One of my goals very early on was to try and get myself financially independent as soon as I could. This didn’t necessarily mean seeking a very early retirement or dropping out of the workforce. More having the options to pursue the things I wanted in the way I wanted to pursue them. While I’m still not there yet, our “financial independence cushion” has built up to $25k/yr. So what’s the secret?
It’s rather simple really, but it just takes time and patience to build up. In my mid 20′s I discovered the power of dividend investing or more specifically dividend growth investing through a book called Dividend Growth Investment Strategy, and the ability to build up a steady stream of income based on the willingness of companies to pay out their excess cash flow. Fast forward 10 years later and our dividend cushion now stands at $25k. I’m going to detail below what I did to build up this cushion.
Large cap dividend payers
The reality is that you need a couple of large cap dividend payors to anchor your dividend portfolio. These are those large businesses ($10B+ in market capitalization) that have consistent earning streams that pay out large portions of the cashflow in dividends. In my portfolio, these companies are some big banks and telecommunications companies. I probably have about 40% of my dividends that come from these companies. They generally have yields of 5-6% a year and raise they dividends anywhere around 5-10% a year. Not great in terms of dividend growth, but generally a very dependable income stream year on year.
The key with adding these dividend payors to your portfolio is to get them when they are out of favor. One of these large cap dividend payors that I have is a company called Telstra (a large cap Australian telecommunications company). I was lucky enough to pick this one up when there was general panic about its prospects and it was sent down to historic lows, with yields of almost 10%.
Telecommunications companies in mature markets tend to be part of an oligopolistic market structure. That means you generally have only a few major players. Its a scale business where the largest survive, so I had every confidence this company would continue to exist. While the shares have subsequently recovered, buying large yielders in panic situations can be a great boost to your dividend income. In the US market, your classic large cap dividend payors are companies like PG, McDonalds, Walmart, Coca Cola.
Mid cap dividend payers
I like to have a lot of my dividend income coming from this group of companies. I’d estimate that another 40% of my dividend income comes from here. These are companies in the $1B to $10B in my view. Mid cap investing can be a little tricky if you are not careful. You need to look at companies with strong barriers to entry and what I call competitive moats. Moats are unique advantages that these companies possess, whether its brand, intellectual property, unique manufacturing process.
I like these companies because the dividend growth that you get from them tends to be much higher than the large cap payors (often at rates exceeding 10%), and they are likely to have a solid trajectory of growth for a decade or more, which means you will get a sustained, increasing dividend stream. I also like to acquire these businesses when they are out of favor.
Cochlear (a large Australian ear implant company) one of my favorite businesses, was briefly beaten up due to a scare over a product recall in late 2011. I used that opportunity to pick up a large holding in the stock. It was one that I had been watching for a while, it had just never been cheap enough for my liking. Look for large moats, strong competitive advantages and solid growth in free cash flow for these companies. Dividend growth of greater than 10%pa is possible here.
Small cap/micro cap dividend payers
In my mind, this is really dividend investing gold, but definitely the area fraught with the most risk. I try and look to cap the dividends from this group of companies to no more than 15% of my dividend portfolio. These are the companies with the $<1B market cap.
If you are able to identify these companies correctly, you will be rewarded with a rapidly increasing dividend stream for a long period of time. These are also the companies that have the greatest potential to grow into mid to large business, and you will not only benefit from a steady income stream but also good capital growth as investors reward these companies for their performance and the yield they generate and bid their price up accordingly.
These companies are difficult to identify and even harder to analyze given the lack of information that exists about them. So how do you go about finding them? Look for an value based small cap fund manager that’s is focussed on this area. What are the characteristics of good candidates? Its largely the same thing as for the mid and large caps. You need strong business models, competitive advantages and solid cash flow growth.
The fact that these small caps are paying a dividend in the first place says a lot about their financial stability. I am less fixated at picking these companies up at rock bottom prices, because with this size of company, the rapid dividend growth rates that they will achieve will likely mean substantial increases in market valuation over an extended period of time.
Dividend investing is a great way to help secure your passive income future. With the right mix of stocks, you will have a well diversified portfolio that provides solid dividend growth over a long period of time. For those that feel more comfortable, looking further downstream to mid and small cap dividend payors can be an area of substantial long term reward.