When investing for income, many retirees focus on the dividend stream. Living off dividends in retirement is helpful in creating a consistent stream of income because dividends do not fluctuate as wildly as stock prices do. Focusing only on the distributions, however, without giving much thought to anything beyond the juicy current yield, could be dangerous.
Dividend investing is a process with several stages to minimize risk of income reduction in retirement. The first stage should be selecting quality income candidates from a pool of securities that have certain characteristics the dividend investor is looking for. For example, I tend to purchase companies that have consistently raised dividends for at least 10 years in a row. As a result, I start my screen with the list of Dividend Achievers.
The second stage should be applying a set of entry criteria to the list of qualified candidates to narrow it down to a more manageable list for further research. This set of criteria should reflect important points of the investor’s strategy, determined by their experience in the markets and risk tolerance.
The next stage should be analyzing each security in detail. Given the wealth of data on the Internet these days, many investors tend to focus on the quantitative side of analysis. While it is helpful to see the trends behind the data, and it is fun to project past results, investors should not stop there. Evaluating qualitative characteristics such as branding, product mix, competitive advantages, strengths, weaknesses, opportunities, trends and industry factors should be an important part of the analysis toolset. Obtaining an understanding of the business by reading annual reports or research reports and news stories, as well as observing the business operations in person, also would add to the investment evaluation of the business.
While creating a diversified income stream is important, investors also should not forget about capital gains. It is important to understand where the distributions are being derived. In certain investments, investors were receiving a large portion of the distribution as a return of capital, rather than income. While the cash flow was high enough to lure investors into the high-yielding investment, the security was paying these distributions on borrowed time. Once the capital base was depleted, investors would end up with no income and their security might be worthless.
One such security is U.S. oil and gas royalty trusts. Most of these pass-through entities tend to pay high current distributions every month out of their royalty interests in oil and gas fields. As these fields get depleted, however, there comes a time when there revenues will run out, and thus there will be no profits to distribute to shareholders. A larger portion of the current distributions of these businesses represents a return of capital, which is logical given the fact that for every barrel of oil equivalents pumped out of the ground, there is one less barrel to be pumped in the future. Once all the barrels in the reserve have been depleted, there will be no more oil to be produced and sold.
Dividends typically account for 40% of annual total stock market returns. The remaining 60% come from capital gains. It also is important to not forget about capital gains because they ensure your principal investment maintains and even grows its purchasing power over time. That is why selecting companies that have future prospects for growth is so important.
Companies whose future growth is virtually unlimited include:
McDonald’s (NYSE:MCD), together with its subsidiaries, operates as a food service retailer worldwide. This dividend aristocrat has raised distributions for 35 years in a row. During the past decade, the company has managed to boost dividends by 26.5% per year. Yield: 2.8% (analysis).
Johnson & Johnson (NYSE:JNJ) engages in the research and development, manufacture and sale of various products in the health care field worldwide. This dividend aristocrat has raised distributions for 49 years in a row. During the past decade, the company has managed to boost dividends by 13% per year. Yield: 3.5% (analysis).
Procter & Gamble (NYSE:PG) provides consumer packaged goods in the United States and internationally. This dividend aristocrat has raised distributions for 55 years in a row. During the past decade, the company has managed to boost dividends by 10.9% per year. Yield: 3.4% (analysis).
Coca-Cola (NYSE:KO) manufactures, distributes and markets nonalcoholic beverages worldwide. This dividend aristocrat has raised distributions for 49 years in a row. During the past decade, the company has managed to boost dividends by 10% per year. Yield: 2.7% (analysis).
Unilever (NYSE:UL) provides fast-moving consumer goods in Asia, Africa, Europe and the Americas. This international dividend aristocrat has raised distributions for 11 years in a row. During the past decade, the company has managed to boost dividends by 9.2% per year. Yield: 3.7% (analysis).
Wal-Mart (NYSE:WMT) operates retail stores in various formats worldwide. This dividend aristocrat has raised distributions for 37 years in a row. During the past decade, the company has managed to boost dividends by 17.8% per year. Yield: 2.8% (analysis).
Full disclosure: Long MCD, JNJ, PG, KO, UL and WMT. For more information, visit DividendGrowthInvestor.com.