PLAN.AHEAD: "That is all good mate but I want options. I want freedom to do as I wish. If I spend all my money today I will have none for tomorrow"
CONTENDER: "What about dividend investing, will this work?"
PLAN.AHEAD: "Contender, the stock market is a casino mate! you have less chance in it than in the ring with THE.FUTURE!"
Over the past 12 months a lot of work has been carried out to develop a strategy for a sustainable dividend income for our Tribe.
Part 1 of this post is going to look at the pros and cons of dividends versus capital appreciation of stocks. Part 2 is going to look at risks of investing in dividend stocks, our strategy and tracking progress.
The Tribes Dividend Journey
We have been investing heavily for the past 7 years in three portfolios GROWTH, INCOME and PROTECTION (covered here). It is only in the last year we have been heavily interested in increasing the share of the INCOME portfolio. In particular we are buying individual company shares for their dividends.
To get to the target we are gradually selling our tracker funds from the GROWTH (Primarily global, European and emerging markets) and adding capital from dividends and adding income from Mrs C's [delete] income into individual shares. The PROTECT portfolio is staying static.
In the current climate of a historically high priced stock market (P/E ratios are at towards the top of their historical trading ranges) and what THE.CONTENDER considers a stagflation environment this poses several concerns about the timing of owning MORE shares.
We currently live in a very different financial landscape with lots of printed money circling the globe. This is very supportive of stocks so there is no reason to believe the stock market will capitulate just yet.
- Our exercise is moving money out of one group of shares (funds) to another group (individual dividend stocks)
- We are adding some extra earned income so we are in effect nearly neutral on purchases.
- Our objective is all about GROWING INCOME over CAPITAL APPRECIATION.
- We are comfortable in owning a large amount of stocks but... we want to be more DEFENSIVE with the choice of these shares.
- We are buying shares in these sectors that we consider DEFENSIVE: utilities, energy and pharmaceutical.
- We consider their goods and services as a "need" instead of "want".
- We understand dividends can be variable such as energy companies that are beholden to the underlying price the the commodity they are selling.
- We hold some fixed income assets (preference shares and cash accounts)
Perhaps lots of cash is better? Unfortunately like anything in life it is all about risk aversion. Cash loses value to inflation but is safe. At our point in our lives we are do [which one?] not need to be overly safe. If a problem happens we will do what it takes to get back on track.
We are aiming for 80% INCOME and 20% in GROWTH and PROTECTION after the purchase of a property in FRANCE and the semi early retirement situation we are looking for.
Starting a portfolio
"An investment in knowledge pays the best interest." - Benjamin FranklinWe have read about dividend investing from several sites and blogs such as the dividend monk, seekingalpha, monevator and several early financial independence blogs such as brave new life, retire by 40 and jlcollinsnh.
We have a list of our our current holdings and the current dividend income they provide per month. We have added "what if" we bought x shares in each company to work out what the portfolio could look like to generate our desired final income (more detail will be provided in part 2 of the post).
All of the stocks are researched (Mr C spends lots of time on this) and evaluated. Decision of what to buy each month are made by having a look at share valuations and performance. We are currently concerned about buying some of the shares we have identified that have had large run ups at the start of the year (typically 10-20%).
We are currently targeting the "laggards" - shares that are behind the market gains. Is this a good approach? Laggards are usually laggards for a reason? Well perhaps that is because their sector is out of favor and might be the next "performer". There is a "risk on" appetite in the market so some defensive sectors have been laggards / sold off in favor of stocks with perhaps more growth prospects.
Please read on for: Are companies paying dividends the right choice? High paying dividend stock considerations. Dividend champion investing.
Paying Dividends Vs Share Buyback
Dividends can provide a regular fairly consistent (providing there is diversification) growing source of income. Why then has Warren Buffet's Berkshire Hathaway never offered a dividend?
The main reason for this is that dividends are taxed as they are paid [as income] [ explain]. Warren Buffet sees more benefit to the shareholders by buying back the shares or investing in new companies to avoiding the "income" tax.
If a return is required, shares can be sold and incur the capital gains tax.
Here in the UK there is a capital gains tax allowance of 10.6K per year for 2013 and a tax rate of 18% on gains greater than this amount. Dividends incur a 10% tax taken at source. If we require a small income each year we see that the capital gains approach can be more "tax" efficient than dividends.
Our little tribe are in the phase where we need regular income. We are concerned if there is a significant drop in the market and we have to sell shares for living costs we could erode the capital (number of shares) faster than it is replaced by gains.
By choosing dividend stocks where the payout ratio is deemed safe - even when in a recession - hopefully we can avoid selling shares, reducing capital and reducing income. If we choose growing companies as well eventually we should be able to realise some capital gains as well.
We will not have spare funds at first for future investment but when we do in the future we will have a good look at the capital gains approach to minimize our tax liabilities.
Looking for High Paying Defensive Dividends (is this sensible?)
Our choice of companies is currently realizing a high dividend return of around 5.9%. There is there a catch to this. If you look at dividend champion investing (companies that consistently raise their dividend) on US shares the dividend rates are typically much lower 3-4%. You would be right in assuming the higher yield we are achieving can infer either:
- Riskier investments / companies (e.g. energy trusts and home builders)
- Mature companies with limited growth (e.g. utilities)
- Leveraged companies (e.g. real estate investment trusts REIT's)
At the current point in time US companies are typically are more expensive to buy than European stocks. This is understandable and has been the case for years as the US has the reserve currency and its companies are generally global growth behemoths.
On the other hand we are based in Europe. The markets are lower priced and higher yields can be found. An example of this is legislative issues / policy on energy that has damaged the share prices of European utility companies. Several of these companies have dividend yields > 7%! and have global operations.
Living in Europe US tax withholding is a big consideration (15% - you have to claim back any excess). Lower taxes are leveled at a resident in the UK at 10% and it is cheaper to buy individual stocks. This difference can make European stocks more appealing.
See topyeilds for European Markets
Dividend Growth Investing
Many companies such as those in the consumer goods sector have been expanding their global sales each year. With the world population already above 6 Billion and due to peak somewhere around 9 Billion there is a lot of growth still available to them. Let's not forget that the west standard of living is currently not available to the majority of the world population. Rising living standards are also another huge opportunity for growth.
Dividend champions although they pay lower dividends and have higher price to earnings ratios provide comfort in the future growth of their sales and the dividend. The dividends have generally outpaced inflation.
See dividend champions XL sheet from drip investing for US stocks.
One consideration on this approach is how long it will take to gain enough income to cover your living costs. A 3-4% yield requires a lot more capital than a 6-7% yield. Perhaps a good approach is a mix of dividend aristocrats mixed with some higher but lower growth stocks to get you to your income goal quicker?
If this allows earlier financial independence it will free time to look at new opportunities. Perhaps an exciting opportunity may arise that may not have been available before. The extra income could then be used to change the mix of the portfolio.
THE.PAST THE.PRESENT. THE.FUTURE
Perhaps if THE.CONTENDER was 18 again he might have started out with a portfolio of low cost tracker funds adding capital each month. When he was 3/4 to his target he would have shifted aggressively to a mix of dividend aristocrats and high paying dividend stocks. Finally a re-balancing would occur towards dividend champions (in select sectors). Any excess would either be passed on to the kids or re-invested in diversified REAL assets.
This is one idea of a strategy, one of thousands out there and each needs to be a personal choice based on expectations and circumstances*
Next up lets have a look at the Tribes current strategy and its risks.
Peace, prosperity and happiness
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