The goal of every dividend growth investor is to create a portfolio which throws off a sufficient stream of income that pays their expenses. As soon as the amount of dividends exceeds the monthly expenses, the investor has reached financial independence. Let’s assume that an investor needs approximately $3000/quarter for their expenses. This translates to $1000/month.
Now that we have the end goal in mind, we have to determine when exactly we need to be able to achieve the target monthly dividend income. The next step would be the actual creation of the dividend portfolio.
Time is an important ally for the dividend investor. After all, by allowing their dividends to reinvest for many years, investors will be able to compound their income to reach their goals. The dividend growth factor further increases the speed of compounding, and allows for reaching the target income figures much faster. Assuming that a portfolio constructed today yields 4% and has a future annual dividend growth rate of 6%, investors need a $300,000 lump sum investment in order to generate $1000 in monthly dividend income. Few investors have such massive amounts of cash ready to be invested however. In reality, investors make small purchases every month.
If however investors expect that they will need the $1000/month in a decade, there is a much smaller lump sum that will be needed. In fact, an $114,000 investment today in a dividend growth portfolio with a yield 4% and dividend growth of 6% will generate the target monthly income in 10 years, assuming dividend reinvestment.
Dividend Income: Annual
|Year||Dividend Income||Dividend Rate||Units|
If the portfolio construction is broken down to a more realistic monthly investment program however, one would notice that only small amounts of regular investments in quality companies prevent them from achieving financial freedom. For this exercise I assumed that the income portfolio throws off 1% once per quarter, which is reinvested in a batch of dividend stocks which exhibit 4% yields and 6% dividend growth. I also assumed that the investor methodically adds $1,200/month to their dividend portfolio. The monthly spreadsheet can be opened from this link.
Rather than looking at individual stocks for the yield and growth characteristics, I chose to look at the dividend portfolio as a whole. There are companies which will exhibit these yield/growth characteristics today, but might not in five or ten years. As a result, the enterprising dividend investor would have to keep scanning the market for adequate opportunities for the purposes of reinvesting their dividend income during the accumulation phase.
Just because a portfolio yields 4% today however, does not mean that all components are high yielders. It is possible to include stocks with low current yields, and still achieve an overall target portfolio yield. In my portfolio, I have a few positions where yields are less than 2%, which is heavily compensated by the high expected growth in distributions.
In order to make the calculation easier, I assumed that every dollar is invested in a dividend stock trading at $1. This is what the dividend unit means.The second step involves the actual composition of the portfolio. I have previously discussed my screening selections as well as the quality criteria I use for further analysis of potential investments. I basically look for dividend growth stocks with attractive fundamentals which have wide moats, or strong competitive advantages. Four such stocks include:
1) Johnson & Johnson (NYSE:JNJ) engages in the research, development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 50 years in a row, and has a ten year average dividend growth rate of 12.40% per year. Yield: 3.80% (analysis)
2) Philip Morris (NYSE:PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has managed to boost dividends at a double-digit pace since being spun off from Altria Group (MO) in 2008. Yield: 3.60% (analysis)
3) Wal-Mart (NYSE:WMT) operates retail stores in various formats worldwide. The company has raised dividends for 38 years in a row, and has a ten year average dividend growth rate of 17.90% per year. Yield: 2.70% (analysis)
4) McDonalds (NYSE:MCD), together with its subsidiaries, franchises and operates McDonalds restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. The company has raised dividends for 35 years in a row, and has a ten year average dividend growth rate of 27.40% per year. Yield: 3.10% (analysis)
Full Disclosure: Long JNJ, PM, WMT, MCD