and intelligence systems, as well as a range of mission support services in the United States and internationally. Raytheon has raised dividends for 9 years in a row. Over the past decade, it has managed to boost distributions by 25.40%/year. The outstanding shares from decreased from 415 million in 2003 to 326 million in 2013. Analysts expect that this dividend stock would earn $5.66/share in 2013 and $5.95/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 13.20 times earnings and yields 3%.
Northrop Grumman Corporation (NOC) provides systems, products, and solutions in aerospace, electronics, information systems, and technical service areas to government and commercial customers worldwide. Northrop Grumman has raised dividends for 10 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 368 million in 2003 to 238 million in 2013. The company has an open buyback facility to repurchase approximately 25% of outstanding shares by 2015. Analysts expect that this dividend achiever would earn $7.78/share in 2013 and $7.99/share by 2014. In contrast, it earned $7.81/share in 2012. Currently, the stock is attractively valued at 12.20 times earnings and yields 2.50%.
L-3 Communications Holdings, Inc. (LLL), through its subsidiary, L-3 Communications Corporation, provides command, control, communications, intelligence, surveillance, and reconnaissance (C3ISR) systems; aircraft modernization and maintenance; and national security solutions in the United States and internationally. Over 75% of revenues were derived from US Department of Defense and Government Agencies, while International Sales accounted for 19% of revenues. The remainder is generated from sales to US corporate customers. L-3 Communications has managed to increase dividends for 9 years in a row. Over the past five years, it has managed to boost distributions by 15.30%/year. The outstanding shares decreased from 127 million in 2007 to 91 million in 2013. The number of outstanding shares increased from 106 million in 2003 to 127 million in 2007, because the company has grown through acquisitions, paid for by stock and cash. L-3 Communications has an open buyback facility to repurchase approximately 20% of outstanding shares by 2015. Analysts expect that this dividend stock would earn $8.13/share in 2013 and $8.17/share by 2014. In contrast, it earned $8.30/share in 2012. Currently, the stock is attractively valued at 11.20 times forward 2013 earnings and yields 2.40%.
A company can only afford to maintain and increase dividends per share over time only through increases in earnings per share. Without earnings growth, the dividend can only grow to a certain level after which it would stagnate and lose purchasing power to inflation.
For companies like the ones mentioned in this article, a large portion of revenues are derived from the US Government or US Government Agencies. The problems with the US budget deficit are widespread. As a result, it is very possible that defense contractors would experience decreases or limits to the amount of weapons they can sell to their main customer. This could potentially lead to lower profits and dividend freezes or cuts.
Because most defense contracts are won after a competitive bidding, it might wise to acquire shares of several contractors such as Lockheed Martin, Raytheon, General Dynamics, Northrop Grumman, rather than focus on a single company. I am unable to determine which one would win the most revenues from the defense budget pile, which is why such an approach could be useful. In troubled times, I wouldn't be surprised to also see consolidations in the sector.
One positive is that companies have been able to repurchase a large portion of its stock over the past decade. A company which can consistently retire 1%-2% of shares each year, pays 4% yield and that can grow net income by 1-2%, can easily manage to grow distributions at a rate that can maintain purchasing power of the income. If the largest customer cuts their spending budget however, this yield could get axed as profitability suffers. Either way, if a company generates so much cash flow that it is able to buyback a significant amount of outstanding stock at attractive valuations, and could continue doing so, it could provide decent returns to investors. Some notable buybacks include the ones from Northrop Grumman (NOC) and L-3 Communications (LLL), which could retire as much as 20 - 25% of outstanding shares within 2- 3 years. This could also provide room for dividend increases, even if overall sales and net incomes are flat.
However, US will always need to spend money on defense, given its role as a “world cop”. The world is continuing to be a hostile place, particularly in certain hot spots such as North Korea, Iran and a few of the countries that participated in the Arab Spring in 2011.
In the long-run however, (say 20 years from now), I cannot see anything else but increases in US government spending on defense. The world would still be a hostile place, and countries need to spend on defense simply to keep up with pace of technology. This means that if you buy today, you can still experience dividend cuts five years down the road, although chances are your distributions would recover within 10 years or so. This cyclical nature of dividend booms and busts makes relying on defense dividends riskier than relying on distributions from Coca-Cola (KO).
Surprisingly, some of the best times to acquire defense companies was right after the cold war ended in 1989. Other attractive times to buy defense companies occurred right after the official end of Vietnam war in 1975.
To summarize, the major bearish factor behind defense companies is the US Government spending situation in the next few years, and the need to reduce the budget deficit and curtail the growth of national debt. This could cause stagnating or decreasing military budgets. Since the major wars the US fought over the past decade are pretty much over, this could potentially affect profitability in defense companies.
The major bullish factors include cheap valuations, and the potential for a few of those companies to repurchase massive amounts of stock at these low valuations. If I were to invest in the sector, I would focus on the companies that reduce a large portion of shares outstanding. If net income can be at least maintained, the reduction in shares would lead to increases in earnings per share, which could also result in dividend growth.
Relevant Articles:
- General Dynamics (GD) Dividend Stock Analysis
- Lockheed Martin Corporation (LMT) Dividend Stock Analysis
- Two dividend paying stocks to consider today
- Three Stages of Dividend Growth
- Share Buybacks versus Dividends
Defense companies earn money from providing products and services for US government. If government pays them for research, and companies can use this knowledge, then this know-how could bolster prospects of earnings significantly over time. The relationship between inventions and profitability is not linear, as it takes time for an idea to come to market and reach a certain level of following, before generating profits. From a long-term perspective however, it could pay dividends for years to come.
The past decade had been tremendously profitable for defense companies such as Lockheed Martin (LMT), Raytheon (RTN), General Dynamics (GD) and Northrop Grumman (NOC). These companies enjoyed rising earnings that allowed them to bump up distributions to shareholders every year. Share prices increased as a result of the improved profitability at these corporations as well. Currently, a lot of these companies are looking attractively valued, and also have above average market yields. The question in the minds of many dividend investors is whether these companies are worth purchasing right now.
Lockheed Martin Corporation (LMT), a security and aerospace company, engages in the research, design, development, manufacture, integration, and sustainment of advanced technology systems and products for defense, civil, and commercial applications in the United States and internationally. The company derives over 80% of revenues from US government and US agencies. Approximately 18% is derived from sales to foreign governments. Lockheed Martin has raised dividends for 11 years in a row. Over the past decade, it has managed to boost distributions by 24.70%/year. The outstanding shares from decreased from 450 million in 2003 to 326 million in 2013. Analysts expect that this dividend achiever would earn $9.49/share in 2013 and $9.68/share by 2014. In contrast, it earned $8.36/share in 2012. Currently, the stock is attractively valued at 14.20 times earnings and yields 4.30%. Check my analysis of Lockheed Martin.
General Dynamics Corporation (GD), an aerospace and defense company, provides business aviation; combat vehicles, weapons systems, and munitions; military and commercial shipbuilding; and communications and information technology products and services worldwide. The company derives over 66% of revenues from US government. Approximately 13 percent of revenues are derived from international defense the remainder is from commercial customers. General Dynamics has raised dividends for 22 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 398 million in 2003 to 353 million in 2013. Analysts expect that this dividend achiever would earn $6.96/share in 2013 and $7.23/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 12.60 times forward 2013 earnings and yields 2.60%. Check my analysis of General Dynamics.
Raytheon Company (RTN), together with its subsidiaries, provides electronics, mission systems integration, and other capabilities in the areas of sensing, effects, and command, control, communications, and intelligence systems, as well as a range of mission support services in the United States and internationally. Raytheon has raised dividends for 9 years in a row. Over the past decade, it has managed to boost distributions by 25.40%/year. The outstanding shares from decreased from 415 million in 2003 to 326 million in 2013. Analysts expect that this dividend stock would earn $5.66/share in 2013 and $5.95/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 13.20 times earnings and yields 3%.
Northrop Grumman Corporation (NOC) provides systems, products, and solutions in aerospace, electronics, information systems, and technical service areas to government and commercial customers worldwide. Northrop Grumman has raised dividends for 10 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 368 million in 2003 to 238 million in 2013. The company has an open buyback facility to repurchase approximately 25% of outstanding shares by 2015. Analysts expect that this dividend achiever would earn $7.78/share in 2013 and $7.99/share by 2014. In contrast, it earned $7.81/share in 2012. Currently, the stock is attractively valued at 12.20 times earnings and yields 2.50%.
L-3 Communications Holdings, Inc. (LLL), through its subsidiary, L-3 Communications Corporation, provides command, control, communications, intelligence, surveillance, and reconnaissance (C3ISR) systems; aircraft modernization and maintenance; and national security solutions in the United States and internationally. Over 75% of revenues were derived from US Department of Defense and Government Agencies, while International Sales accounted for 19% of revenues. The remainder is generated from sales to US corporate customers. L-3 Communications has managed to increase dividends for 9 years in a row. Over the past five years, it has managed to boost distributions by 15.30%/year. The outstanding shares decreased from 127 million in 2007 to 91 million in 2013. The number of outstanding shares increased from 106 million in 2003 to 127 million in 2007, because the company has grown through acquisitions, paid for by stock and cash. L-3 Communications has an open buyback facility to repurchase approximately 20% of outstanding shares by 2015. Analysts expect that this dividend stock would earn $8.13/share in 2013 and $8.17/share by 2014. In contrast, it earned $8.30/share in 2012. Currently, the stock is attractively valued at 11.20 times forward 2013 earnings and yields 2.40%.
A company can only afford to maintain and increase dividends per share over time only through increases in earnings per share. Without earnings growth, the dividend can only grow to a certain level after which it would stagnate and lose purchasing power to inflation.
For companies like the ones mentioned in this article, a large portion of revenues are derived from the US Government or US Government Agencies. The problems with the US budget deficit are widespread. As a result, it is very possible that defense contractors would experience decreases or limits to the amount of weapons they can sell to their main customer. This could potentially lead to lower profits and dividend freezes or cuts.
Because most defense contracts are won after a competitive bidding, it might wise to acquire shares of several contractors such as Lockheed Martin, Raytheon, General Dynamics, Northrop Grumman, rather than focus on a single company. I am unable to determine which one would win the most revenues from the defense budget pile, which is why such an approach could be useful. In troubled times, I wouldn't be surprised to also see consolidations in the sector.
One positive is that companies have been able to repurchase a large portion of its stock over the past decade. A company which can consistently retire 1%-2% of shares each year, pays 4% yield and that can grow net income by 1-2%, can easily manage to grow distributions at a rate that can maintain purchasing power of the income. If the largest customer cuts their spending budget however, this yield could get axed as profitability suffers. Either way, if a company generates so much cash flow that it is able to buyback a significant amount of outstanding stock at attractive valuations, and could continue doing so, it could provide decent returns to investors. Some notable buybacks include the ones from Northrop Grumman (NOC) and L-3 Communications (LLL), which could retire as much as 20 - 25% of outstanding shares within 2- 3 years. This could also provide room for dividend increases, even if overall sales and net incomes are flat.
However, US will always need to spend money on defense, given its role as a “world cop”. The world is continuing to be a hostile place, particularly in certain hot spots such as North Korea, Iran and a few of the countries that participated in the Arab Spring in 2011.
In the long-run however, (say 20 years from now), I cannot see anything else but increases in US government spending on defense. The world would still be a hostile place, and countries need to spend on defense simply to keep up with pace of technology. This means that if you buy today, you can still experience dividend cuts five years down the road, although chances are your distributions would recover within 10 years or so. This cyclical nature of dividend booms and busts makes relying on defense dividends riskier than relying on distributions from Coca-Cola (KO).
Surprisingly, some of the best times to acquire defense companies was right after the cold war ended in 1989. Other attractive times to buy defense companies occurred right after the official end of Vietnam war in 1975.
To summarize, the major bearish factor behind defense companies is the US Government spending situation in the next few years, and the need to reduce the budget deficit and curtail the growth of national debt. This could cause stagnating or decreasing military budgets. Since the major wars the US fought over the past decade are pretty much over, this could potentially affect profitability in defense companies.
The major bullish factors include cheap valuations, and the potential for a few of those companies to repurchase massive amounts of stock at these low valuations. If I were to invest in the sector, I would focus on the companies that reduce a large portion of shares outstanding. If net income can be at least maintained, the reduction in shares would lead to increases in earnings per share, which could also result in dividend growth.
Relevant Articles:
- General Dynamics (GD) Dividend Stock Analysis
- Lockheed Martin Corporation (LMT) Dividend Stock Analysis
- Two dividend paying stocks to consider today
- Three Stages of Dividend Growth
- Share Buybacks versus Dividends
Monday, October 14, 2013
Why do I own so many individual dividend paying stocks?
In the past month, I published the list of dividend holdings I own to my subscribers. Many subscribers were amazed at the number of companies I own. I have always mentioned that having at least 30 – 40 individual positions is great for diversification purposes. This ensures that I am not overly reliant on a single company for my dividend income, in case it cuts or suspends distributions.
However, there is the other side of the coin, where owning too many securities is too much. It could mean that effective monitoring a portfolio might be more difficult with more than a certain number of positions in it.
The first reason behind the excessive number of companies in my portfolio is corporate actions. For example, several of the companies I own stock in have tended to split in two separate entities. Examples of that include when legacy Abbott Laboratories divided itself into Abbvie (ABBV) and Abbott Laboratories (ABT) in 2013. Another example includes when Kraft Foods split into Kraft (KRFT) and Mondelez International (MDLZ). Currently, my small position in Vodafone (VOD) will result in yet another addition to my portfolios after it distributes Verizon Wireless (VZ) stock to me in 2014.
The second reason behind the excessive number of companies in my portfolio is valuation. When I identify a quality company at a reasonable price, I tend to start nibbling at it one lot or half lot at a time. Because I have a limited amount of capital relative to the number of investment ideas I have, I might end up making an investment in a new idea once or twice per year. For example, if it was cost efficient to purchase stock in $1000 increments and I had the ability to put only $12,000/year, I can only make 12 purchases in my portfolios. Therefore, if I had 12 ideas, I might not be able to make another investment in any of those ideas for a whole year. By that time, the stock could have become overvalued or there might be a better value in a whole new enterprise. The company would still be a good long-term hold, which is why selling it would violate common sense. This is why I am considering dividing my monthly contributions into all my ideas, using Sharebuilder. I just need to make sure I can find $2,400 every month, in order to make this exercise cost effective at a $12 monthly fee for 12 trades.
The third reason behind the large number of securities I own is because I have been investing in dividend paying stocks for several years. When I first started investing in dividend stocks, I did not pay any commissions and could only put a small amount of funds to invest. Therefore, I usually put about $100 - $200 per position. Over time, I have increased my lot size from there. Unfortunately, some of those companies stopped being attractively valued, which is why I ended up stuck with them. Since I am now paying commissions to sell those legacy securities, I have calculated I am better off sitting on them. For example, I try to maintain my trade costs below 0.50%. Therefore if I paid a $5 commission to buy or sell stocks, it would not make economic sense to sell a position whose value is less than $1,000. Investment costs can add up pretty quickly, which is why I try to run a tight operation. It also does not make sense to sell stock in a company that is delivering earnings and dividend growth, and its only sin is being overvalued.
Reasons number two and three have contributed to a number of great companies, where I have pretty low position amounts in plenty of companies.
The fourth reason I own so many companies includes some points from reasons two and three. I essentially have managed to find attractively valued stocks at every single point since 2007 – 2008. Unfortunately, the list of attractive candidates for my money has changed over time pretty significantly. For example, for several years I had companies like Colgate – Palmolive (CL) or Clorox (CLX) or Procter & Gamble (PG) on my shopping list whenever I had cash to put to work. Unfortunately, these companies have been selling at prices that exceeded what I was willing to pay for them in 2013. In addition, since I constantly search for unconventional ideas, I might end up finding better values. This is how I ended up with so much in Phillip Morris International (PM) or Kinder Morgan Inc (KMI) for example.
The fifth reason behind this large number of portfolio holdings is some actions I took over the past year. I sold my shares in a position I believed to be overvalued and having poor future, and then divided the money into several ideas. For example, I also did some selling of a few overvalued REITs such as National Retail Properties (NNN) or Universal Health Realty Income Trust (UHT). I then put the money to work in three new REITs and added to positions in an existing REIT (O). These reits included American Realty Capital (ARCP), Digital Realty Trust (DLR) and Omega Healthcare Investors (OHI). Another example includes the sale of Cincinatti Financial (CINF), and using the money to buy stock in the five leading Canadian Banks – Toronto Dominion Bank (TD), Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Royal Bank of Canada (RY) and the Canadian Imperial Bank of Commerce (CM).
The good part of owning so many companies is that I can still monitor these positions regularly. I am reminded I own these companies anytime I receive an annual report in the mail. I also monitor the conditions of companies I have sold previously. That way, I am able to keep up with and learn about business ,which should hopefully pay dividends for a long period of time. Although I do not have the time to read 500 pages/day like Warren Buffett, I try to find the time to search for knowledge on a daily basis. I have quite a few “starter” positions in companies that were attractive at some point, but later on were not or there were better values out there. I do monitor them however, and could add to them if I saw the right opportunity. For example, in 2013 I added to Family Dollar (FDO) and Yum Brands (YUM), when there were weaknesses in the stocks, which were not warranted.
I believe that investors should follow as many companies as possible, in order to learn as much as they can about business. Even if you only own 20 companies in your portfolio, if all you do is keep up with those 20, you might be doing yourself a disservice.
Overall, I do realize I have too many companies in my portfolio. However, I am never going to let this stop me from looking for new opportunities. For example, I like General Mills (GIS) stock at current levels. I find it a much better value than competitors than existing peers I already hold in my portfolio. I recently initiated a position in the stock. I could theoretically buy shares in PepsiCo (PEP) or Nestle (NSRGY) or Kellogg (K) instead, in order to keep the number of positions in my portfolio static. From a capital allocation point however, it seems pretty dumb not to focus on the best value you find when you have new money to put to work.
I find that investors who focus on absolute number of stocks in a portfolio, miss this important nugget of gold. There is no limit to the amount of companies in your dividend portfolio. It should only be limited by the number of good ideas you have. You should also build your portfolio slowly, one position at a time, and several buys per each position. The worst piece of advise I hear is from those who paraphrase Warren Buffett and his supposedly concentrated approach. The saying goes that your 25th idea is not as good as your first idea.
I have news for you - you are not Warren Buffett. I am highly skeptical that investors know in advance which ideas are their best ideas. From my experience, my best ideas were way past portfolio components number 25 or 30. At the time of purchase, you do not know which company will keep raising dividends, and which would cut them and burn to the ground. With income investing, you are dealing with a lot of bits and pieces of imperfect information, which is why it is impossible to know which company will perform great. In addition, while Warren Buffett was not very diversified during the days of the Buffett Partnership, he has diversified extensively since the early 1970s. I have read his annual reports, and he has never once said that Berkshire Hathaway has too many subsidiaries or stock holdings.
I do not believe that holding so many stocks is probably not perfect if I wanted to outperform all other investors. You can see that despite the large number of holdings, the top 30 positions account for almost 80% of the portfolio. The top 40 positions account for 90% of the portfolio. Some of the remaining ideas have the chance to grow if they became attractively valued. For example, Peter Lynch from the Fidelity Magellan Fund managed an outstanding performance over a 13 year period, while holding hundreds of individual stocks in his portfolio. This did not hurt his performance at all. While I am not a super investor, I believe that the notion of finding a good idea and testing it with real money, before adding a significant amount of change to it has some merits.
I believe the real reason behind my comfort level with so many individual holdings, is because of my intense focus on reducing risk. I believe that you only need to get rich once in life. I would hate to spend years of my adult life accumulating a nest egg, only to lose it due to a few concentrated stupid investments. I would much rather end up with $1 million but with lower risk, than shoot for the stars and end up with somewhere between $10 million or zero dollars. If all I need to be retired is the $1 million, then why shoot for the stars and potentially risk it all?
Full Disclosure: Long everything mentioned above except for NNN, UHT, VZ and CINF
Relevant Articles:
- Check the Complete Article Archive
- Best Brokerage Accounts for Dividend Investors
- Dividend Portfolios – concentrate or diversify?
- Buffett Partnership Letters
- Warren Buffett on Dividends: Ideas from his 2013 Letter to Shareholders
However, there is the other side of the coin, where owning too many securities is too much. It could mean that effective monitoring a portfolio might be more difficult with more than a certain number of positions in it.
The first reason behind the excessive number of companies in my portfolio is corporate actions. For example, several of the companies I own stock in have tended to split in two separate entities. Examples of that include when legacy Abbott Laboratories divided itself into Abbvie (ABBV) and Abbott Laboratories (ABT) in 2013. Another example includes when Kraft Foods split into Kraft (KRFT) and Mondelez International (MDLZ). Currently, my small position in Vodafone (VOD) will result in yet another addition to my portfolios after it distributes Verizon Wireless (VZ) stock to me in 2014.
The second reason behind the excessive number of companies in my portfolio is valuation. When I identify a quality company at a reasonable price, I tend to start nibbling at it one lot or half lot at a time. Because I have a limited amount of capital relative to the number of investment ideas I have, I might end up making an investment in a new idea once or twice per year. For example, if it was cost efficient to purchase stock in $1000 increments and I had the ability to put only $12,000/year, I can only make 12 purchases in my portfolios. Therefore, if I had 12 ideas, I might not be able to make another investment in any of those ideas for a whole year. By that time, the stock could have become overvalued or there might be a better value in a whole new enterprise. The company would still be a good long-term hold, which is why selling it would violate common sense. This is why I am considering dividing my monthly contributions into all my ideas, using Sharebuilder. I just need to make sure I can find $2,400 every month, in order to make this exercise cost effective at a $12 monthly fee for 12 trades.
The third reason behind the large number of securities I own is because I have been investing in dividend paying stocks for several years. When I first started investing in dividend stocks, I did not pay any commissions and could only put a small amount of funds to invest. Therefore, I usually put about $100 - $200 per position. Over time, I have increased my lot size from there. Unfortunately, some of those companies stopped being attractively valued, which is why I ended up stuck with them. Since I am now paying commissions to sell those legacy securities, I have calculated I am better off sitting on them. For example, I try to maintain my trade costs below 0.50%. Therefore if I paid a $5 commission to buy or sell stocks, it would not make economic sense to sell a position whose value is less than $1,000. Investment costs can add up pretty quickly, which is why I try to run a tight operation. It also does not make sense to sell stock in a company that is delivering earnings and dividend growth, and its only sin is being overvalued.
Reasons number two and three have contributed to a number of great companies, where I have pretty low position amounts in plenty of companies.
The fourth reason I own so many companies includes some points from reasons two and three. I essentially have managed to find attractively valued stocks at every single point since 2007 – 2008. Unfortunately, the list of attractive candidates for my money has changed over time pretty significantly. For example, for several years I had companies like Colgate – Palmolive (CL) or Clorox (CLX) or Procter & Gamble (PG) on my shopping list whenever I had cash to put to work. Unfortunately, these companies have been selling at prices that exceeded what I was willing to pay for them in 2013. In addition, since I constantly search for unconventional ideas, I might end up finding better values. This is how I ended up with so much in Phillip Morris International (PM) or Kinder Morgan Inc (KMI) for example.
The fifth reason behind this large number of portfolio holdings is some actions I took over the past year. I sold my shares in a position I believed to be overvalued and having poor future, and then divided the money into several ideas. For example, I also did some selling of a few overvalued REITs such as National Retail Properties (NNN) or Universal Health Realty Income Trust (UHT). I then put the money to work in three new REITs and added to positions in an existing REIT (O). These reits included American Realty Capital (ARCP), Digital Realty Trust (DLR) and Omega Healthcare Investors (OHI). Another example includes the sale of Cincinatti Financial (CINF), and using the money to buy stock in the five leading Canadian Banks – Toronto Dominion Bank (TD), Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Royal Bank of Canada (RY) and the Canadian Imperial Bank of Commerce (CM).
The good part of owning so many companies is that I can still monitor these positions regularly. I am reminded I own these companies anytime I receive an annual report in the mail. I also monitor the conditions of companies I have sold previously. That way, I am able to keep up with and learn about business ,which should hopefully pay dividends for a long period of time. Although I do not have the time to read 500 pages/day like Warren Buffett, I try to find the time to search for knowledge on a daily basis. I have quite a few “starter” positions in companies that were attractive at some point, but later on were not or there were better values out there. I do monitor them however, and could add to them if I saw the right opportunity. For example, in 2013 I added to Family Dollar (FDO) and Yum Brands (YUM), when there were weaknesses in the stocks, which were not warranted.
I believe that investors should follow as many companies as possible, in order to learn as much as they can about business. Even if you only own 20 companies in your portfolio, if all you do is keep up with those 20, you might be doing yourself a disservice.
Overall, I do realize I have too many companies in my portfolio. However, I am never going to let this stop me from looking for new opportunities. For example, I like General Mills (GIS) stock at current levels. I find it a much better value than competitors than existing peers I already hold in my portfolio. I recently initiated a position in the stock. I could theoretically buy shares in PepsiCo (PEP) or Nestle (NSRGY) or Kellogg (K) instead, in order to keep the number of positions in my portfolio static. From a capital allocation point however, it seems pretty dumb not to focus on the best value you find when you have new money to put to work.
I find that investors who focus on absolute number of stocks in a portfolio, miss this important nugget of gold. There is no limit to the amount of companies in your dividend portfolio. It should only be limited by the number of good ideas you have. You should also build your portfolio slowly, one position at a time, and several buys per each position. The worst piece of advise I hear is from those who paraphrase Warren Buffett and his supposedly concentrated approach. The saying goes that your 25th idea is not as good as your first idea.
I have news for you - you are not Warren Buffett. I am highly skeptical that investors know in advance which ideas are their best ideas. From my experience, my best ideas were way past portfolio components number 25 or 30. At the time of purchase, you do not know which company will keep raising dividends, and which would cut them and burn to the ground. With income investing, you are dealing with a lot of bits and pieces of imperfect information, which is why it is impossible to know which company will perform great. In addition, while Warren Buffett was not very diversified during the days of the Buffett Partnership, he has diversified extensively since the early 1970s. I have read his annual reports, and he has never once said that Berkshire Hathaway has too many subsidiaries or stock holdings.
I do not believe that holding so many stocks is probably not perfect if I wanted to outperform all other investors. You can see that despite the large number of holdings, the top 30 positions account for almost 80% of the portfolio. The top 40 positions account for 90% of the portfolio. Some of the remaining ideas have the chance to grow if they became attractively valued. For example, Peter Lynch from the Fidelity Magellan Fund managed an outstanding performance over a 13 year period, while holding hundreds of individual stocks in his portfolio. This did not hurt his performance at all. While I am not a super investor, I believe that the notion of finding a good idea and testing it with real money, before adding a significant amount of change to it has some merits.
I believe the real reason behind my comfort level with so many individual holdings, is because of my intense focus on reducing risk. I believe that you only need to get rich once in life. I would hate to spend years of my adult life accumulating a nest egg, only to lose it due to a few concentrated stupid investments. I would much rather end up with $1 million but with lower risk, than shoot for the stars and end up with somewhere between $10 million or zero dollars. If all I need to be retired is the $1 million, then why shoot for the stars and potentially risk it all?
Full Disclosure: Long everything mentioned above except for NNN, UHT, VZ and CINF
Relevant Articles:
- Check the Complete Article Archive
- Best Brokerage Accounts for Dividend Investors
- Dividend Portfolios – concentrate or diversify?
- Buffett Partnership Letters
- Warren Buffett on Dividends: Ideas from his 2013 Letter to Shareholders
Saturday, October 12, 2013
Interesting Articles on Dividend Investing For Week of October 12, 2013
For your weekend reading enjoyment, I have highlighted a few interesting articles from the archives, which I find to be relevant today. The first five articles have been written and posted on this site, while the last five have been selected from other authors. I tend to post anywhere between three to four articles to my site every week. I usually try to write at least one or two articles that contain timeless information concerning dividend investing. This could include information about my strategy, or other pieces of information, which could be useful to dividend investors.
Below, I have highlighted a few articles posted on this site, which many readers have found interesting:
I read a lot about companies, and also read a lot of interesting articles from all over the web. A few that I really enjoyed over the past several months include:
I read a lot about companies, and also read a lot of interesting articles from all over the web. A few that I really enjoyed over the past several months include:
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