DGI Lesson 8: How to Build a High-Yielding Dividend Growth Portfolio

This lesson is about how dividend yields grow in a dividend growth portfolio. It pulls together principles we have seen in other lessons, including:

  • How income goes up over time as stocks raise their dividends (Lesson 2)
  • How income also rises as you reinvest dividends to buy more stock shares (Lesson 5)
  • How yield on cost reflects your portfolio’s income as a percentage yield based on original cost rather than current value (Lesson 6)

To refresh, here is the formula for yield on cost.

Yield on Cost = Next 12 Months’ Dividends / Original Price

So, this lesson is about building a portfolio that eventually achieves a high yield on your original investment from stocks that individually are not necessarily high-yielding themselves.

Projecting Dividends

The formula above requires that we plug in the next 12 months’ dividends for our portfolio.

How do you know what your future dividends are going to be? Well in actuality, you don’t. Any of the following may happen:

  • A company may cut or suspend its dividend.
  • A company may increase its dividend.
  • You may add, subtract, or swap out stocks in your portfolio.

But there is a standard way to project the next 12 months’ dividends: Take all current information, and simply assume that conditions will stay the same for 12 months.

That is, you assume that there will be no dividend increases or cuts. You also assume that there will be no new purchases or sales from the portfolio. That gives you the best snapshot of what the next 12 months will look like.

Most brokerages calculate expected dividends for you. For example, here is the calculator at E-Trade, where my Dividend Growth Portfolio (DGP) resides. This shows their projection of dividends over the next 12 months for the DGP as of this writing.

Dividends that have already been declared are shown in black. The “Estimated” ones are shown in purple, and they are based on information known at the time of the calculation. The calculator makes the assumptions described above:

  • No company will cut its dividend
  • No company will raise its dividend
  • No changes will be made to the holdings in the portfolio

Projected Rising Dividends Are Inspirational

One of my inspirations when I began dividend growth investing was the idea that over time, I could receive, from my companies, significant percentages of my investment every year in the form of dividends.

The dividend income would not be generated by selling assets.

I keep all the assets.

The income is generated naturally – organically – by the portfolio.

My thought was that, at some point in the future, I could collect, say, 10% of my original investment every year in the form of dividends.

Those dividends would replace my paycheck during retirement.

That manner of collecting income without working seemed nearly miraculous then, and frankly it still does.

After all, if you are retired and selling 10% of your assets each year to finance your life, your nest egg will last only a few years, because you will run out of assets to sell. But with dividends flowing in, and indeed increasing every year, you can spend 8% or 10% of your original nest egg every year and never run out of money.

Dividend Growth Investing Is Like Being a Landlord

The mindset of the dividend growth investor is not unlike that of real-estate investors who rent out their properties. Most such investors:

  • Focus on the rental income from the properties.
  • Don’t check the market prices of their properties constantly, because they are not intending to sell them.
  • Don’t panic when the real-estate market softens, so long as their properties keep producing the income they desire.
  • May take advantage of soft markets to buy another property.

Thinking of your investing as a business (see Lesson 12), your business model as a dividend growth investor includes these elements:

  • Find great stocks to own, ones that fit well with your eventual goal of providing income in retirement. You’ll want to identify companies that are likely to pay increasing dividends over a long period of time.
  • Buy the stocks that you want to own.
  • Don’t overpay.
  • Don’t put all your eggs in one basket. Diversify across different company types, sizes, industries, yields, and growth rates.
  • Collect and accumulate the assets that you want. Build your portfolio over time.
  • Don’t churn it too much. Dividend growth investing is not about flipping assets for short-term profits. It is based on building a money machine over a long period of time.
  • Manage your portfolio intelligently. This is mostly a collection strategy, but your business plan should spell out the circumstances under which you will sell or trim a holding.
  • Collect your dividends. If you are accumulating, reinvest them. If you are retired, spend them.

How Your Portfolio’s Yield Grows

Over time, the cashflow from your dividend growth portfolio should grow. There may be interruptions and setbacks along the way, but the overall direction of the amount of cash that the portfolio generates should be upward.

Here is the historical record of my DGP, showing the dividends (in dollars) it has generated each year.

Currently, the estimate for the next 12 months’ dividends for this portfolio is $3848. When I started the DGP in 2008, I spent $46,783 to buy the original stocks. I’ve never added any more outside money.

Using the formula for yield on cost:

Yield on Cost = Next 12 Months’ Dividends / Original Price

Yield on Cost = $3848 / $46,783 = 8.2%

So after almost 10 years of running my little investment business, the portfolio is now generating 8.2% of my original investment, in cash, per year. And as you see from the chart above, that amount has grown each year.

How has that happened? It is the result of 3 phenomena that dividend growth investors experience:

  • Companies raise their dividends.
  • The investor reinvests those dividends to buy more shares, which create more dividends, etc., in a virtuous circle of compounded growth.
  • The investor makes occasional changes to the portfolio to correct mistakes, take advantage of compelling opportunities, and the like.

By the way, if I convert the dollars in the above chart into yields, the chart looks the same. Only the labels change. That is because yield is a percentage, and if we hold the denominator constant at the amount of the initial investment ($46,783), the resulting annual percentage yields march upward at exactly the same pace as the dollar amounts themselves.

In a year or two, if everything continues on the path illustrated by the green bars, my portfolio will generate 10% cash dividends each year, based on the original amount invested. My original inspiration will become reality.

Let’s Clarify Current Yield and Yield on Cost

I don’t want the material above to confuse anybody. I am not saying that after a long period of investment, your portfolio will have a high current yield. Current yield depends on what the portfolio is currently worth, not what it originally cost.

What I am saying is that after a long period of investment, your portfolio can achieve a high yield based on what you paid for it.

When you first start a portfolio, its initial yield is the same as its yield on cost. Say your portfolio has just one stock, and that its current yield at the time that you buy it is 4.0%. Its yield on cost is also 4.0%, because neither the expected dividends over the next 12 months nor the value of the portfolio have changed yet.

Over time, both change. If the stock increases its dividends each year, the expected dividend payouts go up. And of course, every day that the market is open the stock’s price changes. So the portfolio’s yield on cost soon departs from its initial yield.

The initial yield when you first purchase a stock is known at the time you buy it. If the company does not cut its dividend, your yield on cost will never drop below that initial amount. Your initial yield on cost is “locked in.”

The company’s future dividend growth rate cannot be known at the time you buy it. The future is unknowable. You can look at the recent history of a dividend growth stock and see that its 5-year dividend growth rate has been 10% per year for the past 5 years.

However, if you project that growth rate into the future, you are speculating. No one knows what the future holds. Remember that in projecting dividends earlier, we did so only for 1 year forward, and we did not presume that any growth would take place in the stock’s dividend payout.

So beware of projecting high dividend growth rates into the future. Particularly if a company has a 5-year dividend growth rate that is quite high (say > 10%), understand that it is unrealistic to think that the company will be able to increase its dividend that fast every year. You might want to use a more typical rate, like 6% or 7%, if you feel the need to make projections several years ahead.

On the plus side, if you are reinvesting dividends, the number of years to hit a higher yield on cost will be reduced. The additional shares purchased with reinvested dividends will themselves pay dividends. Thus you will see a faster increase in the dividend stream –and in the portfolio’s yield on cost – than if you did not reinvest the dividends.

As of this writing, my portfolio’s current yield is 3.7%. The portfolio’s yield on cost is 8.2%, which is a full 121% more than the current yield.

Why is the yield on cost so much more than the current yield? The reason is that the yield on cost is computed on the original investment that I made in the portfolio 10 years ago.

Since then, the yield on cost has ballooned to its current rate for the 3 reasons described earlier: dividend increases, dividend reinvestments, and occasional portfolio changes.

Key Takeaways from this Lesson

(1) Dividend growth investing is a lot like being a landlord: You own properties not for what you could sell them for, but for the income that they generate.

(2) Dividend growth investors can maintain a disinterest in day-to-day price changes, because they are not planning to sell their properties anyway.

(3) Dividend growth investors can create portfolios that generate rising income practically every year.

(4) Yield on cost can be inspirational. When you are starting out, it helps you imagine a time in the future when your portfolio may generate annual dividends that are a large percentage of the amount you invested.

(5) Don’t project high dividend growth rates into the future. Very few companies have ever maintained high dividend growth rates for more than a few years in a row.

(6) Annual dividends rise for 3 reasons: Companies raise their dividends; you reinvest the dividends to buy more shares that generate more dividends; and you make occasional portfolios changes that improve your portfolio’s performance.

Dave Van Knapp

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