I remember the first time I read Warren Buffett's annual letter to Berkshire Hathaway shareholders. It was witty, it was entertaining, and it wasn't anything like your standard annual report with glossy pages, full color photos, and mind-numbing marketing-speak.
That first time, the page that blew me away was his list of stock investments – specifically the dividend producing stocks.
Berkshire Hathaway, as of the 2014 letter, owns 400 million shares of stock at a cost of $1.299 billion. Each share pays out $1.32 a year. Berkshire Hathaway gets $528 million from Coca Cola every single year.
That's an annual yield of 40.6%.
How is this possible!? What is this sorcery!?
Buffett acquired shares of Coca-Cola in 1988. Back then he wrote “We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.” (1998 letter)
The formula is simple. He bought the shares a long time ago, his cost basis was much lower than the market value, and KO kept increasing dividends. If you buy shares today, you get 3.44% yield. Warren Buffett is getting 40.6%.
I wanted to replicate his success. I wanted to build a portfolio of blue chip, dividend stocks that would produce passive income for us.
I'll start with explaining where dividends fit in our existing portfolio, follow it up with a discussion why we invest in individuals stocks and not dividend funds, a brief chat about the factors in our favor followed by the strategy I use to pick stocks. Let's go!
Table of Contents
Where Dividends Fit in Financial Picture
Before we get into how I built my dividend portfolio, it's important to know how it all fits.
70% of our stock market investments are in various Vanguard funds. The balance is in individual dividend producing stocks. The Vanguard funds also produce dividends, since many stocks in the stock market produce dividends, but I don't consider those funds part of the “dividend” section of our portfolio. The Vanguard 500 Index Fund Shares has a healthy 2.23% yield, so it's not inconsequential!
My goal with dividends was to create a stream of passive income that would act as insurance against the unpredictability of entrepreneurship.
In 2015, that stream amounted to $55,152.60, a 10.4% increase over 2014. (what's nice about this income is that it's taxed at the 15% long term capital gain rate too!)
Part of the increase was due to more investments, part of it was due to dividend growth. Dividend growth is especially attractive because I don't have to commit any more money to get greater dividends… can't beat that!
Why Individual Stocks?
If low cost index funds are the best, why not use a low cost dividend fund from Vanguard? The Vanguard Dividend Appreciation Index Fund Investor Shares (VDAIX) has a 2.25% yield with an expense ratio of 0.20% (the Admiral version's expense ratio is just 0.10%).
It holds many of the same companies that I would end up buying. At the end of Jan2016, 36.6% of the holdings were in Microsoft, J&J, Coca-Cola, P&G, Pepsi, Wal-Mart, IBM, CVS, Medtronic, and 3M… classic dividend producting blue chippers. As of this writing, of that list, I only own Microsoft, Medtronic, and Coca-Cola.
So why didn't I go with a fund? I wanted to cherry pick companies that had higher dividend growth rates and a higher dividend yield. 2.25% on a dividend fund is meh, especially when the S&P 500 yields 2.12%, right? I wanted more.
I also wanted to have a little fun and scratch that stock picking itch in a way that was safe, smart, and fit our financial plan.
A Few Factors in My Favor…
To put everything in better context, it's important to know a few things I saw as my advantages:
- I just sold a company and had a sizable sum of investable assets – While this allowed me to grow my dividend portfolio faster, it didn't give me any special access or advantage other than lower transaction fees on Vanguard.
- The great recession just brutalized stocks, I was getting them at a big discount – The bargains will be fewer and farther between now. General Electric was as low as ~$7 in March 2009! With so many bargains, I was able to make some mistakes and not get burned as badly by them.
- I have time on my side – I view our assets as a series of buckets. Near term (needed within the next 5 years), middle term (5-10 years), and long term (10+). All of this money was long term money so I could put it in individual companies, with greater volatility, because I could wait out the volatility. Every stock I've owned for more than 3 years is positive (not positive in “real” terms, like vs. inflation or the S&P or any other benchmark, but they're green).
I believe that if you need the money in the next five years, do not put it in the stock market. It's just too volatile. If you don't need it for 10+ years, it has to be in the stock market (or some other investment). It cannot be in cash, you give up too much growth.
I also believe that dividends are awesome. You've probably heard statistics that say dividends account for a big percentage of gains in the stock market (here's an article by Bob Pisani about it). I see it as a good insurance against income volatility, of which I experience a fair amount as an entrepreneur.
Check out the historical chart for KO, a Dividend King, on Google Finance:
In July 1998, KO hit $43.59 – a high that wouldn't be revisited until October 2014. Ack!
That would stink if you needed your money because KO's stock price languished for many many years. But… They kept on paying and increasing that dividend. KO's stock price may have stunk but KO was doing its job and paying its dividend. That's pretty awesome.
(Charts like that also make stock market bloodbaths more palatable — as long as the stocks keep doing their jobs!)
How I Built My Dividend Portfolio
My criteria for picking companies has slowly evolved over the years.
It's not perfect, I don't think any system ever is, but it has worked for me.
The first filter is that they must be a well-known household brand or be a Dividend King or Dividend Aristocrat. A Dividend King is a company that has increased their dividend for 50+ years, only 18 companies have done that.
A Dividend Aristocrat is a company that has increased their dividends for at least 25 years. (DRiP Investing Resource Center calls them Dividend Champions and organizes them in a very useful Excel spreadsheet) All Dividend Kings are Dividend Aristocrafts.
As everyone knows, “past performance is not indicative of future results!” I fully believe that… but I don't stop my analysis with those lists. They merely pare down the universe of stocks to a more reasonable subset. Also, 25 and 50 years is a long time. 🙂
The next filter is financial and the big number I want to look at has to do with dividend coverage. Dividend coverage is the company's earnings per share divided by the dividend per share. I want earnings to be at least twice that of the dividend, or a dividend cover of 2 times. I also look at some of the other metrics many use to analyze a company (increases in earnings per share, equity per share growth percentage, etc.). The basic idea here is that I want to make sure they can continue paying the dividend (coverage) and that they can continue to grow the dividend (increasing EPS).
Now I'm confident that the company is financially stable, I check out is dividend growth. It needs to beat 3% each year, which is what I put in my head as average inflation. Inflation is such a fickle number but I'm confident that by having a growth rate greater than 3% means the dividend will grow faster than inflation.
Next, I start doing some searches about these companies on other financial websites I trust. Dividend Growth Investor is a blog I've been following for years, he does a good job of analyzing a lot of companies. His commenters are also really good too and I've discovered folks like Passive Income Pursuit through him. I also like Crossing Wall Street, though it doesn't have a dividend angle, it's well informed and the Friday market reviews are a must read.
I read other blogs not for their analysis per se, but a lot of times they uncover news or tidbits I didn't see. It's also fun to read someone else's approach and see what you can integrate into your own.
Lastly, know when to fold em. I sell when the conditions change. You always need to know when you plan to exit, or you run the risk of making decisions based on emotion. Just recently, ConocoPhillips announced they were slashing their dividend. I sold it because its purpose was to be a dividend stock (and at a certain yield)… and they cut their dividend from $2.96 a share to $1 a share. It's still a dividend stock, just a lower yield one, but it stopped doing the job I needed.
The Importance of Dividend Growth
The sneaky non-obvious part about dividend investing is that you can build a safe portfolio that produces ever increasing cash flows. By selecting companies that grow their dividend faster than inflation, you are building a stream of income that grows upon itself.
You can also achieve this by automatic reinvestment of dividends because this will grow your stake in the company. This is useful if you're don't actually need the income. I don't reinvest dividends because keeping track of those separate purchases can be a bit of a pain. I'd rather just buy more when favorable conditions present themselves.
Looking only at individual dividend stocks, my 2014 yield was 5.623%. If you were to buy the exact same basket of stocks today, the yield would only be 3.707%. (don't try to do the math using the $55k dividend income above to reverse engineer our portfolio size, the income number included index funds which aren't included in this 2014 yield calculation)
OK, part of the difference has been the run-up (and slight correction) in the stock market but the rest has to do with how much you benefit from investing in companies that increase dividends every year. When you find companies that consistently increase their dividend and do so at a rate greater than inflation, your yield is sure to improve.
Dividend growth FTW!
Maybe one day that number will be 40% like the Oracle of Omaha. 🙂
Are you a dividend investor? What is your process and approach?