Starting with stable, well established, consistent dividend growth payers should be part of the core of any investor’s portfolio. Having these dividend payers in one’s portfolio will help provide some income stability to the portfolio, as well as stock price stability.

These companies have developed strong competitive advantages and have generally been able to construct wide moats for themselves over many years. With very strong value propositions, they enjoy superior returns on equity and have been able to develop a long streak of paying and increasing their dividends.

Most importantly, these larger dividend payers tend to pay moderate yields of around 3-4% and provide consistent increases in their dividends of at least the rate of inflation.

McDonald’s (MCD) and The Coca-Cola company (KO) are two examples of companies that could be considered as core holdings for younger investors.

Click here to read the rest of my article on Seeking Alpha

Luckily for me, the time when I first started my first full time job and was able to make some reasonable money was during the beginning of 2000. I was in the market just long enough to see the tail end of  gogo days at the end of the internet bubble. I remember watching with some amazement as prices would move by 5%, 10% even on a daily basis, and I remember thinking that I knew I wanted some of that action.

So I set about trying to create some of my own internet wealth, and invested some of my hard earned income into a biotech start up and an internet start up that I was expecting would at least double in a few months. Of course, it was wasn’t to be, and both were bankrupt by the end of the year.

Over a decade later, I know better!. I know that one shouldn’t expect instant wealth and riches from companies whose main asset is a powerpoint deck, and which has a business model of giving away shareholders money!

But both of these early investments were foundational to my journey as an investor. Why was losing $5k one of the best financial investments I made ?

I realized my Method doesn’t work!

It made it easier to accept there was something wrong with my current method When you lose money, you come to accept the hard reality that the method and approach you have doesn’t work.

No matter how many times someone tells you that a certain strategy is better, its often a lesson best learnt on your own, and there is no better way to learn it than losing your own money. If one is smart enough and doesn’t like losing money, its highly likely that you pivot and learn from the mistake and get to something else that works better.

I understood that I need more research

I quickly understood that I needed to spend more than just 5 minutes understanding a stock. My initial investments were made on the basis of a hot stock tip from a couple of the financial wizards in the newspaper.

Folks that were probably similarly caught up in revenue to earnings multiples and who had no cares that a company hadn’t made a profit and had no clear path to making a profit. I learnt pretty quick that trying to get financial advise from people who probably had no clue on how businesses work was probably not such a good idea.

I discovered dividend growth from wide moats

I discovered wide moats and growing dividends. Probably most significant for me, after several years of experimentation on techniology stocks and active funds management and even internationally oriented stocks, I stumbled upon businesses with wide moats paying increasing dividends as a way driving total return. It was the simplicity of the investment philosophy and the clear path to driving increasing earnings and dividends that was most attractive to me.

In my view, it was as a result of some missteps that I made that helped me  settle on an investment strategy that not only made sense to me and that I can stand by, but one that I believe can ultimately drive financial independence for me and strong total returns.

While there are some that are fortunate enough to stumble onto an investment strategy that works well for them without the loss of significant capital, I still consider myself pretty fortunate. Again, why?

Personal finance is such a broad area that one could easily spend days trying to get on top of everything that is covered. Saving, investing, taxation are such involved and detailed area that you could break these down into hundreds of smaller topics. In my view however, there are probably just a handful of topics that you have to have a really good understanding of to make smart financial decisions.

Financial risk

This is a really important one, and I’d probably rank this top on the list. You’re ability to derive strong returns are directly correlated to how much financial risk you are willing to take. I define financial risk as the risk associated with the preservation of capital.

There is no such thing as a free lunch in my view, and the same holds true in chasing investment returns. Each of us has our own  risk return trade off that we are happy with in pursuit of investment returns.

I for one, am happy to bypass government bonds. The tiny rates of return that are currently on offer from bonds globally, specifically government bonds, don’t make it worth the time to invest. Frankly, I am happy to take far more risk for the prospect of substantially higher returns, which is why I have made my path with a dividend investment strategy.

Of course, investing in individual stocks carries the prospect of a complete loss of capital, which you can mitigate to a degree with careful stock selection.  Investing in a basket of stocks such as an ETF or a managed fund helps minimize that risk to a much larger extent.

There is a less well understood financial risk associated with investment in bonds in my view. While bonds are considered safe investments, their rate of return in a low interest rate environment may actually be such that bond returns don’t keep up with inflation. Thus while your principal may be safe, real returns from bonds may get eroded over many years by steadily increasing rates of inflation.

Taxation

Taxation is another area that not much attention is given to in my view, but an area that is exceptionally important. People are generally accustomed to thinking about their returns on a  pre tax basis rather than in a post tax way.

However what you ultimately take home is far more important than what you may happen to earn on headline, notional terms. Certain forms of investment are far more tax effective than others. Regular interest, for example tends to attract taxation at an individuals marginal tax rate, whereas dividend income from dividend paying stocks tends to be capped at 15% for most people.

Regular wage income tends not to attract any special type of tax deduction. More to the point, its subject to a whole host of taxes that non wage investment income doesn’t attract, such as medicare and social security taxes as well as other state taxes.

This actually collectively makes investment income far more tax efficient than wage income. Its why the rich have very low rates of effective taxation, and why I think dividend income is far more tax effective than ordinary wage income.

The power of compounding

I’ve heard it said that Einstein referred to compounding as the 8th wonder of the world. If so, its with good reason. The ability for individuals to grow their investments at progressively faster rates as each dollar gets reinvested is truly pretty amazing.

It also helps explain why the best time to start investing is as soon as you reasonably can. Compounding investment dollars at an early age can leave you with a significant amount of wealth later on in life.

An investor in The Coca-Cola Company  who invested $10,000 about 50 years ago would have had a stock value of almost $500,000 today. If you think that’s impressive, consider the scenario where those dividend were reinvested. That same investor would have almost $1.75M in an investment in The Coca-Cola company!. Talk about an acceleration in wealth from compounding returns!

Debt can be  valuable tool

Many of us have been conditioned to the thinking that all debt is bad, whether its credit card debt, student debt or mortgage debt. We want to get rid of it, as soon as possible. Whatever you have should be paid off in a hurry so that you dont have any of it. This is true in some ways, and not true in others.

We are all familiar with various types of nasty debt. This is the type of debt that you feel you are drowned by. The debt that you can’t seem to make any inroads into and that you keep trying to extend, transfer and roll over.  And its almost always the debt that is used to buy personal good.

Its the type of debt that you wrack up on credit cards, personal loans. This type of debt is particularly bad because the value of the underlying assets that you are financing decreases over time. You basically incur interest charges against an asset that is going down in value!

However debt can be good. It can help you acquire assets that increase in value over time. It can help you increase your return on equity as those assets increase in value and give you a tax break for paying interest.

Margin debt, for instance can help you purchase more stock that what you otherwise could have, and thus grow your total asset value faster over the long term. Housing debt can get you a deduction for interest that you pay, as well as get you a high growth asset, not to mention a permanent roof over your head!.

My Takeaways

• Investment returns are directly correlated to the investment risk you are willing to take. Low investment returns can have financial risks that aren’t always apparent.
• Taxation is a powerful tool in helping you keep more of what you make, and it can help to have an awareness of the basics.
• Compounding interest really is the 8th wonder of the world!
• There’s something to be said for using other peoples money to build wealth- if one is comfortable with the risk involved.

Who is Peter Lynch?

Peter Lynch was a star fund manager at Fidelity. His claim to fame was as the spearhead of the Magellan fund which he ran for more than a decade. He  managed to turn a fund which had $18M in assets in the mid 1970′s to a $14B fund by the time he retired in 1990.

Aside from Warren Buffet, Peter Lynch is probably one of the best known advocates of investing in businesses that you know and understand.

How did Peter Lynch invest?

Peter Lynch was a big advocate of investing on the basis of a company’s “story”. This was the blueprint for how a given company was going to increase earnings, and therefore its share price.

He liked to develop a detailed thesis or blueprint for how a company would increase its earnings, and if he couldn’t see such a clear blueprint for how a company would make money, then he wouldn’t invest in a stock.

Given his interest in developing a clear thesis for how a company would grow earnings and therefore create value and share price growth, Lynch tended to avoid businesses that he couldn’t understand.

He tended to gravitate toward business that were simple and had a clear and transparent business model and earnings profile.

Lynch also had a preference for slightly smaller companies that were less than $1B in value. This was particularly the case if these companies had  rapidly increasing sales and earnings and could be invested in at attractive valuations.

I’ve written before as to why I think mid/small cap dividend stocks can be the gems of dividend growth investing. While picking these types of businesses can be fairly complex, stumbling across a strongly growing mid cap company that pays an increasing dividend can not only lead to rapid dividend growth in a short period, but also significant share price appreciation as well.

Lynch generally preferred to avoid large cap, slow growth companies, but was not as averse to large cap, moderate growth companies that could grow faster than the economy as a whole.

These large cap, moderate growth companies tend to be those that make up the bulk of the dividend growth investing universe and include such companies as Coca Cola and Proctor & Gamble, which Lynch himself invested in for the Magellan fund.

With a fund the size of Magellan, its no surprise that these types of investments grew to comprise a large portion of investable assets toward the latter stages of Magellan’s tenure under Lynch.

Lynch was very much a fundamental investor who preferred investing with a bottoms up approach. He specifically loked for companies with limited competition and with a sustainable competitive advantages. Interestingly, he often gravitated to the strongest company in down and out industries.

Lynch also liked companies that were involved in the provision of routine, regular tasks that were non discretionary in nature, things such as medications, razor blades. Also, rather than a business that provided all things to all people, Lynch had a preference for companies with specific niches that afforded these businesses  considerable pricing power.

Finally, he had a preference for companies whose management demonstrated a strong affinity and interest in the business, typically shown by substantial investment of equity into the business by management. If the company itself was buying back shares in the business, even better.

Classic Peter Lynch Plays

Lynch was very interested in finding unloved, out of favor businesses with strong fundamentals. Some of the classic Peter Lynch plays included Dunkin Donuts, Pier 1 Imports and Taco Bell.

Each of these investments turned into “ten baggers”  (in Lynch’s language) for Peter Lynch, meaning they all grew more than 10x Peter Lynch’s initial investment, a fairly phenomenal achievement in an era where fund managers are focussed on rapid turnover and quarterly performance targets.

What can you learn from Peter Lynch

Buy what you understand – Much like Warren Buffet, Lynch suggests that an individual investor is more likely to be successful if they invest in things that they can understand and explain. How does a business make money? What are its profit drivers etc.

Focus on fundamentals – Lynch believed in a ground up approach to understanding a business and ignoring noise, such as macro events beyond his control. He believe that a focus on long term investment would serve individual investors well.

Also ignoring predictions and sticking to facts is a better use of investors time. People make predictions which are invariably wrong, but an understanding of facts relevant to the businesses you have invested in will give you a sense for how they are tracking.

Consider smaller, rapid growth companies – Smaller companies with strong revenue, earnings and cashflow can be valueable additions to your portfolio if acquired at the right price.

Of course, these companies come with considerably higher risk that more established large caps, but they can lead to considerable dividend growth increases as well rapid share price appreciation if chosen well.

For those of you that haven’t  come across this book, this is one of the most detailed statistical profiles of America’s millionaires that exist. Its a fairly dated book (published sometime in the mid 1990′s), but I don’t doubt that much of what the authors learned about the wealthy in America still holds true even today.

Who is the millionaire next door?

• On average, our millionaire next door is in his mid 50′s, married with kids….and he’s overwhelmingly male (I’m not sure if this was just a quirk of the sample that the authors pulled)

• The majority of the millionaire sampled were self employed, not necessarily in glamorous professions, but owned decidedly normal businesses such as welding, pest control and paving

• The majority of the millionaires were home owners (greater than 97%). I don’t recall if home equity was included as part of the definition of wealth, but it would be interesting to see how the decimation of home owner wealth from 2008 impacted this group.

• The millionaires were also careful with their spending. There was a reference in the book to the millionaires wearing “inexpensive suits and driving American cars” (I never knew American cars were considered inexpensive before i read this book!). They also weren’t interested in the latest model cars and preferred to own versus lease. As a group, the millionaires live on less than 7% of their total wealth.

• The self made millionaires were pretty highly educated. 80% had completed a college degree or higher education, with close to 20% having advanced degrees (ie masters, PHD etc).

• The wealthy  love to invest, and interestingly they also seem to be self directed investors, meaning that they want to be in control of their decisions to invest their capital. Almost 80% of them have their own brokerage accounts. Interestingly, the authors note that they rarely “sell equity investments”, which seems to suggest a buy and hold mentality.

The wealth equation

As an aside in the book, the authors derived a formula for benchmarking optimal wealth accumulation, based on age and income.

Expected Wealth = Age * Household Income * 10%

For example, a 35 year old making 100,000 per year would be expected to have wealth of $350,000.

Average Wealth Accumulation is considered to be between 50% -200% of your expected wealth

Above Average Wealth Accumulation is considered to be >200% of expected wealth

Below Average Wealth is considered to be <50% of expected wealth.

Thus for the 35 yr old making $100k, anything less than $175k in wealth would be below average, while anything above $700k in wealth would be above average.

While the authors cut some slack for those below 30, who really haven’t had much time to generate wealth, I think the formula they have come up with works best for the 50+ age group who have had a lot of time to see their income and wealth compound over a significant period of time.

What can we learn about the millionaire next door?

I really enjoyed my reading of the millionaire next door. It was very interesting look into the behaviors, habits and attributes of a core group of seriously wealthy individuals who all created their own wealth.

I was interested to see what could be generalized from this group to look at a “blueprint” for  wealth creation.  If I had to distill  handful of key principles, they would be the following:

Frugality is a common theme among the group. While the authors may have been trying to have a joke at the group’s expense about how tight they are, this really struck a chord with me.

Most of the group didn’t care for the trappings of great wealth. They didn’t go out shopping for the most fashionable car, they didn’t blow through their newly acquired wealth on the most expensive suits.

They have deliberately chosen to live within their means and live modestly. This reaffirmed for me that it is possible to be happy being frugal, if you can find your own balance.

Interestingly, the authors mention that the millionaires have more than 6 times the wealth of their non millionaire neighbors, yet non millionaires outnumber the millionaires more than 3 to 1 in the neighborhoods that they live in.

I thought this was pretty telling because it speaks to the self made wealthy choosing modest accomodation that they can easily finance, and avoiding trophy properties, even though they could probably afford more.

Contingency planning is also evident among the self made millionaires . The wealthy take the concept of an emergency fund to new extremes. This may be a function of the fact that many of them have their own businesses and need to plan better for contingencies.

Forget a 6 month, or even 1 year contingency fund. These guys have the equivalent of almost 13 years in living expenses on average that they can fund through their wealth alone. However, they key is that these funds aren’t parked in cash that sits idle, but is part of realizable assets that can be cashed out if needed.

Education is highly valued. Investing in yourself is a big, big deal to these guys. They all have some basic education, but they are also keen on ensuring a high level of education for their kids as well. They recognize education as a key lever to boost income returns, which in turn is a crucial part of driving wealth.

Ownership of assets is a key tool of wealth creation.  I thought this was probably the most significant of all. In spite of the fact that the group had already reached impressive levels of wealth, they weren’t looking to bunker down with their hard earned money stashed beneath a mattress, or parked in bank accounts earning 1%.

Much like the rich dad in Kiyosaki’s Rich Dad Poor Dad, the millionaires that were studied by the authors were focussed on continuing their path of asset acquisition. Roughly 20% of their income each year continues to be invested into  a variety of asset classes, even though they have already all reached levels of comfortable wealth.

In general, the group loved stock investment, with roughly 20% of their holdings going into stocks. However they recognized the importance of being well diversified, with holdings in a variety of other asset classes as well.

The rich as a group realize that the key to consolidating and building wealth is having your money working for you with ownership of assets, and not to sit back and relax once you have achieved wealth. Rather, they are hungry to keep building and accumulating more.

As people who have stopped by here occasionally may be aware, I’ve set myself an aggressive dividend target of trying to get to $50k/yr in dividend income within the next 5 years. That may sound aggressive, foolhardy even, but the good news is that I am not entirely starting from scratch and my combined US, Australian stocks should throw off somewhere in the vicinity of $27k in dividends in 2013 based on my estimates.

However demanding goals aren’t forgiving on lax stock selection and speculative investments,so I’ve taken the opportunity to try and solidify the portfolio by replacing some less certain dividend payers with prospects that I feel are more secure.

Changes in the  portfolio

I had a few positions in my US portfolio which were in a select number of growth stocks and did not pay any dividends. While I am still optimistic about the total return that I can expect to achieve from these positions, I’d like to further strengthen my dividend buffer.

Accordingly, I made the following changes in the last month:

Sales

• Exited my position in Yandex – While I still believe in the business model and the growth opportunity that Yandex offers, the unfortunate reality is that this Russian search engine giant wasn’t paying me a dividend, so I have entirely exited this position, netting ~$8k, and a $1k profit.

•  Trimmed my position in Mercadolibre. I still very much like this Latin American start up, which offers an e-commerce business model in the likes of Ebay and Amazon. Mercadolibre also pays a tiny dividend, which is unfortunately so small that it doesn’t make much of an impact to my dividend income. I realized $4k from the sale, and a $1k profit.

• Trimmed my position in Bidu. Bidu has been going through some troubles recently as far as being able to convince the market that it can make it successfully in mobile search. I cut  my position here in half, realizing about $5k and incurring a small loss.

• Sold my position in Quality Systems – I started feeling a little nervous about QSII’s ability to pay out a consistent dividend given its lack of recent sales traction. I decided to take some proactive action here before my hand was forced, and realized $7k from the sale.

•  Sold various Australian positions which were non dividend paying positions. I realized ~10k net here, which I expect to deploy later in the year if I can find suitable opportunities to invest.

Purchases

•   Increased my stake in BP to $16k – BP was one that I couldn’t pass up at current prices levels. With a current yield of almost 5%, reasonable payout ratio, and ~10% dividend growth, I am happy to sit in BP and wait and watch as the various legal actions get sorted out. I added almost $7k to my investment in BP @$40.50

•  Acquired a $5k stake in Lorillard. I was particularly attracted to Lorillard by the nice yield on offer ~5%, as well the dominant position that it holds in the US cigarette market. Of course, this is a business that is constantly exposed to regulatory risk, which is something that will limit the size of the position that I take. Revenue and dividend growth for the business has been fairly good for Lorillard over the last 10 years. My thanks to My FI Journey for his excellent analysis which highlighted this stock as one to watch.

•  Acquired a $5k stake in Lockheed Martin. I was also attracted to Lockheed by the nice dividend on offer, at close 4.75%. Lockheed dividend growth has also been very strong for the last few years, with the dividend most recently hiked 15%. I can’t see this continuing, particularly with some of the budget cuts for defense that will impact Lockheed. As the dominant defense contractor in the US, I expect the company to be able to manage through this, albeit with dividend growth rates in the 5-7% range over the medium term.

• Acquired a $4k stake in Apple. While Apple doesn’t have the dividend paying history to be considered a dividend growth stock, I could resist the opportunity to snap up a little stake in Apple at an effective yield of 3%. Apple also recently hiked its dividend 15%, something which I’d love to see it do over the next few years to reduce its mounting cash position.  I jumped into Apple @$405 as an entry point, and may consider adding more if I can pick up some more at $350. Apple is very much a company in transition, and I expect it to have a more mature growth profile with declining margins as it introduces more price competitive versions of its products. I am happy with my small entry position here, and won’t consider additions unless price point becomes more compelling.

• Acquired a $7k stake in Cisco. While Cisco is a fairly recent dividend payor with a pretty short dividend history, Cisco itself is a fairly mature business which not only plays the role of traffic cop for the internet, but also is increasingly moving into cloud and mobility offerings. I recently purchased an $8k stake in the company at an effective yield of 3.2%. With a fairly low payout ratio, and high single digit revenue growth I’m confident that Cisco can maintain dividend growth of 10% for the near term.

I’ll be updating my portfolio accordingly in the next few days to reflect these changes, but the net of it is that I expect a slight increase to my current estimated dividend income for 2013.

While the material of Rich Dad Poor Dad isn’t really that earth shattering, the way the book is written is very unique. Kiyosaki introduces a “rich dad” to share all the insights that his “poor dad” didn’t know or wasn’t able to communicate to be financially successful.

Kiyosaki’s rich dad suggests the following as some of the keys to drive wealth:

• Pay yourself first
• Leverage other people’s money to grow assets
• Be an owner of assets rather than being an employee
• The poor and middle class work for money, while the rich have their assets work for them

Rich Dad Poor Dad suggests that these were the key principles that help generate financial success for the rich. There are probably other learnings and lessons from Rich Dad, but these were some of the main ones that I was able to distill from my quick flick through the book. Common sense right? Well apparently common sense sells well, Kiyosaki sold close to 26M copies of his book!.

 What can you really learn from the “rich dad” ?

If you look at Rich Dad Poor Dad as a guide for lessons learned, what is the advise that a rockstar financial mentor like”rich dad” can give you in terms of insights or secrets of the rich?

Pay yourself first

Once you’ve tended to the basics of the bills and what you need to get through everyday living, be sure to set aside some money for your financial future.

Make good use of other people’s money

This is something that I have made good use of myself in the past by using debt to juice up my returns from investing in stocks. This one needs to come with a really big disclaimer against going too crazy with leverage, in case another financial crisis strikes and asset values plunge. Should this scenario happen, then the margin calls will come thick and fast.

Focus on being an owner of assets rather than an employee

This is actually a very important principle and not necessarily something that is very obvious to most people. Owning assets is actually far more lucrative than being an asset, like employee labor . Why is this?

For starters, the tax consequences associated with asset ownership are far more favorable than those associated with earned income. Consider the effective rates of tax for capital gains and dividend income versus wage income for starters, as well as all the extra taxes that you pay on your wage income. I have previously written about why dividend income is far more tax effective than ordinary wage income.

Even more than the tax consequences. consider the rates of increase in dividend growth and profit increases for wage income versus company income. While you are lucky if your wage goes up much above the rate of inflation on an annual basis, corporate profitability increases and general stock market returns have historically  increased at multiples beyond these levels.

The long term total return of the Dow Jones year over year is approximately 9-10% p.a. Compared to nominal increases in wage income of 2-3% per annum, you can see why its much more fun to be a stockholder and an owner of capital than working as an employee for a living.

As an owner of assets, or the owner of a business that manages assets, I’m as focussed on squeezing as much value out of these assets as I can so that I can keep all the excess return. I “sweat the assets” to get as much out of them as possible so I can juice up what’s left over to me at the end.

You can see why being an employee and receiving a fixed return for the labor that I provide can be a pretty raw deal. If I’m one of the assets that the corporation is “sweating”, it probably means longish hours for minimal returns.

I’m not sure that this is something that the average person really thinks about and understands, so kudos to Kiyosaki for bringing out this point in his book. While not necessarily earth shattering, its a fairly powerful idea that isn’t too frequently voiced.

The poor and the middle class work for money

While a little patronizing on the surface, I actually had the opportunity to pause and reflect on actually how true this is. But frankly, you don’t even have to be “rich” to start putting this into practice.

The way I think about putting assets to work for you versus having to work for money is something that I like to think off as the 3 stage active to passive income crossover.

Stage 1:  In the first stage of the crossover, the increase in your annual asset value each year exceeds your expenses. This is where your asset growth can fund your current lifestyle. In our case, we crossed this level a few years ago. I view this measure as important because it tells me that at a minimum, you should be able to meet your expenses with just annual growth in asset values.

Stage 2:  In the second stage of the crossover, the annual increase in your assets  each year exceeds your income. This is literally having your assets work for you, which you would technically be in a position to do at this stage. I view this Stage as more symbolic than anything else because you are subject to the vagaries of market performance to actually convert fixed assets into income, but its a significant milestone if you can get to this point in my view.

Stage 3: In the third stage of the cross over, the income from your assets exceeds your living expenses. This is what I’m shooting for with my idea of an early retirement. You don’t have to sell anything, you’re not dependent on market valuations. Yet you have your assets doing all the hard work for you and you just cultivate the passive income to meet your living expenses.

My take:

In some ways, the philosophy of Kiyosaki’s Rich Dad Poor Dad actually embraces the notion of dividend growth investing. Its the idea of owning powerful assets and having those assets do the work for you to replace the income that you otherwise have to go out and work for. But its not just the rich that can put this  into practice, frankly anyone can no matter how rich or poor.

• I’ve been a big proponent of dividend growth investing and have previously stated the reasons why I am a dividend growth investor. Dividend Mantra writes about the reasons he prefers dividend growth investing
• Writeyourownreality has an intriguing post on finding the right job and a scoring matrix to assist in the decision of evaluating that new job offer, beyond just considering salary.
• MyFI Journey gives his take on the economics of the purchase of a new vehicle versus trying to eke out more mileage from your existing vehicle.
• Passive Income Pursuit provides a nice write up of Proctor & Gamble.Its a business I greatly respect, but I’ve felt it out of my strike zone on valuation grounds for some time.
• Evan from myjourneytomillions has a great post on the decision to sell dividend stocks. I know this is a decision that I have struggled with in the past, particularly when a stock has had a nice run up.
• Brick by Brick talks about some of the key rules you need to keep in mind to ensure you are on the path to retirement
• MyMoneyDesign poses a question that has been on my mind recently, which is when can one retire?
• Dividend Growth Stock Investing discusses why dividend investing is not for everyone. I actually believe that everyone can benefit from dividend investing, however for certain people venturing into the stock market may not be the right course of action if you can’t tolerate wild swings in price.

What is an “investment in time”?

While I agree that an investment in time sounds like a rather bizzarre concept, in my mind its actually a proactive decision that I have made to let my investments sit , grow and compound. One could also look at this in a similar way to buy, hold and monitor. You do the hard work and due diligence up front in the investment selection process. After that, you let time and compounding do the rest. Who would have thought that doing nothing could lead to investment success?

Doing nothing generates some nice returns and big dividends!

If you’ve picked the right business and are happy to just let it ride then an investment in time will do a lot of the heavy lifting for you.

I have held a select few of my Australian stocks greater than 5 years. In this period of time, some of these stocks have more than doubled in price. In fact some stocks such as Commonwealth Bank are almost are on the verge of almost tripling since I acquired them.  Dividends have also more than doubled  since acquisition. My annual dividend from Commonwealth Bank stock is now close to $1700, up from approximately $800 when I first invested.

The bigger the investment in time the better

I have held Mastercard stock on and off since it had its initial public offering in 2006. While I didn’t get stock in the initial offering itself, I was able to pick up some stock shortly after listing at around $50/ share.  I flipped a substantial portion of my holding in Mastercard a few years later in 2008 for almost $200 a share. I was feeling pretty proud of myself for having realized close to a 4x return.

Of couse hindsight is a beautiful thing. Had I held on to all of my Mastercard stock, instead of the small parcel that i was left with, my $5k initial investment would have been worth more than $50k!. I got greedy and settled for 4x upside, when I should have let time do the work and just ride the returns.

My lesson from that misstep was that if you happen to be sitting on a phenonmenal business which is part of an entrenched duopoly with substantial barriers to entry and experiencing strong growth, its best just to make your investment and check in every few years to assess progress and any business changes. Over thinking investment returns can short change you out of a potential 10 bagger.

The same holds true for some of the classic dividend growth investment stocks that are part of investment portfolios.

Consider the example of McDonald’s stock. An investor who invested $10k in McDonald’s stock in 2003 would have almost $80k worth of stock today. Along the way, with the spikes in Mcdonald’s stock, an investor would have had numerous opportunities to cash out and reinvest those proceeds into the S&P 500.

However, looking back an investor who did so would probably be kicking themselves for the loss in potential returns that they would have experienced from following such a strategy. While a $10k investment in McDonald’s 10 years ago would have turned into almost $80k today, a similar $10k investment into the broader S&P 500 basket would be worth approximately $22k today.

To really see the effects of an investment in time, we should consider even longer time periods than just 10 years. Lets go back to 1970. Consider an investment of $10k in Coca Cola. That investment would be worth almost $1.67M. 10 bagger? 20 bagger? Think 167 bagger!!.

An investor who invested $10,000 in the S&P 500 basket of stocks in 1970 would have almost $190,000 today. Certainly not a bad return, but an investor in Coca Cola would have absolutely smashed that. Their investment would have a value almost 9 times what a comparable investment in the S&P would have delivered.

Having the courage to invest in time

While people talk about investing in time as an easy thing to do, its really not. Trust me. Over a 10 year period I’ve been scared  into selling my stocks a bunch or times and been too greedy to be unable to resist selling my stocks on other occasions.

Of course in both situations, that was exactly the wrong thing to be doing. It meant that i sold too low in the first instance, and short changed myself out of a huge multiple return in other instances.

So what can you do to make sure you don’t over think an investment and just leave it alone? In my opinion, if you pick the right type of businesses, you can have a great deal of confidence that they will continue to grow in value over time.

Strong sustainable business models:  Look for companies with rock solid business models and strong competitive positions, The credit card oligopolies of Visa and Mastercard are one such example. Huge barriers to entry, strong cash generation, high returns on invested capital.

Get paid to hold: To me this is actually the most important. Its why I love dividend stocks so much. Not only do they help encourage me not to sell to cheap. They also help me maximize my returns by helping to ensure that I don’t sell too early. Getting paid to keep holding helps gets my finger off the sell button.

While the rise of low cost brokerage has been a great thing for an individual investor in terms of cost effective trades, its frankly made it far too easy for us to sell. The process is so easy, you just log into your account and execute a trade. I don’t have to speak to anyone, the trade just goes through all for just a few dollars in commission. Low cost trading has helped turn us all into a generation of frequent traders than investors.

The one thing that really causes me to pause from hitting that sell button is the big fat dividend cheque that I’ll be getting from that company during the course of the year, and every year that follows. That helps me hold on to a stock and let time do its work.

My take:

Investing is far more psychological than it is intellectual. In many cases, we may have made the right investment decision only to be talked out it by friends, a spouse, or the talking heads on TV. With the ease of trading most of us are always looking to take action and to just do something. We can’t just sit still.

Sometimes that leads to us overthinking investing and trying to take quick, immediate actions. At times its best just to do your dilligence, make your investment and then sit around and let an investment in time do the rest. Getting paid to do this via dividend paying stocks can certainly help you let time do its thing.

Using dividends to meet retirement expenses is a fairly well accepted idea. Most folks wait till traditional retirement age to implement this, while others have a goal of trying to do this much faster. In any case, the concept of using dividends to achieve expense replacement is much the same in either case.

However when considering this idea, I’ve always understood this to mean deriving a broad based dividend income from a variety of stocks and applying this income to meet living expenses.

I have run across a few blogs and articles where expense replacement via dividends is applied more literally. In these cases, people are focussed on the specific companies that they are paying expenses to and then investing in these companies to generate the necessary dividend income to meet those expenses.

Sound interesting? Suppose I have a cell phone bill that I pay to Verizon that is ~ $1000 per year. To execute against this strategy, I would buy enough Verizon stock over time that I could cover my $1000 Verizon bill. Verizon is currently yielding ~4%, so this would assume I purchased almost $25k of Verizon stock.

I could apply this same logic for many expense categories. For my cable bill, I look at Comcast stock for example, which pays a nice 2% yield. My electric bill? Con Ed has me covered with a nice 4% yield. Kitchen cleaning supplies? Well there’s Clorox. Shampoo. haircare & other personal essentials, maybe P&G or Kimberly Clark. Heck, you could just cover everything & the kitchen sink with Walmart.

Once I got over my intrigue with the concept, it occurred that this may not be as terrible a way to construct a dividend portfolio as I had thought on initial reaction. Why?

Positives

Buying what you know :

This theory or approach to portfolio construction takes Warren Buffett’s buy what you know one step further. Its literally by what you use. For a beginner investor, I could think of far worse ways to start my investment portfolio than through investing in a bunch of companies that I know and use everyday.

At the very least, I should have some awareness of what they do and how they make money, given that I am helping contribute to how they make money. Of course, that doesn’t necessarily make all these companies good companies to invest in, but at least this is a good place to start.

Its highly unlikely that by following this kind of an approach that an investor will end up with any investments in  stocks or businesses that aren’t very intuitive to understand. You’ll probably be able to avoid the next Enron with a strategy like this one.

Broad Market Coverage:

Its highly likely that through following this type of strategy that I will get a reasonably broad based coverage of many sectors of the economy. Of course, there’s a limit to how far you can take this, but just considering my major expenses, I’d probably cover banking, insurance, power & utilities and telecommunications.

Its not a perfect representation of GDP, but not bad in terms of not being highly concentrated in one specific area (like being all in on just banking stocks for instance).

Expense Hedge:

The other thing that occurred to me with this method is that these investors are to some degree protected by wild swings in their expenses. How so? Suppose there is a massive shortage in electrical power capacity from  flooding or other natural disaster which drives up power prices one  year.

In theory, as an investor in Con Ed, I would expect to be able to benefit from this event through Con Ed having a bumper profit and passing on some of that to me. Of course, whether the magnitude of my increase in dividend offsets the increase in my power bill is entirely another question, but I’m likely to see some positives in the dividend that is paid to me as an investor.

Negatives

Are these the best stocks to buy?

Buying businesses based on what you use doesn’t necessarily make them the best stocks to buy at any point. The industry could be characterized by low barriers to entry, the company may not have any sustainable advantage. At a more basic level, there is no assurance or guarantee of how solid the business is, whether it is trading for a fair price, or whether such an investment is the best use of capital.

Dividend payouts and dividend growth for the selected companies also have a chance of being lousy. Just blindly selecting a stock for the reason that it can help fund expenses shows no real consideration of whether the dividend payout is reasonable, whether there will be good dividend growth going forward and whether you have optimized a good blend of yield versus growth.

Diversification of capital

Trying to cover your expenses with dividends based on how much you spend can lead to some lopsided capital allocation decisions. You may end up with a lot of your capital tied up in areas where you have most of your expenses.

If you have a big mortgage for instance, this could lead you to very skewed capital allocation towards mortgage lenders and big banks, some of which imploded and decimated their dividends during 2008-2009. This could lead to sector concentration in an area far greater than what is actually healthy for a diversified portfolio. It doesn’t meet dividend diversification in my book.

Additionally, your dividend income stream could soon be very large yield with minimal dividend growth following this approach. Most of the traditional providers of non discretionary services, for example Verizon, AT&T, Con Ed or the big banks pay high yields, but offer pretty minimal dividend growth. Verizon & AT&T barely offer 2-3% dividend growth. Over time, you may just be barely edging up a little over the rate of inflation.

Ongoing Monitoring

Its possible that if you are merely focussed on seeing where your expenses are and which companies you can cover them with, you won’t be as focussed on monitoring the actual businesses themselves investments and seeing how those businesses are performing. The focus is more likely to be on how much do I need to cover the expense that is being incurred, rather than how is the actual business performing.

My take

Looking at dividend stocks to cover living expenses by receiving dividends from companies to whom you pay expenses is an interesting dividend strategy.

While this can serve as a good screen for dividend candidates,  an investor may be doing themselves a huge disservice in terms of not investing in the best businesses at a fair price. They may also not be making smart decisions about capital allocation by following this strategy.

A far more sensible approach in my book is to construct a diversified dividend income portfolio which one can use a basis to meet aggregate expenses as a whole, rather than trying to replace expenses piece by piece through investment in companies to whom expenses are paid.

This way, you maintain a focus on the best companies with the best dividend prospects and getting these businesses at the right price. It shouldn’t matter what sector or industries those businesses are in and whether you necessarily use those products or not.