With most of the comments suggesting a move towards personal finance this post will outline the basic rules to allocating capital in a dividend based portfolio. We assume that most of our readers are interested in having capital gains and dividends hedge out a sizable portion of living expenses as fast as possible. With that here’s an our outline for dividend investing:
Basic Guide to Filtering Dividend Securities:
1) Only Buy Needs: Your dividend portfolio should be entirely based on companies that deliver a necessary need to consumers. Oil and Gas, Electricity, Food, Health and Shelter, a couple of examples would be Coca-Cola and Johnson & Johnson. Avoid technology stocks that offer products as their main form of income, they may quickly go out of date and this is certainly not the sector to invest in for long term yields (simply take a look at BBRY and NOK as examples).
2) Use EPS as a Proxy for Cash Flow: Companieswill have various payout ratios some may exceed EPS and others will have payouts that are a dismal portion of EPS (payout is simply annual dividend/annual EPS). In an ideal situation you will find a company with a growing EPS and increasing payout ratio. Simply put use EPS growth as your proxy for long-term dividend growth and search for companies that start at small payout ratios that are expected to increase in the future.
3) Dividend Discount Model (DDM) Valuation: The second back of the envelope calculation that every investor must use is the DDM (P= D/(r-g)). Theoretically, R and G are the cost of equity and perpetual growth rate of the dividend. We suggest making the equation more stringent and search for a price where the annual dividend is divided by (9-g) where 9% will represent total market returns. You can apply this method to obtain an approximate valuation discount or premium based on the current stock price, just remember the valuation assumes the entire entity is valued based on dividends.
4) Dividend Aristocrats: This term is being thrown around more and more lately, a company with 25 years of consecutive dividend increases. For the lazy you can simply invest in SDY or SPDAUDP for exposure to these names. In our view, some exposure to dividend aristocrats should be baked into the dividend payment section of your portfolio (depending on age ~10-40% dividend portfolio, with 25% representing aristocrats)
5) REIT Exposure: Finally, the last piece of filtering a strong dividend portfolio is having some exposure to REITs (Real Estate Investment Trusts). Essentially a REIT pays out 90% of its taxable income to shareholders directly and is a play on property (apartment buildings, homes, malls etc.). While this falls into the “need” category we’re separating it out as an investment option as the taxes paid on REITs are at your nominal tax rate versus the dividends paid by other investment vehicles which are taxed at just 15%.
With the basics out of the way it is time to go ahead and optimize your investment strategy on a dividend reinvestment front.
Building Your Portfolio:
1) All Dividends Are Re-Invested: Remember that every penny you put into the stock market is to remain untouched until you have enough money to quit forever. On a quarterly basis your goal is to reinvest all dividends into their parent companies (Eg: REIT dividends are reinvested in REITs and dividends from your chosen companies are reinvested in the same basket of goods).
2) Avoid Taxes: As we noted in the 401K post, you will have opportunities to move assets into both taxable and non-taxable portfolios. With this in mind you can quickly run the math and realize your ROTH IRA exposure should run your REIT portfolio while your personal taxable accounts should run your dividend payments. For the astute reader you’ll quickly realize REITs can see a 0% tax rate on dividends if they are in a ROTH portfolio as these are tax free gains. Notably, the reverse is true in a taxable account where instead of investing in REITs you will have exposure to qualified dividends. For the short story, qualified dividends are for your personal taxable portfolio, unqualified dividends can hide in a ROTH IRA to collect tax free gains.
3) Your Age Matters: Above we gave a wide range of exposure to dividends (10-40%) and this is dependent entirely on your age and how much you are able to reinvest into the market excluding your dividend contribution. Assuming you have a relatively high paying job ($5K post taxes per month) if you are in the 20 year old bracket you’ll spend more time reinvesting income into riskier assets where the standard deviation works in your favor (medical securities). Below is a back of the envelope guide on dividends versus high risk stocks.
- 20’s: 10% dividends 30% risk
- 30’s: 20% dividends 20% risk
- 40’s: 30% dividends 0% risk as you switch to holding bonds
Concluding Remarks: For the too long, didn’t read type the simple concepts can be boiled down as follows: 1) All qualified dividends should be in securities that are based on needs (home/food/electricity etc.), 2) Non-qualified dividends should be held in a tax sheltered ROTH IRA account, 3) As you age your dividend reinvestments should make up a larger contribution of reinvestment relative to personal income contributions and 4) always run back of the envelope stock price analysis with DDM and EPS growth.
Based on the comments we’ll see how much deeper we should dive into personal finance and the level of security analysis. Good to be back.
