Most novice dividend investors typically are under the impression that successful dividend investing entails finding and purchasing the highest yielding stocks. This strategy is flawed, because it does not take into account the sustainability of the dividend. Words: 671
In further edited [ ] excerpts from the original article* the DividendGrowthInvestor.com goes on to say:
I purchased American Capital (ACAS) in 2008 when this business development company was trading at $30 and was yielding 13%. Just a few months later the company suspended its dividend payment, and I sold it immediately. The thing to learn from this example is that investors have to check the sustainability of distributions in light of cash flows generated by the business, the amounts of debt relative to total assets and the amounts of interest expenses. If you find a high yielding stock, which generates enough cash flow growth and has limited amounts of debt, then it could be a buy on the next dip.
While companies are not contractually obligated to share profits with shareholders, it is nice to see when boards increase dividends and declare stock buybacks, This typically sends positive signals about management’s confidence in projected cashflows, generated by the business.
I like to hold stocks with different yield/dividend growth characteristics where yields are somewhere between 3% and 5% and dividend growth is in the upper single digits or in the double digits.
I do realize however that some investors are interested mostly in current income generation, and not so much about future dividend growth. Thus recommending Wal-Mart with its 2% dividend yield to an investor who wants to generate as much income as possible now might sound ridiculous. Just because one wants to generate as much income as possible however, doesn’t mean that they should throw caution away with the wind. Sustainability of the dividend should be evaluated, in addition to sustainability of the dividend growth. A stock with a sustainable but unchanged dividend, which yields 9% on cost, would produce a lower inflation adjusted income level over time.
The 4% Rule
In addition to that, most studies of portfolio durability show that one should not spend more than 4% of their portfolio value each year. If you have a dividend portfolio valued at $1 million dollars, which generates $40,000/year in dividend income, and whose dividend growth closely matches the inflation rate, you are ok as long as you don’t spend more than $40,000/year. If you spend more than that, you could end up eating your principal.
Thus, even if you found the highest dividend stock, you should not be spending more than 4% of the starting value of your portfolio each year, adjusted for inflation. If you owned a 10% yielder on a $1 million portfolio, and you spend all your dividend income, you would be in trouble when one of two things happen:
1) The company cuts dividends
2) The company fails to increase dividends to compensate for the eroding value of inflation
In order to increase portfolio longevity, I would consider at least a 25% allocation to fixed income, which would provide some buffer during bear markets and deflationary environments. In addition to that, having an allocation to lower yielding stocks with higher dividend growth characteristics could also provide a buffer for dividend increases if you are lucky enough to spend more time in retirement.
Your goal should always be for your money to outlive you, no matter what. [High yield stocks with both the liklihood of long term growth and sustainability will achieve just that.]
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