Dividend Investing for Retirement

When I first started out as an investor I was not in the least bit interested in dividends. My plan was to invest for growth by investing primarily in the accumulation units of a FTSE All-Share tracker, and then at some distant point in the future switch over to an income strategy, which would most likely be an annuity of some sort.

Since those early days I have had a long and bumpy route from passive investor to active stock picker, and today my opinion on dividends could not be more different. Dividends are now the cornerstone of my retirement investing strategy and I intend to use the same basic strategy for both capital accumulation today (through dividend reinvestment) and income in retirement (through dividend withdrawal).

I want my portfolio to be flexible and capable of providing both capital accumulation and dividend income and so it has three major goals, each of which is defined in relation to the FTSE All-Share: 1) have a higher dividend yield; 2) produce higher capital and dividend growth; and 3) be less volatile.

To achieve those goals I only invest in dividend-paying stocks that appear to offer the best combination of defensiveness and value-for-money. Defensiveness refers to aspects of a company like its growth rate, growth quality and profitability, whilst value-for-money refers to factors such as a stock’s earnings and dividend yields.

As a gentle introduction to how I approach the task of dividend hunting, in the rest of this article I’ll outline five key points which are at the heart of my strategy and then briefly review a couple of popular dividend-paying stocks.

Key point #1: Build a diverse portfolio

The first point to remember as a dividend investor is that dividends are not guaranteed. In a well-run company dividends are paid out of cash which is either not needed for current operations, or cannot be re-invested within the business (perhaps by building a new widget factory) at an attractive rate of return. However, if a company runs into hard times and finds that it isn’t generating enough spare cash to cover the dividend then the right thing to do may well be to cut or suspend the dividend.

Given this uncertainty around dividend payments, the sensible thing for income-seeking investors to do is to spread their portfolios across a diverse range of income-generating stocks. For me that means holding around 30 stocks, with most of them making up somewhere between 2% and 5% of the portfolio, and none making up more than 6%.

With that degree of diversification I can sleep well at night even if one company completely suspends its dividend. Although that’s unlikely, even if it did happen the impact to the total dividend thrown off by the portfolio would be negligible.

Beyond holding shares in many companies and making sure that no one position is excessively large, it’s also a sensible idea to try to diversify in terms of industry and geography. For me this means holding no more than three companies from any particular industry and making sure that, on average, at least 50% of the revenues generated by my investments come from outside the UK.

Key point #2: Buy high quality companies

A broadly diversified portfolio of weak or badly run companies is unlikely to generate a steady stream of growing dividends, so my second key point is to focus on high quality companies, or perhaps above average companies at the very least.

Defining “high quality” in the context of companies is a complex and subjective matter, but for me it comes down to these four cornerstones of quality: 1) an unbroken record of dividend payments stretching back at least ten years; 2) an above average growth rate (measured across revenues, earnings and dividends); 3) above average consistency or quality of growth; 4) above average profitability – i.e. the rate of return generated by the company’s fixed and working capital.

There are many other factors of course, but if a company doesn’t have a long track record of reliable dividend payments and a good combination of growth, consistency and profitability, then I think it would be difficult to describe that company as high quality, especially from the point of view of a dividend investor.

Key point #3: Buy when prices are low and when yields are high

Although the quality of each company is important, just as important is the price paid for a company’s shares. Sometimes I will avoid a high quality company because its share price is too high and its dividend yield too low. At other times I will invest in a company which is not quite in the high quality bracket but only when its share price is very low and its dividend yield very high.

The problem with buying companies at low valuations and with high yields is that there is usually a good reason why the yield is high – and it’s usually an unpleasant reason. If everything looked rosy then investors would buy the stock and pump up the share price, which would in turn lower the yield. So for the yield to be relatively high there is usually some sort of problem that the company is facing, and to be a high yield investor you have to be willing to invest in companies that have obvious (but hopefully short-term) problems that other investors would rather avoid.

Key point #4: Hold for years rather than days, weeks or months

Most income investors already have a relatively long-term outlook, so the problem of excessively frequent buying and selling is less of an issue than it is with many other types of investor. But it is still a point worth making. In most cases when a stock is bought the intention should be to hold it forever, unless something particularly good or bad happens (which I’ll cover in the next key point).

Barring exceptionally good or bad outcomes, I would say that most of your investing time should be spent doing nothing other than simply watching your dividends roll in month after month.

Key point #5: Regularly take profits on winners and replace losers

Buy and hold investing is a popular approach for income investors, where the intention is to simply buy a company’s shares and hold them forever; but I prefer to be slightly more active than that.

Rather than buying a dividend-paying stock and then never touching it again, or only making another investment decision if the original company is taken over or goes bust, I think a regular plan of portfolio maintenance is a better idea. A good analogy is gardening, where fast growing plants should be trimmed back and weeds removed if a garden is to be maintained in tip-top condition.

In the investing world this means taking profits on holdings that have done exceptionally well and occasionally removing investments that have done badly and are unlikely to recover. I like to do my portfolio gardening on a regular basis, but I don’t want to be hyperactive so I limit myself to an average of about one investment decision each month.

Those five key points make up a framework upon which many separate activities and investment rules of thumb hang.  One of those activities is the analysis of potential investments, which is actually quite an involved process on its own and one I don’t have the space to cover today. Instead I’ll finish this article off with a couple of short reviews of two very different companies, which will hopefully highlight the ever present trade-off between quality and price.

Unilever: A quality company, but is it a quality investment?

Unilever is the name behind many famous brands such as Magnum ice cream and Dove soap. It is a classic defensive dividend stock as it operates in the non-cyclical (i.e. defensive) consumer goods sector. It sells small ticket, repeat purchase items that its customers will buy even in the middle of a bad recession.

The company has a long history of dividend payments and profits, fairly consistent growth and above average profitability. In short, Unilever is definitely the sort of company I would be happy to invest in, at the right price.

And just what is the right price? Here’s one way to think about it:

Unilever has grown its revenues, earnings and dividends by an average of around 3% a year over the past few years. As I write, its share price is 3,141p and its dividend yield is 2.8%. If we assume that Unilever can continue to grow its dividend by 3%, and that the dividend yield remains the same, then investors will receive a return of 2.8% from the dividend and 3% per year from growth, giving a total expected return of 5.8% per year.

In comparison, the long-term average return from the FTSE 100 has been around 7% per year. With the FTSE 100 at 6,106 and its dividend yield at 4.1%, the index would only have to grow its dividend by 2.9% each year for investors to continue to receive that historically average 7% long-term return. Looking at the FTSE 100’s track record it appears that a 2.9% dividend growth rate would not be out of the ordinary.

So why would an investor buy Unilever with an expected rate of return of 5.8% when they can buy the FTSE 100 (which is less risky than Unilever) which has an expected rate of return of 7%?

The answer is that Unilever’s investors are probably expecting the company to grow by more than 3% per year. Perhaps Unilever can grow faster than that, but by paying a high price and accepting a low dividend yield, those investors are taking on a lot of risk. If that high growth rate fails to materialise then the market could re-price Unilever as a low-growth stock, with an appropriately higher dividend yield, and that would mean a significant decline in its share price.

For example, if Unilever continued to deliver a 3% growth rate then its dividend yield would need to be around 4% in order for its future shareholder returns to at least match the market. A 4% yield for Unilever would occur at a share price of 2,200p, and that’s some 30% below its current price.

I’m not saying that Unilever’s shares are about to decline by 30%, but it’s a distinct possibility unless the company can kick-start its growth rate.

BP: A high risk, high yield investment

Unlike Unilever, BP is definitely not a defensive dividend stock. For a long time investors thought it was, and perhaps they were right; but those days are over. In recent years the company, its dividend and its shareholders have been through the meat grinder; first because of the Gulf of Mexico disaster in 2010 and now because of a collapse in oil prices.

Unlike Unilever, which sells ice cream and soap and other things that people will buy no matter what, BP sells oil and related products which can have massively volatile prices. That volatility can in turn massively affect the company’s profits and cash flows from one year to the next.

As things stand today BP’s dividend is completely unsustainable with oil prices at their current low levels. For now the company has decided to stick with its dividend and maintain the payout, but that situation will not last without a significant rebound in oil prices, although nobody really knows if or when that will occur.

This high degree of uncertainty is reflected in BP’s share price and dividend yield, which are currently 353p and 7.6% respectively. In most cases a dividend yield above 5% should be viewed with suspicion, and that is definitely the case here.

So does BP’s unsustainable dividend and volatile characteristics mean it’s a no-go area for dividend investors? I don’t think it does. Although the risks around BP’s dividend are substantial, I think they are mostly already in the price. If BP’s dividend is cut in half then the yield will still be 3.8%, which is respectable. Of course it could be cut further than that or even suspended entirely, but it might also be maintained at its current level for years and that would almost certainly lead to a significant rise in the share price.

This is all very speculative, but personally I don’t see anything wrong in having a small number of these more speculative positions in a dividend portfolio. That’s why, despite the relatively high risk, I currently have about 2% of my portfolio invested in BP.