I focus on dividend growth stocks, which are companies that tend to grow distributions every year. I search for companies that typically yield more than 2.50%, have demonstrated growth in earnings and dividends over the past decade, and have a strong foundation that can support further distribution growth.
Per my dividend retirement plan, I expect to be able to cover expenses through a dividend portfolio around sometime 2018.
However, I do focus on a lot of companies where average yield is somewhere in the 3% to 4% range. These companies have sustainable dividends, and dependable dividend growth rates, that are very likely to exceed 6%/year for the next decade.
Some readers have asked me why I don’t merely focus my attention on higher-yielding stocks, that pay anywhere between 6% and 8% today, and speed up my financial independence. I could load up my portfolio with companies like:
- Kinder Morgan Energy Partners (KMP) operates as a pipeline transportation and energy storage company in North America. This master limited partnership has managed to increase distributions for years in a row, and currently yields 7.50%. Check my analysis of Kinder Morgan.
- American Realty Capital Properties (ARCP) owns and acquires single-tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment-grade and other creditworthy tenants. This real estate investment trust has managed to increase dividends for years in a row, and currently yields 7.60%.
- Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. This real estate investment trust has managed to increase dividends for years in a row, and currently yields 5%. Check my analysis of Realty Income.
I equate higher-yielding companies with higher risk. In a competitive marketplace for stock securities, a reasonable investor cannot expect to find higher-yielding stocks without incurring higher risks.
If a real estate investment trust (REIT) wants to buy an apartment complex that generates an 8% yield, it might not be a very good idea to issue stock or debt to investors that yields more than 8%. However, even if the REIT ends up paying a lower yield on equity or debt, but it needs to refinance that debt in a few more years at higher rates, this could be bad for dividend incomes. The problem with most high-yielding companies is that they are pass-through entities which essentially share all of their free cash flows with investors by sending out fat dividend checks. This leaves those companies exposed to hiccups in financial markets, which are vital for their growth and for access to capital.
In addition, there is always the increased risk that those pass-through entity structures are abolished by the tax authorities. With a pass-through structure like a REIT, master limited partnership, or a Trust, there is no taxation at the entity level. All the taxation occurs at the individual shareholder level. In comparison, corporations like Coca-Cola (KO) pay taxes at the corporate level, and then individual investors pay taxes on dividends they receive in taxable accounts. This is why pass-through entities like Realty Income, American Realty Capital Properties, Kinder Morgan Energy Partners can afford to pay such fat dividend yields – they essentially do not pay income taxes and rely on capital markets for capital on capital spending, and acquisitions. However, if the revenue-starved governments decide to get a higher share of the tax mix, they could start taxing those entities. This would effectively reduce attractiveness of pass-through entities, lead to steep dividend cuts, and losses for investors.
This is why I believe that there is generally a higher risk of a dividend cut with high-yielding stocks.
In addition, there is a high risk of lack of dividend growth. This will reduce purchasing power of my principal, and result in constant downgrade to my lifestyle.
I also believe that by owning a portfolio consisting predominantly of pass-through entities, I would be taking a concentrated risk, which is contrary to the ideas of diversification I have been preaching on for the past seven years.
If I needed $30,000 in annual dividend income, but only had a portfolio worth $500,000, I could do two things. The fist is to design a portfolio with an average yield of 6%, and call it a day. The second thing would be to invest in a mix of more reasonably priced companies, wait for a few more years of savings and patiently compound my capital before achieving my goal.
The risk with the first scenario is that those higher-yielding stocks stop growing dividends, which would reduce purchasing power of my income. In addition, if there are dividend cuts, my lifestyle would be even worse off. If you need $30,000 to live on in year 1, you would likely need $30,900 in year two (assuming a 3% inflation).
What good is a high-dividend stock that yields 6% today if it gives me a 50% chance of a dividend eliminations within next decade, compared to a stock yielding 3% that has only a 10%-15% chance of a dividend cut? If I earn 6% this year, but next year I get a 50% dividend cut, I am not better off eventually than an investor who started out with a 3% yield that was unchanged in year 2.
As an investor, my goal is to maintain and increase my real income, and only suffer the least amount of losses. If I just focus on the yields today, I might end up missing out on the risks I am taking in the process.
With a more moderate dividend growth stocks yielding somewhere between 2.5% and 3.5% today, I have a better chance of reaching my goals, having a sustainable income stream, and a better fighting chance against dividend cuts and inflation.
I believe that I only need to get rich once. Therefore, my goal is to be patient, and build my dividend foundation slowly and carefully, rather than be in a hurry — that’s why I avoid excessive risks.
Full Disclosure: Long KMR, KMI, ARCP, O