by Dividend Growth Investor | December 31, 2013 11:00 am
Back in early 2008, I was getting started building my dividend portfolio. At this time, I made a prediction about the next bubble in the making. Now, I seldom make predictions, as I believe that noone can predict the future accurately with any consistency. Rather, this was more of a post in wishful thinking.
In this article, I had described how the need for a growing stream of income, will likely cause investors to focus on dividend paying stocks. This is because a lot of retirees need income in their golden years, that also increases over time to protect the purchasing power of their dollars.
It also makes a lot more sense to focus on the income you need to pay for your retirement needs, rather than focus on a total dollar amount of assets. This is because by focusing on income, you are getting something to pay for your retirement, and gaining capital gains as an afterthought. Using the traditional approaches to retirement, you are focusing your energies on creating a huge pile of cash first, and then worrying how to use it to pay for your retirement later. The second process just seems so inefficient and backwards as a retirement planning tool. It also exposes the success of your retirement on fluctuations in stock prices, which are often irrationally set by Mr. Market.
I have no way of predicting what the next five, ten or thirty years would look like. However, I know for sure that at some point, there will be a difficult time for dividend investors. From the limited knowledge I have in 2013, I can predict that taxes on dividend income could be increased even for ordinary people earning more than say $43,000 per year.
I would also not be surprised if we get a few severe bear markets, where quoted prices of dividend paying stocks drop by 30 – 40% or so, and remain there for a relatively long period of time. In addition, if interest rates increase dramatically from here, and you have a situation where 10 year US treasuries yield 8% – 10%, prices of many dividend paying stocks are going to reflect that.
For example, there was a time in the 1970s and early 1980s, where some consumer staple companies had managed to increase earnings, and raise dividends, yet their stock prices were either low or declining for a few years. While dividend incomes were increasing above the rates of inflation, investors were dumping their relatively lower yielding shares for Treasuries yielding 12% – 15%. Today it would sound stupid to sell Procter & Gamble (PG) or Coca-Cola (KO) that yield 4% – 6%, but in a double digit risk free interest rates environment, it wouldn’t be unheard of for some investors.
That being said, I wouldn’t be surprised if the next five years are not as good as the last five years for share prices of dividend stocks. It is likely that stock prices on many overextended dividend stocks would stop increasing, and would be relatively flat over the next five years. The pundits who are in the anti-dividend camp would probably be exhilarated. As a long term dividend investor in the accumulation stage, I am actually hoping that dividend stocks become hated by everyone. This would mean that I would be able to buy future dividend income at bargain prices. Therefore my investment dollars would provide me with a higher benefit.
The goal of this exercise is not to scare you, and make you think that dividend investing is a flawed strategy. In reality, no single investment strategy works ALL the TIME! Even shares of Buffett’s Berkshire Hathaway (BRK.A, BRK.B) had difficult times in the early 1970s and again in the late 1990’s. However, what truly matters is to stick to your strategy through thick and thin, and not abandon ship at the worst time possible.
The goal is to also get you thinking about probabilities, and how you can protect your golden goose, so that it keeps laying its golden eggs every 90 days for you on average. You need to be able to mitigate your risks somehow. Otherwise, if you panic, you might undo the positive compounding effects on your portfolio from previous years. By understanding potential risks and devising a plan to mitigate them, you should be able to do well next time you hear about the end of dividend investing. You will also be prepared to be calm next time stock prices fall by 40% – 50%. If you also manage to buy shares at depressed prices, when it seems like the world is coming to an end, that would be a tough but ultimately rewarding action to take.
For example, if you are already fully invested, and just live off the dividends generated by your portfolio, you should understand that stock market fluctuations are not hurting you at all. As long as the business fundamentals of the companies you own are sound, they will be able to pay and raise dividends for you, even if their stock prices are down by 40 – 50%. This is because stock prices for most quality companies that generate solid earnings always come back up, helped by bargain hunters who identify the value of dividends and earnings.
In a second example, if interest rates increase dramatically to say over 6%, and your portfolio is yielding say only 4%, there is no room for concern as long as the business fundamentals of your holdings are still sound on aggregate. You should not be worried, because your portfolio will generate a growing stream of income to compensate you for the faster increase in inflation. Therefore, if your portfolio is worth $500,000 and generates $20,000 in annual dividend income to cover all of your expenses, rising interest rates should not mean anything to you.
It is true that you can sell your dividend stocks, and earn $30,000 in annual interest income. However, this stream of income will be certain to lose purchasing power in the inflationary world that produces yields of 6%. In addition, if rates increase further to say 8%, your bonds yielding 6% would surely lose value and you would still only earn 6% on your cost. However, if you didn’t do anything in the first place other than hold on to your sound businesses, your dividend portfolio would have likely delivered the growing stream of income that would have ensured purchasing power even as interest rates kept increasing.
A third way to mitigate certain risks is through diversification. Diversification gets a lot of bad rep, but it could protect your assets in the case things take an unexpected turn of events. Let’s face it, no one can predict the future. Therefore, even if you know everything there is about a company, you can still lose money on this investment if an unexpected turn of events occurs.
If you hold less than 10 – 15 individual dividend paying stocks in your portfolio, you are likely asking for trouble. This is because just a bad apple or two could seriously derail your dividend earning potential for a few years, thus potentially causing you to dip into principal. You should also try not to concentrate your portfolio in companies that are in similar industries.
If you owned ten oil and gas companies, and five pipeline MLPs, you are not diversified adequately. Many investors have been betting heavily on major energy companies in 2013, but they might be ignoring the fact that they have no pricing power. If commodity prices drop, those earnings could cause dividend freezes across the board. In addition, having a slight 20-25% allocation of US Government bonds could help you avoid losing sleep in case deflation happens. Unfortunately, since 2010 it has been difficult to get decent returns with Treasuries and Agencies in terms of yields.
During any of the scenarios above, and probably others that I cannot even conceivably forecast today, you would likely get a pretty negative sentiment towards dividend investing. This is actually fine, because as a true contrarian investor, you should be happy when everyone hates your strategy. This is because when the fans of your investment style are few, security prices are usually lower as there is less competition from others. So, anytime you hear about the death of dividend investing, rejoice a little. This is because lower entry prices for the quality companies we discuss on this site would translate into better entry yields for you. This could potentially help you reach your financial goals much sooner.
In conclusion, dividend investors can expect some temporary short-term discomfort when holding dividend paying stocks, due to some of the reasons above.
However if the dividend investor did their homework in stock selection and bought shares at reasonable prices, they can afford to simply sit down and watch their capital compound over time. This is because on aggregate, their portfolio of quality businesses will keep earning more, and showering him or her with more cash each year. This rising stream of dividend payments coming to his bank or brokerage account will provide this investor with the strength to keep holding, even during the most turbulent times.
Full Disclosure: Long PG and KO
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