The Why Question is Important
Respected journalists know that they need to ask questions. These questions begin with these five “W” and one “H”: “Who? What? Where? When? Why? How? The who, what, when, where, and how of any matter all matter to some extent. But, perhaps more often than not, the “why” is the most important element. I can teach you some of my thinking about what investments to buy, and when to buy them, and even the how of my process. However, I believe these will take on more value and importance if you understand the why’s. Perhaps that is one reason that children often ask the question “why?” when they are given instructions or are trying to understand purpose.
Five Primary Whys
There are many reasons why I prefer dividend growth stocks and ETFs over a focus on growth stocks, speculative investments, day-trading, bonds, and precious metals. In this piece I will focus on the reasons I switched from doing each of those to the model that has worked for me. The five reasons are automatic, consistent, inflation, returns, and history.
Automatic Income Flow – the ATM of Investments
When you are in your working years, it is highly likely that most workers expect to be paid weekly, biweekly, semi-monthly, or monthly. Of course, there are exceptions to this, but the vast majority of the workforce can reasonably expect regular income. When you retire, if you contributed to Social Security, you will be paid monthly. One of the things you can expect from companies and ETFs that pay a dividend, is that most of them will pay you quarterly. If you have enough diversification, it is likely that you can see income every week. Of course, this requires some extra work, but it can be done. Some investments pay monthly, and I own some of these in our accounts. If a company pays a dividend, it can be monthly, quarterly, semiannual, annual, special, or supplemental. When researching a company, it is wise to note the frequency so that you can budget accordingly.
The nice thing about a dividend is that I don’t expend any effort to receive it. I am a partial owner in the company. Companies that pay dividends are (normally) paying the dividend from the profit of the business or from free cash flow. In 2022 Cindie and I can reasonably expect to average over $10,000 per month in dividend income. This, I will remind you, is automatic. It is like driving up to an ATM that is always handing us dollars.
Consistent Regular Income
Not only is the income regular, when you invest using a dividend growth model you can expect the dividends to be consistent. There is an underlying reason for this. Companies that have a track record of paying a growing dividend are very hesitant to change the practice. That means they don’t want to disappoint you, the co-owner of the business. If they keep a good eye on the company’s growth and want to be reasonably certain that they can continue to increase the dividend, then they will be careful about the dividend payout ratio. Of all of the numbers associated with a dividend stock, the payout ratio is the most important. The sustainability of consistent regular payments has a direct impact on the share price. A dividend cut or suspension can cause the price of the shares to drop and causes true dividend investors to go elsewhere.
Dividends that are consistent are important. Dividends that grow are preferrable because they can help keep pace with the costs of living. This is especially important in an inflationary economy. It isn’t hard to find companies that increase their dividend by 5-10% per year. Again, this is usually consistent and can create a significant source of income to counter the drain of buying power caused by inflation.
Some of our investments do not pay a dividend. Investing in growth companies is also a prudent way to gain value. At present, twenty-nine of our investments do not pay a dividend. The largest ones, by dollars invested, are AMD, AMZN, and FLGT. Bear in mind, however, that we have a total of about 200 investments (stocks and ETFs) and most of those are dividend growth in focus. Furthermore, even some of the dividend investments are not dividend growth. Sometimes it is better to have monthly income and sacrifice growth. This is true of investments like O, MAIN and GAIN.
Returns From Business Growth
You cannot spend capital gains until you sell some or all of your shares. If you are forced to sell to get cash for living expenses or other unanticipated needs, you may receive a profit, but you can also wind up with a loss. I don’t have to sell anything to get income from most of our investments. If for example, we need to purchase a new car or repair some damage to our home not covered by insurance, it is reasonable to expect that $10,000 will be arriving in the next thirty days.
Companies that don’t pay a dividend are saying something to investors. Their message is, “trust us to invest every dollar of profit to grow the business to make your ownership in the company even more valuable.” That is, of course, often a good thing. However, a bird in the hand is worth one hundred in the bush. I can eat the bird in my hand, but the hundred in the bush could fly away. Therefore, the dividend payout ratio is important here as well. If the payout ratio is 40%, then the business is keeping 60% of the profit to grow the business. This is a win-win for the dividend growth investor.
History of Stock Market Returns
Finally, I have done a lot of reading and research about growth, value, dividend, and options investing. Many studies have shown that a large portion of a stock market’s returns are fueled by dividends and reinvesting of dividends. In the last couple of months the stock market has brutally punished growth investors. While our total investments have declined in value, they have not declined at the same pace. In fact, most weeks our returns are better than the S&P 500 index returns.
Can You Prove It Works, Wayne?
Perhaps the easiest way to illustrate the power of this type of investing is to show you some pictures. Each of these is a chart from Fidelity Investments. The first two charts show how income has grown since the beginning of 2003. The third shows the 5-year growth and average total monthly income. The fourth just looks at the last three years. The final one shows the last twelve months. It is true that I bought and sold investments over the years, but the model for income has remained essentially unchanged for the last fifteen years. You can attempt to make $10,000 per month day trading. I prefer to make $10,000 per month and do other things with my time.
Three Final Thoughts
First, there will be days when you see your accounts drop in value for no apparent reason. Do not forget that the “value” of a dividend-paying position will decrease by the amount of the dividend that is promised on the ex-dividend date. Your account balance has artificially dropped only because you are promised some cash from that investment. There will be days when your account balance will increase by the same dollar amount when the dividend is paid.
Second, not all companies are good for dividend growth investing. It is wise to start with a focus on dividend champions or a good dividend ETF. Generally speaking, if a company has been paying an increasing dividend for ten or more years, and their dividend payout ratio is rational, and the business model is sound, then each year will see an increase in the dividend. For example, The Coca-Cola Company (KO) has been paying a dividend for 59 years. I don’t own shares of KO, but Warren Buffett does. Furthermore, KO shares appear in our ETF holdings like VYM. KO is in the top 25 holdings of VYM.
Finally, someday my wife may be a widow. She doesn’t need to be creating an income stream. If I have done my job, she can just use and give the income away.