Q: You are a proponent of investing in “rising dividend” stocks for income, especially in retirement. Can you explain what you mean by that?
A: There are a number of reasons why I prefer investing in rising dividend stocks instead of the “old school” approach of investing in bonds to generate income. First, with interest rates near historic lows, bonds may offer little or no yield advantage over dividend stocks. Second, interest rates on bonds are usually fixed and offer no protection against the rising cost of living over time. In contrast, the income from a carefully selected portfolio of companies with a pattern of increasing their dividends each year, may realistically be expected to double or even triple every ten years or so. Additionally, qualifying dividends from U.S. companies are currently taxed at favorable rates relative to ordinary taxable interest income.
Investors should be aware, of course, that, despite the appeal of rising dividend income, the underlying investment is still common stock. Stock prices will always be volatile, and, unlike a bond that has a set maturity date, investing in stocks provides no assurance of return of principal if the stock is sold.
Q: Can you elaborate further on your approach to investing in rising dividend stocks?
A: As I explain to all clients, the approach I apply does not really entail any stock picking ability, but is rather about applying a disciplined set of screening criteria. There are a number of criteria (e.g., P/E ratio, dividend payout ratio, etc.) I use to help screen for companies that are reasonably priced and that seem likely to continue to increase dividend payouts over time. However, I have just one sell criterion – if a company cuts its dividend. Beyond that, like Warren Buffett, “our favorite holding period is forever.” It doesn’t matter if we are in a bull market or a bear market, if the companies we buy keep increasing their dividends, we keep holding.
There are obviously no guarantees that a company will continue to increase its dividends year after year, but companies that have demonstrated this pattern, tend to be well managed and financially healthy. Building a diversified portfolio of 15-20 of these companies may further reduce company specific risk.
Q: There have been a number of recent articles talking about the run up in dividend stocks and the idea that rising interest rates may put downward pressure on their valuations. Do you think this has validity?
A: I have read some of these articles too. I don’t disagree that rising rates may have an adverse effect on high yielding dividend stocks, such as REITs and utility stocks. Stocks with high dividend yields (and high dividend payout ratios) may be vulnerable to rising interest rates in the same way that long term bonds and preferred stocks are.
There is a subtle but important distinction, however, between “high dividend” stocks and “rising dividend” stocks. Many of the rising dividend companies on my radar screen do not necessarily have high current yields. These days, most have yields in the 1%-3% range. As I mentioned earlier, focusing on companies that are able to increase dividend payouts each year is effectively a screening mechanism for healthy, well-managed, mature companies. In doing this stuff for almost 30 years, I can’t recall a bad time to invest those types of companies.
Q: You mentioned earlier that you would only recommend selling if a company cuts its dividend. If the valuation of a stock you recommended a few years ago seems high now, why not sell? What if the economy tanks?
A: There is a fair amount of academic research suggesting that investors, including professionals, are not particularly adroit at timing their sell decisions. When I look back at the rising dividend stocks accumulated in client portfolios over the past quarter century, I know I would have regretted selling most of those companies whenever their valuations may have seemed high.
In terms of the economy tanking, the first decade of this century saw two of the worst bear markets in history. For the most part, investors who held onto their rising dividend stocks were rewarded for their intestinal fortitude. To the extent that dividends continue to be paid (and increase) during such downturns, it also makes it easier for investors to ride out the storm.
Q: How would a portfolio like this fit into one’s overall allocation.
A: To be clear, rising dividend stocks are still, well,… stocks. As such, they fall clearly within the equity category of the broad asset allocation pie chart (comprised of stocks, bonds, and cash). They are definitely not a pure substitute for bonds.
By the same token, with interest rates still hovering near historic lows, there has been a paradigm shift in the ideal asset allocation for maximizing portfolio sustainability in retirement. The old adage of using “100 minus your age” to determine one’s stock allocation in retirement might have had some merit when bonds were paying 6% or more, but with intermediate term bond rates closer to 2-3%, a number of recent research papers have suggested that high bond allocations may actually increase the risk of portfolio depletion. Whereas stock:bond allocations of 50:50 to 60:40 may have been advisabe15-20 years ago, today allocations of 70:30 or even 80:20 may be more appropriate in retirement.
In terms of how much of one’s equity allocation should be devoted to rising dividend stocks, it really depends upon the investor’s income need and balancing this requirement with the benefits of including exposure to non-dividend paying equity classifications, such as small cap and international equities.
As I mentioned earlier, rising dividend stocks tend to lend themselves well to taxable accounts, where investors may wish to use retirement accounts for their stock mutual fund allocations, so such considerations may also factor into allocation decisions.
Q: What resources would an investor use to do research?
A: We live in the information age. If it was ever true that investment professionals had access to better information than individual investors, it is surely a myth today. There are scores of great websites to help investors research publicly traded securities. If pressed to recommend one, Morningstar is a great tool for providing objective fundamental information about both stocks and mutual funds.