Yesterday I had one of those thoughts that makes you go “Hmm, I should look into that more, even if it is a horrible idea.” Over at Mint.com I have taken advantage of the “Goals” tool to set up plans for numerous life events that I evaluate have a 99%-100% chance of happening and that will require more than pocket change to fund. One of those goals is to purchase a home at some point in the future for which I have set a target down payment of $60,000. This does not necessarily mean I am going to be in the market for a $300,000 house (using the 20% down-payment guideline): it is just an amount of cash that I determined would provide me financial peace of mind when it comes time to make a decision on a house. While I am deployed this is my main savings goal outside of retirement and my dividend stock investments. I do not plan on even seriously thinking of buying a house (due to projected mobility) for at least five years and will rent for the time being. That five year mark made me think though: does that provide me with a far out enough time horizon to consider investing this money in dividend stocks?
I’ll admit that despite training myself to take fairly conservative actions when it comes to investing that I am not immune to aggressive or even undisciplined thoughts before those actions are made (nor am I perfect in actually implementing financial conservatism). Part of being a successful investor, as the successful ones will tell you, is having discipline. If I had run off and had thrown the $10,000 I had saved up to this point for the house into the stock market and crossed my fingers for the market to match its historical returns for the next five to ten years so I could double my money that would have been just plain foolish. I also believe that taking this money (where the protection of principal is extremely important) and trying to trade growth stocks also exposes me to a level of risk that in this scenario is extremely disproportionate to the upside that I am looking to achieve. Writing this entry is a concerted attempt on my part to force myself to make the disciplined and wise choice.
Before discussing the risks involved let me lay out what the objective of this move would be. I would use a minimum timeline of five years and a maximum timeline of ten years when determining my possible returns. I am confident in the five year minimum as the chances that I will for some reason be forced into buying a house as opposed to renting before I plan on it are slim to none. As stated above protection of capital is paramount so if I do put the money in dividend stocks I will be looking most likely for blue-chip, low beta stocks with annual dividend increases at an above average rate. If I aim for a portfolio that averages a dividend of 3.5%, a dividend growth rate of 10%, and annual stock price appreciation of 6% (I’m plugging 3% into the calculator and writing off the other 3% to inflation), and re-invest the dividends then I can expect a total return of 43.8% (7.54% annualized) in five years and 124.5% (8.42% annualized) in ten years. Given how much I want to very much not lose any money I would be more than content with these returns! Using the calculator at buyupside.com I calculated for the following scenarios using stock price as my independent variable:
Yield | Div Growth | Stock Price Growth | 5-Yr/ 10-Yr Total Return | 5-Yr/ 10-Yr Annual Return |
3.5% | 10% | -12% | -28.4% / -9.3% | -6.45% / -0.97% |
3.5% | 10% | -9% | -17.2% / +3.82% | -3.71% / +0.38% |
3.5% | 10% | -6% | -4.55% / +22.50% | -0.93% / +2.05% |
3.5% | 10% | -3% | +9.73% / +47.81% | +1.88% / +3.98% |
3.5% | 10% | 0% | +25.81% / +81.17% | +4.7% / +6.12% |
3.5% | 10% | 3% | +43.84% / +124.47% | +7.54% / +8.42% |
3.5% | 10% | 6% | +64.00% / +180.06% | +10.4% / +10.85% |
The way inflation plays into the above chart is that for me to achieve the gains of the 3% stock price growth rate (real return) then I would have to get a 6% nominal return out of the stock. If I didn’t want to tolerate anything less than a -9% decrease each year in the stock price then I would have to achieve a nominal return of -6%. You can see the difference those 3% intervals make and see what inflation can do to your returns! Looking at the above numbers I would say that I would set the -9% row as my maximum risk tolerance for this principal (so a -6% nominal return). Since I am looking for dividend growth and not deep value with a five year minimum and ten year maximum time horizon I don’t see any reason why I would hold on to stocks with that kind of return for more than a couple of years at most anyways. Furthermore the 3% real return growth rate provides a healthy annual return. It is not spectacular but it is much better than I’d be getting out of a savings account or a CD. So given that this task seems doable with an acceptable amount of risk and does not require an unreasonable amount of growth to generate adequate upside lets look at how I can manage the risks more specifically.
Since I treated the stock price growth as my independent variable the above figures are reliant on the portfolio maintaining the average yield and dividend growth rate that I established. I can minimize the risk of the deviation of these variables by selecting companies that are committed to providing value to their shareholders in the form of dividends. By utilizing screens with a minimum of a 3.5% yield and a maximum of 7% yield I can eliminate stocks with unsustainable yields from my search. By screening for a five year dividend average growth rate at a minimum of 10% I can eliminate stocks that are not increasing their payouts at a rate that I want to work with. Punching these two criteria into the Fidelity.com stock screener turns up 118 results. Adding a third major screen criteria I set the maximum allowable payout ratio at 60% and shrink the field down to 52 stocks (see this post for further explanation on how useful these three criteria are for looking at dividend growth stocks). For my fourth criteria I set a requirement for a minimum five year EPS growth rate average of 10% (if earnings don’t grow the dividend payout ratio will rise and eventually be unsustainable). This brought me down to 24 stocks.
Now to further guarantee the sustainability of the positive trends that I am attempting to identify I went back and capped the dividend growth rate and EPS growth rate at 20%. This ensures the averages aren’t being boosted by one time increases and also is a better reflection of what dividends will be around five years from now (a company can’t grow its dividend at 80% per year for long). I also set a floor of 30% for the dividend payout ratio: I want stocks that are committed to paying a serious dividend, before setting this require I had a lot of low payout ratios on the screen…one was 0.89%! Those low ratios don’t assure me that the company will stand by their dividend if earnings hit a rough patch. My potential basket of stocks now stood at a total of 10 companies which I have listed below by score (highest to lowest) assigned to them by Fidelity’s screener which gives a higher score to stocks that best fit my criteria:
Alliance Resource Partners LP | ARLP |
Unisource Energy Corp | UNS |
Telus Corp | TU |
Greif Inc | GEF |
Espey Manufacturing & Electronics Corp | ESP |
Raytheon Co. | RTN |
Consumers Bancorp Inc | CBKM |
Aflac Inc | AFL |
Communications Systems Inc. | JCS |
Republic Bancorp Inc. | RBCAA |
I own a one-third position in Aflac in my current portfolio and I am familiar with Raytheon however none of the other stocks have ever crossed my radar in a serious way before. Part of this is because the 10% growth criterion was a bit too high of a bar for the more well-known dividend paying blue chips to meet. This brings up another sort of risk: knowing your investments. I will have to put a significant amount of time into investigating these stocks further in order to determine if they are worthy of being entrusted with my house capital. Furthermore these are for the most part relatively small companies. The largest are Aflac at $15.7 billion market cap followed by Raytheon at $14 billion. Four of them are worth less than $500 million and the smallest (Consumer Bancorp Inc.) is miniscule at $24 million. While these might prove interesting as long term plays they make me wary of being able to produce the desired results with a five to ten year timeframe!
The 800-pound elephant in the room are taxes, both on capital gains and dividends that I would pay when I pulled the money out to raise cash for the house when the time comes. Part of the reason I am not rushing into making this move is so I can further observe the political winds as regards to the taxing of investments. As always you need to occasionally take your head out of the weeds and be aware of how the world around you is going to influence your investments.
Full Disclosure: Long Aflac
Related Post: Four Criteria For Evaluating Dividend Growth Stocks
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