Thursday, May 29, 2014

Let dividends do the heavy lifting for your retirement

As a dividend growth investor, my goal is to build a portfolio of quality dividend paying companies, that grow dividends over time. My success in achieving that is dependent on amount of savings I can put to work each month, the returns I can generate and the time I allow the investments to compound.

I believe that consistently saving a portion of my income is the basic foundation behind my financial independence calculation. However what I do with that money is equally as important, because if I am successful, the amounts I earn from investing will be many times what I would have earned during my lifetime. In other words, if I saved $1000/month for 20 years, I would have ended up putting approximately $240,000. Let’s assume that I invest it all in dividend growth stocks that yield 3% today and grow distributions by 7% annually. Distributions are then reinvested in more companies yielding 3%, which grow dividends by 7% per year.

After 20 years, the value of this hypothetical portfolio would be approximately $715,000. It would be earning over $21,500 in annual dividend income. The power of compounding has resulted in a gain of over half a million dollars in net income. This power of compounding was created when earnings were plowed back in the business to maintain and increase profits and have the capacity to increase dividends. Those increased dividends are then also plowed back to buy more shares, which turbocharges the income growth potential.

As you can see, by year 20, the amount of dividends that is earned covers the amount of funds put to work in the portfolio almost by a factor of two. This shows that consistent compounding of capital and dividend income can result in much more funds that those initially put to work. The amounts put to work are really minuscule relative to the ending amounts, after a period of consistent compounding of capital and income.
If you continued compounding for another 30 years, the amounts put would look even smaller, relative to the ending amounts of capital and income.

Of course, this goes on to show that even small amounts of money that are left to compound over long periods of time and a consistent rate of return, could mushroom into pretty sizeable fortunes. This is why you should never despise the days of small beginnings, but should start investing as soon as possible. The earlier your start, the more time do you have to compound your capital.

For example, if you are 25 years old and you can only afford to put $10,000 to work in dividend paying stocks once, you can do pretty well over a 40 year period. When you are 65, you can end up with a portfolio earning almost $13,800 in annual dividend income. If you are 50 years old, and you want to earn the same type of income at the age of 65, you need to put $114,000 to work for you. You can definitely see with this example that starting as early as possible lets your dividend growth stocks do the heavy lifting for you. I have shared the spreadsheet I used to create those calculations here.

For example, one of the largest beneficiaries of the power of compounding is Warren Buffett. He became a billionaire in 1986, at the age of 56. Now, at the tender age of 84, he is worth $58.50 billion. In other words, 98% of this fortune was achieved in the past 28 years. This was mostly done because of the power of compounding.

I keep seeing investors that do not understand why it makes sense to buy dividend growth companies that yield only 2.5% - 3% today. What those investors are missing however is really obvious. They miss that those companies regularly manage to grow their dividends, because they are able to increase profits over time. If you start with a 3% yield today, but you grow the dividend by 7%/year for 30 years, you will end up with a stock that pays you a 24% yield on your cost eventually. In other words, if you put $1000 in a dividend paying stock that yields 3% today, but grows those dividends by 7% per year, you will end up with an annual dividend income of $240 in 30 years. This example of course assumes that you spend all the dividends. If you reinvested those dividends into more stock for 30 years, the annual dividend income produced by that dividend machine would be $520 ever year.

I am going to feature nine quality companies that look attractively valued today, and which could result in pretty decent results if compounded over the next 30 years include:

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has managed to raise dividends for 44 years in a row and has managed to grow dividends by 11.40%/year over the past decade. Currently, is trading at 15.80 times forward earnings and yields 4.70%. Check my analysis of Altria.

Chevron Corporation (CVX), through its subsidiaries, is engaged in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has managed to raise dividends for 26 years in a row and has managed to grow dividends by 10.60%/year over the past decade. Currently, is trading at 11.50 times forward earnings and yields 3.50%. Check my analysis of Chevron.

The Coca-Cola Company (KO), a beverage company, manufactures and distributes coke, diet coke, and other soft drinks worldwide. This dividend champion has managed to raise dividends 52 for years in a row and has managed to grow dividends by 9.80%/year over the past decade. Currently, is trading at 19.40 times forward earnings and yields 3%. Check my analysis of Coca-Cola.

Exxon Mobil Corporation (XOM) explores and produces for crude oil and natural gas. This dividend champion has managed to raise dividends for 32 years in a row and has managed to grow dividends by 9.60%/year over the past decade. Currently, is trading at 13.10 times forward earnings and yields 2.70%. Check my analysis of Exxon Mobil.

Genuine Parts Company (GPC) distributes automotive replacement parts, industrial replacement parts, office products, and electrical/electronic materials in the United States, Puerto Rico, the Dominican Republic, Mexico, and Canada. This dividend champion has managed to raise dividends for 58 years in a row and has managed to grow dividends by 6.20%/year over the past decade. Currently, is trading at 18.50 times forward earnings and yields 2.70%. Check my analysis of Genuine Parts Company.

Johnson & Johnson (JNJ), together with its subsidiaries, is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. This dividend champion has managed to raise dividends for 52 years in a row and has managed to grow dividends by 10.80%/year over the past decade. Currently, is trading at 17.20 times forward earnings and yields 2.80%. Check my analysis of Johnson & Johnson.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. This dividend champion has managed to raise dividends for 42 years in a row and has managed to grow dividends by 13.70%/year over the past decade. Currently, is trading at 18.90 times forward earnings and yields 3.10%. Check my analysis of PepsiCo.

The Procter & Gamble Company (PG), together with its subsidiaries, manufactures and sells branded consumer packaged goods. This dividend champion has managed to raise dividends for 58 years in a row and has managed to grow dividends by 10.60%/year over the past decade. Currently, is trading at 19.20 times forward earnings and yields 3.20%. Check my analysis of Procter & Gamble.

Target Corporation (TGT) operates general merchandise stores in the United States and Canada. This dividend champion has managed to raise dividends for 46 years in a row and has managed to grow dividends by 19.80%/year over the past decade. Currently, is trading at 14.50 times forward earnings and yields 3.10%. Check my analysis of Target.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. This dividend achiever has managed to raise dividends for 11 years in a row and has managed to grow dividends by 10.80%/year over the past decade. Currently, is trading at 18.70 times forward earnings and yields 3%. Check my analysis of General Mills.

Eight of these companies are dividend champions whose annual dividend growth rate exceeded 6%/year over the past 1, 3, 5, and 10 years, yield as above 2.50% and selling for less than 20 times earnings. The last one is a dividend achiever, which I am trying to build a sizeable position in over the next couple of years.

To summarize, savings is important to get you started in investing. However, at some point, the power of compounding is a much stronger and more powerful driving force that would help you achieve your dividend income objectives. This is why it is important to start investing as early as possible, in order to allow your capital maximum amount of compounding time. As they say, it is time in the market that truly counts, not timing the market.

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