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Why Dividend Investors Should Never Touch Principal

 November 20, 2012 11:00 AM
 


I recently read an article from Forbes about generating income in retirement. While I disagree with the portfolio constructed by the editorial staff, what grabbed my attention was the following quote from Lord Greystoke in the movie "Tarzan":

"Someday, he says to the young man from the jungle, this will all be yours: Live off the income from the land, but don't sell any of it."

Living off investments has been something that the rich have done for generations. Living off land income, or income from bonds was widely accepted in 19th and early 20th centuries. The so called "rentier class" has been able to pay for their everyday expenses from income generated by investments in government bonds and land income. Of course, this was during a period of time when inflation did not run at 3% per year.

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As a dividend investor, I follow the same principle of accumulating income generating assets, which generate regular streams of income. I focus on dividend stocks which regularly raise distributions. This ensures that my income keeps its purchasing power over time. The companies I purchase make products that are used in the everyday lives of billions of consumers worldwide. In essence, these companies have built personal relationships with these individuals, which regularly purchase the same brands for decades to come. These consistent streams of income allow these companies to generate stable earnings that are not affected by recessions. In addition, by building a lasting relationship with customers based on quality, these companies are able to pass on cost increases to them, while maintaining and even increasing profitability over time.

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These companies manage to reinvest a portion of their earnings into maintaining and growing their market share. This could include building plants, acquiring competitors, spending money on advertising, innovating or looking for ways to become more efficient in their operations. At the end of the day however, it is not economically feasible for companies to retain all of their earnings. If you run McDonald's Corporation (MCD), you should not expect to double sales simply by doubling the number of restaurants in the US. If you have two McDonald's locations in a town with a population of 30,000 people, adding a third store would likely cannibalize sales, thus leading to subpar returns due to law of diminishing returns. Adding a new product like salads could lead to higher foot traffic from health conscious customers, who might have previously avoided your store. Introducing a new product does take time however, and so does building a new store or a new distribution center that will lead to a reduction in inventory and thus reduce costs. Situations like these are the reason why companies cannot realistically invest all of their earnings back into the business over the course of an year for example.

As a result, the companies I typically invest in are able to generate excess cash. They typically decide to distribute it to shareholders. By reinvesting a portion of their earnings back into the business, these companies maintain their competitive edge and provide a solid foundation for earnings growth over time that leads to higher dividends down the road. As a result, the shareholder not only enjoys a higher stream of dividends each year, but their stake in the business is worth more over time. Dividend investors do not sell shares in the companies they own, since this will reduce their dividend income.

An investor with 1,000 shares of Phillip Morris International (PM) will generate $850/quarter. In order for them to generate the same amount of cash if Phillip Morris didn't pay a dividend, they would have to sell 10 shares/quarter. Over time, this leads to depletion in the asset base. If share prices of Phillip Morris International stock remained flat for the next decade, our investor would have sold 360 shares and would have only 640 left. In addition, by selling of stock in the companies they own, investors are exposing themselves to market fluctuations. Over the past four years, prices of Phillip Morris International have ranged between a low of $33 in 2009 to a high of $94 in 2012. If we get another recession over the next five years, chances are the stock prices will decline. At lower prices, our investor would have to sell higher amounts of stock in order to generate the same level of cashflow. At $35/share, our investor would have to sell 20 shares/quarter and would have funds for 12.50 years until his wealth is gone.

I have argued that dividends provide a return that is more stable than capital gains. As a result, an investor who spends only income, without touching principal has a much better chance of staying retired. An investors who generates $850/quarter with shares of PMI, will likely ignore market fluctuations, as long as his dividends are still paid. In addition, chances are that in a diversified portfolio of blue chip stocks, your income will continue to go up even during bear markets. For example, during 2008 – 2009 bear market, many companies raised distributions, despite the recession and overall negative sentiment in the economy:

Procter & Gamble (PG) raised dividends by 14.30% in 2008 and 10% in 2009. Since 2007, the quarterly distribution has been increased by 60.60%. The company earned $3.12/share in 2012. Analysts expect it to earn $3.95/share in 2013 and $4.30/share in 2014. It is trading at 18.70 times earnings,yields 3.40% and has a sustainable dividend. (analysis)

Johnson & Johnson (JNJ) raised dividends by 10.80% in 2008 and 6.50% in 2009. Since 2007, the quarterly distribution has been increased by 47%. The company earned $3.49/share in 2011. Analysts expect it to earn $5.10/share in 2012 and $5.50/share in 2013. It is trading at 14.50 times earnings,yields 3.50% and has a sustainable dividend.(analysis)

McDonald's (MCD) raised dividends by 33.30% in 2008 and 10% in 2009. Since 2007, the quarterly distribution has been increased by 105.30%. The company earned $5.27/share in 2011. Analysts expect it to earn $5.31/share in 2012 and $5.81/share in 2013. It is trading at 16 times earnings,yields 3.60% and has a sustainable dividend. (analysis)

Chevron (CVX) raised dividends by 12.10% in 2008 and 4.60% in 2009. Since 2007, the quarterly distribution has been increased by 55.10%. The company earned $13.44/share in 2011. Analysts expect it to earn $12.81/share in 2012 and $12.78/share in 2013. It is trading at 8.70 times earnings,yields 3.40% and has a sustainable dividend. (analysis)

PepsiCo (PEP) raised dividends by 13.30% in 2008 and 5.90% in 2009. Since 2007, the quarterly distribution has been increased by 43.50%. The company earned $4.03/share in 2011. Analysts expect it to earn $4.07/share in 2012 and $4.41/share in 2013. It is trading at 18.30 times earnings,yields 3.10% and has a sustainable dividend. (analysis)

Abbott Laboratories (ABT) raised dividends by 10.80% in 2008 and 11.10% in 2009. Since 2007, the quarterly distribution has been increased by 56.90%. While Abbott is splitting in two companies, the diverse product bases and strong customer demand would help drive earnings higher, which would be beneficial for dividend growth. It is trading at 15.90 times earnings,yields 3.20% and has a sustainable dividend. (analysis)

Relevant Articles:

How dividend stocks protect investors from inflation

Dividend Stocks for Inflation Adjusted Income Streams

Dividends versus Homemade Dividends

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