by Dividend Growth Investor | April 20, 2013 9:00 am
One of the biggest misconceptions about dividend investing out there is that investors should change their strategy, depending on their age. I believe that this misconception comes from the traditional world of retirement planning, where advisers told clients to allocate higher and higher amounts to fixed income instruments as they got older.
Over the past 40 to 50 years, fixed income has tended to yield more than stocks. As a result, income hungry investors in retirement seeking current income purchased CD’s, bonds and other fixed income instruments. This chasing of yields exposed them to inflation risks. Unfortunately, investors who need yield at all costs typically do not have the foresight to look beyond the next five years. Had these investors simply followed the same investing strategy throughout their investing career, without adjusting for age, they should have done just fine.
I believe that following the simple four percent rule should have been their benchmark for generating retirement income from a portfolio that includes stocks and bonds. As I mentioned in an earlier article, the four percent rule essentially relied on the dividend and interest income of a portfolio, which is what the traditional retirement industry has failed to understand.
In another article I discussed that for my retirement I plan on relying on the dividend income from my portfolio, which yields around 4%. I would also rely on some interest income as well. I have followed the same investing principles for the past five years, and would follow them for the next fifty (hopefully) years.
Currently, I view the misconception that investors should invest differently depending on their age fully embraced by everyone. Any time I write an article outlining the dangers of focusing simply on yield, I always receive a backlash from a group of investors. The investors that always disagree with me are those who are anywhere between their 60s and 80s. It looks like these investors simply need the income, but it also seems that they are not giving much thought about whether this income is going to continue for the next 20 to 30 years. My article on the sustainability of Pitney Bowes (NYSE:PBI) and Windstream (NYSE:WIN) was not well received. I did notice that many investors were hopeful, although the facts spoke that these distributions are unsustainable.
Investors who make a mistake and get lucky are actually much worse off than investors who make a mistake and pay for it. If you leveraged yourself to the maximum in 1999 to purchase all the Altria (NYSE:MO) stock that you could get, and you made money from this exercise, you learned a bad lesson. If you applied this lesson in leveraging your portfolio to purchase high yielding Canadian energy trusts in 2007, or U.S. Banks in 2008, you would have lost everything. Investors who today are purchasing high yielding telecom stocks such as Frontier (NYSE:FTR) or mREITS such as American Capital Agency (NASDAQ:AGNC) without understanding their risks, might find out that they have been playing with fire in a few years.
These investments would likely generate high yields for the next five years. This might even continue for a longer period of time, if our yield starved investors get particularly lucky.
However, I highly doubt that these companies would maintain their dividends for the next thirty years. If investors spend all the dividend income from these high yielding investments, they would be out of luck when the dividends are cut. However, looking at the brief history of these investments, I would much rather stick to traditional dividend paying stocks yielding 3 – 4 percent on average today.
If a four percent yield is not sufficient for you, then chances are that you do not have enough money to retire. You might try to purchase some time by investing in securities yielding more than that, but you increase your risk of dividend cuts. If your portfolio consists of high dividend stocks yielding 8% on average, and dividends are cut by 50%, then you will need to find a job to cover the difference. Finding a job in your 70s and 80s is not an easy task however.
A company that cuts an unsustainably high dividend is usually punished by a steep decline in its stock price. Thus, investors experience the double whammy of lower income, and a depreciation in asset base. This is a problem, because if our investors need to replace the investment with something else, they would have less money to do so.
This is a particular problem for situations where the dividend is eliminated completely. American Capital Strategies (NASDAQ:ACAS) is a great example for this scenario. In 2008 the company cut dividends, which prompted a sell-off from $10 per share to less than $1 per share within 2 – 3 months.
Stocks are not inherently “bad investments” simply because they have high current yields. If these companies can afford to pay the dividend, and can grow earnings over time then these could be very good investments. However, high yielding companies which cut dividends over time, pay fluctuating dividends, have unsustainable payout ratios and are in declining industries are investments that should probably not be touched with a ten foot pole by individual yield hungry investors, without fully understanding what they are getting into.
The best way to invest your money is to focus on the best opportunities out there. The more experience I get with dividend investing, the more I realize that current yield should not be the most important factor in selecting investments. It should not even be in the top five reasons to select an investment. It is number six in my list of entry criteria.
Investors who salivate over the high yields without understanding whether the business can grow revenues and earnings to pay for the dividend are committing a sin against their asset base. However, I am somewhat impacted by the four percent rule, in that I do believe that a portfolio that yields anywhere between three to four percent is the optimal solution in today’s market environment. I do own stocks whose yield is 1% such as Visa (NYSE:V), as well as stocks whose yield is 6% such as Omega Healthcare (NYSE:OHI). I just purchased the ones that made sense at the time.
In my portfolio, I screen the lists of dividend champions and dividend achievers every week, looking for attractively valued stocks to purchase or to research. I keep an open eye for attractively valued companies with room to grow distributions out of growing cash flow and earnings.
After analyzing companies, I only invest in those ones where I can see earnings and dividend growth for the next two – three decades. For example, I expect that Coca-Cola (NYSE:KO) would still be a company with recognizable brands that will be selling a product that customers desire and are willing to pay for.
Other companies that will be around over the next 20 -30 years include energy infrastructure plays such as Kinder Morgan (NYSE:KMP) and Enterprise Product Partners (NYSE:EPD). These companies create the infrastructure to store and transmit oil and natural gas across the US.
Full Disclosure: Long V, OHI, KO, KMP, EPD
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