Income Growth 2-3x Inflation
There are many different approaches to what is called “dividend investing”. And dividend investing, in most of its forms, is just one aspect of “income investing.” This claim assumes that the primary reason investors are interested in dividend paying stocks is the income that comes from these stocks. Of course, this claim is not always true in that computers, wealth managers, and individuals may prefer dividend paying stocks for a variety of reasons, other than the dividend income. However, let’s assume for the moment that an interest in dividend-paying stocks arises from an interest in creating income with one’s investments. So we should start with the concept of income investing.
Income investing generally refers to the practice of buying an asset that will generate a regular reliable amount of income over the life of the asset. A “bond” meets this definition whereas the traditional “savings account” may not. There are about a dozen different asset types that will meet this definition, each with their own specific characteristics and risks. These include Treasuries, various types of bonds, preferreds, unit trusts, certain annuities, and all types of funds that are concentrated in these asset types. All things being equal, investors find utility in the highest possible yields or the most money per dollar of asset purchase. But all things are not equal.
Yield and Risk
For traditional investors in these income-producing assets, there is a well-accepted, and probably true, relationship between yield and risk. The higher the yield, the more risk there is to the income. It is important to insure a steady and reliable income stream at the highest possible rate. Income investors must always seek a way to stop inflation from ruining their purchasing power. A bond paying 4% in an environment of 5% inflation slowly erodes the purchasing power of the investor. As general interest rates go down, the inflation problem associated with income investing becomes more difficult to address, especially if inflation rates do not also go down significantly. All of the traditional income products (those with fixed payments) contain various types of risks, but the greatest is an interest rate risk. In this situation, a change in interest rates causes the value of the income producing asset to change dramatically. When general interest rates rise, the value of the asset goes down. Another significant risk for all fixed income products, mentioned above, is the risk that inflation will overwhelm the purchasing power of the income stream.
Rising Income Payouts
There is another class of income products that is considered to also generate a regular amount of income, although this income may not be as reliable as a bond. These do normally not have any interest rate risks associated with them, but there is definitely a risk to the amount of the income arising from the asset. Also, these asset types have the possibility that the income could rise over time. These asset types include Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), Business Development Corporations (BDCs), and dividend paying stocks. Of these four, it is very difficult to predict the future growth of payouts from individual MLPs, REITs or BDCs, although many advisors and analysts are trying their best. For dividend paying companies, it is somewhat easier, although still difficult, to predict the future dividend growth rates using historical data on payout rates, selected measures of financial health, management’s attitude towards rising dividends, and other variables. McDonalds, Johnson & Johnson, Proctor & Gamble and Coca-Cola are among those companies with financial metrics that reliably predict dividend growth rates of close to three times the rate of inflation.
Income and Dividends
It seems reasonable that individuals who want steady income with protection from inflation would focus their income search on dividend paying companies that look like those listed above. The only trick is how to pick just those companies, and create a safe growing income stream.
The Dividend Growth Portfolio does just that. It is a collection of diversified companies most likely to increase their dividends at compounded rates of 8% - 10% for years into the future.