Monday, July 30, 2012

Rule #11 Dividends - Buy Stocks for the Cash Flow

A major part of our financial independence plan is to build a portfolio of income producing assets.  These assets will be our income into the future and will replace our need for other types of income such as employment.  Our preferred type of income is Dividend Income from stocks that we own.  Dividends are a form of passive income that provide cash-flow with virtually no "work" on our part to maintain the asset.  The dividends are paid by the corporations to shareholders over a set period, usually quarterly, throughout the year.  The corporations take a portion of their earnings and send a cheque to shareholders as a benefit to owning the stock.  While it is a strategy that has risk - and don't forget every strategy has some risk - if you choose stable companies that provide goods and services that people use everyday, the risk is greatly reduced to almost nothing... note that I said almost.  There are many companies, with decades worth of dividend-paying history, that will continue to pay dividends well into the future.  Another great thing about dividends is that many companies make it a point to increase their dividend at or above the rate of inflation each year.  These are the companies we want.  If the company increases the annual dividend by 5%, and inflation is 3%, we've just gotten a raise that out paces inflation.  Ultimately this means we have increased your buying power that year.

The sectors that we invest in are primarily sectors in which goods and services used by people will either continue or increase in the future such as: Real Estate, Oil and Gas, Energy Delivery (Pipelines and Electricity Transmission), Banks, Insurance, Consumer Staples, Booze etc... We generally stay away from High Tech, Food Retail, Clothing Companies, and Consumer Discretionaries, because these companies are built on ever-changing innovation, thin margins, or primarily good economic times (non-recession proof).

One stock that I have owned for the last 8 years is Bank of Nova Scotia or BNS on the TSX.  It has payed a dividend for 179 years, without ever having cut it.  Most years it has increased its dividend above the rate of inflation, some years increasing the dividend by 10% or more. did a great summary of BNS last year that does a better job than I ever could could at explaining why its such a great company to own for dividends.  You can check that summary out here.

We view buying dividend stocks as akin to buying mini-pensions that will pay our way into the future.  If, at age 25, I buy $10000 of BMO stock today, with a 5% dividend, that stock will now pay me $500 a year this year and every year after that until I sell the stock.  What if I hold this stock until I am 85 years old?  Great! I get to collect that little mini-pension for as long as I hold the stock.  I can do whatever I want with that money along the way... spend it, re-invest it, earmark it for Christmas, whatever.  Sweet!  BMO has never lowered or missed a dividend payment in the past, and there is a pretty good chance that they will keep paying it into the future... and they will likely increase it inline with or above inflation under normal economic conditions.  This way of looking at dividend stocks is different than how most people have been taught to look at stocks.  They look at the price at which they buy the stock and then fret over what price they are going to sell it at.  Timing of the buy/sell trade is particularly important.  We buy the asset for the cash-flow and and then sit on it as long as the company can meet its dividend payments.  We don't fuss on when to sell it, because we have no intention of selling it.

Thats one of the great thing about owning shares specifically for their dividend is that it removes the day-to-day worrying that goes with watching a stock portfolio go up and down in volatile markets.  Because I own the company primarily for the cash-flow, if the stock goes up or down it makes little difference to me, because I don't intend on selling it any time soon  What I do keep track of is the company's ability to pay me that cheque now and in the future.  So long as the company is healthy and selling their goods, I am happy to own the stock.  During the 2008-2009 financial crisis, only 1 of the 20 or so stocks that we hold cut their dividends, the others either held their payment at the same level or a few even increased their payments.  So our dividend income actually increased overall during the financial collapse because the stocks we owned kept chugging along, regardless of the economy.  Capital appreciation will most definitely happen gradually as earnings and growth continue with the company, and if we really need the money we can liquidate some stock to free up some capital, but thats only under emergency conditions.

During our working (employment) years we roll all the dividends back into the portfolio to buy more stocks, so the dividends also act as a source of income to continue buying even more stocks... Hey, this sounds a lot like the compounding affect.  The bigger our dividend income gets, the more our portfolio grows as we plough it back in with more income.  The longer you can leave it alone, the bigger the cash-flow will be when you pull the plug on working.  When we are finished working or if we are taking a mini-reirement, we stop re-investing the money and just turn on the dividend spigot for our day-to-day cash-flow.

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