Can I Buy A House With Dividend Stocks? Part II

          Back in the first week of October I wrote an article that fleshed out some preliminary thoughts I was having regarding investing some capital that I had set aside for a downpayment on a house. The fundamental idea would be to take some of that capital ($10,000) and invest it in dividend growth stocks in order to increase its buying power when I use it to buy a house five to ten years from now. This would place the capital at the usual risks that come with investing in equities while also providing an opportunity to protect it from the risk of inflation and to actually make money off of the deal. The initial list of prospective companies did not inspire much confidence so this week I adjusted my criteria in order to find more viable candidates for the portfolio.


          Just so we are all clear on my objective here, the point of this project is not to allow me to “buy more house.” I’ve set a goal to have $60,000 available for the downpayment; whether I actually use all of it would depend on circumstances existing at the time of the purchase. What investing part of the invested downpayment will accomplish would be to (assuming positive returns) decrease the amount of money I need to save as it would be made up through dividends and capital appreciation. In turn this would allow me to put more money to work in other investments that would contribute to increasing my net worth.

          The screen (from Fidelity.com) utilized in the original article contained the following criteria:

          Dividend Yield: 3.5%-7.0%

          5 Year Average Dividend Growth Rate (DGA): 10% < x < 20% 

          5 Year EPS Growth Rate Average: 10% < x < 20% 

          Dividend Payout Ratio (Earnings based): 30% < x < 60% 

          Aside from Aflac and Raytheon the list didn’t do much in the way of encouraging me to pursue this line of inquiry. I own shares in Aflac but am wary of Raytheon (and other defense contractors, sometimes you’re better off not investing in what you know). I’d like to have a minimum of six and a maximum of ten stocks in this portfolio so only coming up with one possible winner leaves me dead in the water. Unless, of course, I change my screen.

          Quick note on screens: when you alter your criteria you should do so in order to provide yourself with more options to investigate further, NOT in order to keep lowering your standards until you find a company that fits into your investment strategy. I have one screen that I run every couple of months that has very tight ranges for what it considers acceptable financial performance: if it turns up three companies with one being a possible worthwhile investment it is a good month! For example if a critical part of how you build your portfolio involves not buying companies with more than 50% debt to equity then you generally shouldn’t don’t bump the limit up to 75% just to get the names you were hoping for included on the list. Exceptional cases would be when you were able to identify which aspects of the particular company’s operations convinced you that the extra 25% in debt to equity was justified.

           So, paraphrasing from the first article’s final paragraph, I will now be looking for dividend payers that provide steady but not electrifying yields and dividend growth rates to combine with lower yielding stocks with higher rates of dividend growth. I will also include a market capitalization requirement in order to keep micro-caps out of the search results and to favor larger companies with widely recognized brands. I conducted two screens to search for candidates that fulfilled the requirements I discussed in the preceding paragraph. Below I show the specific criteria I used and five companies selected from each screen. The five companies were not necessarily the five that rated highest in terms of score (Fidelity’s screener evaluates how well each criteria is met and applies a numerical score to the result) but rather five of the most easily recognized names out of the short list of stocks the screens produced. They are listed below in order of dividend yield, from highest to lowest. 

          First Screen: Favoring yield over dividend growth 

          Dividend Yield: 3% < x < 7% 

          5 Year DGA: 8% < x < 15% 

          Dividend Payout Ratio (earnings based*): 25% < x < 80% 

          Return on Equity: 10% < x < 35% 

          Market Capitalization: > $10 Billion

          *Fidelity doesn’t have a FCF Payout Ratio option. What I did was apply a very loose earnings payout ratio and then dug into the selected companies’ balance sheets and cash flow statements to determine a FCF payout ratio using the cash on hand figure from the latest quarterly report and the sum total of the last four quarters of dividend payouts, also known as trailing twelve months (TTM).

Ticker	Yield	5 Yr DGA	FCF Payout	ROE	Rank
WM	4.09%	9.10%	54.1%	15.19%	Challenger
COP	3.76%	12.89%	63.0%	16.59%	Contender
PEP	3.32%	11.41%	75.2%	28.06%	Champion
PG	3.23%	11.11%	61.3%	17.63%	Champion
ITW	3.10%	11.38%	64.0%	19.49%	Champion

       
          Waste Management (WM) is in the waste disposal and recycling business and has increased its dividend for the past 8 years.
          Conoco-Phillips (COP) is an integrated energy company and has increased its dividend for the past 11 years.
          Pepsico (PEP) is in the food, snack, and beverage business and has increased its dividend for the past 39 years.
          Procter & Gamble (PG) is in the household consumer goods business and has increased its dividend for the past 55 years.
          Illinois Tool Works (ITW) is in the manufacturing business and has increased its dividend for the past 48 years.

          Second screen: Favoring dividend growth over yield.

          Dividend Yield: 2.25% < x < 5%
          5 Year DGA: 12% < x < 25%
          Dividend Payout Ratio: 25% < x < 80%
          Return on Equity: 10% < x < 35%
          Market Capitalization: > $1 Billion

Ticker	Yield	5 Yr Div Growth	FCF Payout	ROE	Rank
SWY	3.19%	20.32%	74.5%	11.11%	Challenger
MDT	2.91%	17.13%	29.7%	19.76%	Champion
AFL	2.90%	18.20%	7.2%	15.94%	Champion
ADP	2.82%	14.24%	50.7%	21.13%	Champion
WMT	2.59%	16.86%	66.3%	23.50%	Champion

          Safeway (SWY) is in the food and drug retail business and has increased its dividend for the    past 7 years.
          Medtronic (MDT) is in the medical technology business and has increased its dividend for the past 34 years.
          Aflac (AFL) is company whose primary business is supplemental health and life insurance and has increased its dividend for the past 28 years.
          Automatic Data Processing (ADP) is in the outsourcing (such as payroll services) business and has increased its dividend for the past 36 years.
          Wal-Mart (WMT) is in the discount retail business and has increased its dividend for the past 37 years.

          Note that there is not necessarily a correlation between the size or age of a business and how “hot” its dividend growth rate is. It is entirely possible to load up on blue-chip companies and reap the benefits of both higher yielding stocks as well as those with higher dividend growth. In general though just focusing on blue-chips will limit your potential for price appreciation (notable exception: post-March 2009 recovery) so including companies with more room for revenue growth is an effective way to increase your portfolio’s ability to increase in value.

          Here is a table showing how much income I would expect to earn from each of these stocks if I held it for ten years and did not re-invest the dividends (which in this case I absolutely would). I’ve left the growth rates intact and did not take out 3% for inflation. This is just a simplistic exercise showing, in nominal terms, how different yield and growth values would interact with each other in producing income over time. The table assumes $1,000 of principal was committed to each investment. Stocks from the high dividend growth list are highlighted in gray.

Ticker	Yield	Growth	Income
SWY	3.19%	20.32%	$841.28
COP	3.76%	12.89%	$688.91
AFL	2.90%	18.20%	$688.87
MDT	2.91%	17.13%	$655.82
WM	4.09%	9.10%	$624.37
WMT	2.59%	16.86%	$576.01
PEP	3.32%	11.41%	$566.25
ADP	2.82%	14.24%	$551.72
PG	3.23%	11.11%	$543.00
ITW	3.10%	11.38%	$527.97
Total Income			$6,264.20
3.5% Yield, 10% Growth			$5,578.11
Difference			$686.09

          In the original article I set a minimum requirement 3.5% yield and 10% annual dividend growth for the entire portfolio. As you can see from the table balancing the 3%+ yielders with decent dividend growth with the sub-3% yielders that have high dividend growth the portfolio would return an additional $686.09 over ten years, or 6.89% on the original $10,000 investment. This portfolio’s average yield is actually 3.19% with an average dividend growth rate of 14.26%, so I traded in some yield in exchange for growth. By keeping the initial average growth rate above 10% I provide some breathing room (also known as a margin of safety) in case the higher growth rates drop due to being unsustainable at the current level.

          So what did this week’s exercise accomplish? It identified more reliable dividend paying companies than last week’s screen, mainly due to size and brand power, and included a broader range of yields and growth rates in order to still beat the portfolio's targets. Two noticeable exceptions to my calculations so far have been the impact of inflation and taxes on my returns. It would be unwise to proceed on this investment path without factoring in these two variables so therefore Part III of this series will include them in a more general discussion on the risks facing this portfolio.

Full Disclosure: Long WM, PEG, COP, MDT, AFL, ADP, WMT

Read Part I of this series here

This article was included in the Totally Money Carnival: Scared Straight Edition at Modern Tightwad

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