If you had to describe the ultimate goal of years worth of dividend investing it would be that one day, after decades of hard work and saving, you could retire and live off your dividends. What do you need to achieve this? Actually on a long-term investing horizon it’s less than you imagine. Let’s play the wonderful hindsight game and look back at how you might have achieved this historically.
Let’s say you’re working with a forty year investing lifetime, equivalent to starting your dividend investing strategy at twenty-five for retirement at sixty-five. Actually as it turns out forty years ago would have been an excellent time to begin investing – you start right in the middle of the stagnation years following the market crash of 1973-74.
Now, when you begin investing you want to limit yourself to good old income stocks. Those are stocks with a proven record of high quality profits and history of sharing them with shareholders. Procter & Gamble and Exxon would stand out from the list of Dow Jones Industrial Average stocks from the time. Philip Morris, Eastman Kodak, Coca-Cola and Johnson & Johnson might appeal from the Nifty Fifty list, which a few years earlier had been trading at eye-watering valuations.
Say you stick $1,000 into Johnson & Johnson stock. It’s your only investment and you know that’s risky but your aim is to use the dividends to diversify into other stocks along the way. Today that $1,000 investment means $65,000 worth of Johnson & Johnson shares and current year dividend income of $1,650.
So just on its own that simple dividend investing strategy has yielded current dividend income equivalent to 160% yield on cost. Given the room for future growth, Johnson & Johnson’s financial health and their current dividend payout ratio, you could realistically be looking at income growth of 5% a year for the next five years. By the end of year five you’re up to $2,100 a year in dividend payments.
Now, let’s say in addition to that initial investment in Johnson & Johnson our guy sets aside some of his salary every month to buy more stock – let’s call it $200 (the equivalent of $850 in today’s money). We’ll also assume that our budding dividend investor didn’t bother to adjust for inflation over time – they just kept it steady by pumping $200 each month into more Johnson & Johnson stock. What’s the end result? A portfolio stuffed with roughly $1,600,000 worth of Johnson & Johnson stock and current year dividend income of $40,000.
So our investor is in the position of having retirement income that immediately puts them just under the median US household income, before including any additional sources of retirement income. All of a sudden that 5% a year increase in dividend income over the next five years looks huge. In year two it would grow to $42,000. By year three it is an increase of $2,100 to $44,100. In year four it goes up $46,300 and by the time you get to year five it is $48,600 in annual Johnson & Johnson dividends. So you’ve gone from $40,000 in dividend income to $48,600 in the space of five years, having done no additional work whatsoever. Throw in the $2,100 from the initial $1,000 investment and you’re clearing $50,000 in dividend income.
The best thing about this approach is that you can afford to hit the odd loser every now and then. Say you take the dividend income from Johnson & Johnson after the first decade, plus some extra, and pick up another seemingly solid dividend blue chip stock: Eastman Kodak. Now over the years the fortunes of Kodak deteriorate to the point where eventually they file for Chapter 11 bankruptcy. That’s it, a seemingly safe and stodgy old blue chip dividend payer ends up bust. Even though your stock holding ends up going all the way to approximately $0 you don’t actually see a complete wipeout. From 1985 you see the following on a $10,000 investment: Eastman Kodak cumulative dividends of $17,300, an Eastman Chemical stock spin-off in 1994 that is worth $17,850 today, and finally Eastman Chemical cumulative dividends of $5,930.
Despite the catastrophe of bankruptcy you somehow don’t end up too badly affected at all. Sure it’s huge underperformance versus any benchmark over the period, but combine that with the $1.6m worth of Johnson & Johnson stock and you still ended up compounding wealth and income at a healthy rate. Diversifying those Kodak dividends out into something like Philip Morris would earn you an extra $900 a year in retirement income. The worst case scenario didn’t look all that bad because the earnings quality was still intact on day one. In the case of a formally solid blue chip stock like Eastman Kodak it will took time to degrade the earnings power of the core business.
In practice there are a couple of ways to achieve this dividend investing strategy. Really it’s just about simple compound interest. These days you’re more likely to hear terms like dividend growth investing but the core mechanics are the same. The first, and best, way to go about it would be to start a regular investment program as young as possible. The younger you start the less you need to set aside each month.
If you’re older then you need to bump up the monthly contributions significantly to garner the same effect. Ditto the slower the growth profile of your stocks. Build around a solid core of blue chip dividend paying stocks with strong moats: Colgate-Palmolive, Johnson & Johnson and Unilever to name a few examples.
Eventually you diversify out until you have a set of twenty or so companies that roughly share the same characteristics. They might have different growth profiles (Johnson & Johnson in 2016 is not the Johnson & Johnson of your dad’s generation) but their earnings quality should be similar. Add more in the rare times that they go on sale or dip under their average long-term valuations.
Bump up the monthly contributions in bear markets, lower them a tad in strong bull markets. Reinvest the dividends, enjoy the underlying earnings per share growth and then check back a few decades down the line. When you’re compounding income growth at 5% a year after a few decades you’ll likely see a huge impact on your quality of life. At that point you’ll really be able to enjoy living off dividends. It’s just that don’t see it in the early years when you’re making $50 in dividends that won’t even cover a decent restaurant bill.