Dividend income growth... 16 months in review.

If you follow any of my previous posts, you know I am a believer in dividend growth investing.  We've consistently been able to achieve an increase of our portfolio's annual dividend income since we started using this strategy with the lowest annual portfolio dividend income increase of approximately 5%.  We grow our dividend income through dividend reinvestment, new monies added to the pot, and from dividend increases.  This year and a half has been a bit of a special case from past years because we have added NO NEW MONIES to our investment pot.  Therefor the increases over the past 16 months are solely from the pooling of dividends and then reinvesting them, and from dividend increases which have been plentiful this year.   I've also incorporated some covered call writing in our RRSPs to add a little extra cash-flow but those are really small potatoes compared to effect of the reinvestment and increases of the existing dividends.  From July1 2013 to October 30 of 2014 we have increased our dividend income by a compounded rate of 17.5% over those 16 months.. or just over 1% per month.  Our portfolio currently yields about 4.5%, so over the 16 months about 6% of the growth came from reinvestment and the remaining 11.5% is from dividend increases.  This represents an annual dividend growth rate of about 8.6%. Not too shabby.

The following chart shows the increase to our annual dividend income for each month, which includes both reinvestment and dividend increases.

Note that every month there was an increase in our total dividend income.  Every month had some form of increase and there were no decreases.  In order to give this chart a bit more meaning, lets assume that July 1st 2013, we made $10000 a year in dividend income.  The monthly increases to that amount would look like this:

... to the point where $10000 in dividend income turns into $11749, 16 months later.

If you've been watching the stock market over any period of time, you know that we always see increases and decreases in stock prices, usually by the second during market hours sometimes with big swings to the upside and the downside.  This watching of the market go up an down can rattle some people as they watch their portfolio value increase or decrease by up to double digit swings within short periods of time.  The above chart is the kind of chart I like.  Our dividend income continues to rise month after month.  Some months we had dividend increases and other months we deployed some of the dividend monies that had built up and bought some more stock.. usually ones that we thought were depressed. on sale, or were due for a sustainable dividend hike in the future.

Rule #15 Don't try to "Beat the Market"

Do you know the only thing that gives me pleasure? 

It's to see my dividends coming in. -John D. Rockerfeller

Have you ever heard anyone talk about beating the stock market?  Its what hotshot investors talk about at cocktail parties.  What they mean is that if the stock market has an annual return of 10% in one year, they have had a better return than that 10%.  Very impressive indeed!  They will try to achieve this by building and adjusting a stock portfolio, mutual fund portfolio, or with index funds.  Beating the market is all well and good if the market goes up, but what if the market goes down? If the market has a loss of 5% the next year and the investor only lost 3%, then they have also beaten the market because they have done better than the market has done that year.... but people don't tend to brag about losing money "Yeah! I only lost 3% this year!".  The market (and by market I mean Dow Jones Index, S&P 500 index, or TSX index etc...) has historically returned 8-12% returns annually but those numbers are smoothed out over decades of data, so you certainly couldn't count on a 10% return every single year... as has been the case the last decade.  One thing about measuring returns in the market this way is you only realize these returns when you sell the investment... and that brings on the issue of timing, and few people have mastered that.

I don't really care if I beat the market or not.  Beating the market is not my objective.  I am not in competition with the market, My objective is to build a portfolio that will eventually result in me being financially independent.  Who cares if you beat the market if the market has lousy or negative returns?  If the market loses 25% in a year, I feel no pride in only losing 20% that year.  And if the market were to make 25% in one year, its ridiculous for me to worry that I only returned 22% instead.  I feel this "beat the market" mentality is a waste and makes people take their eyes off the prize, or chase capital returns instead of stable cashflow.  People shop around for stocks or sectors hoping to get a winning year or to follow advisors or mutual funds because they have a few good yearly returns.  That just seems dumb to me.  I prefer a system that provides stable and somewhat more predictable results.

We have our own metrics.  We don't compete with the market, and we sure as hell dont try to beat it.  Our goal is to grow our cash-flow on existing assets by 8% a year... We get this by reinvesting the 3-5%-ish dividends that we get in cash-flow and then plan on a 4+% increase in dividends annually.  We generally don't pay much attention to stock prices once we own the stock because they tend to fluctuate due to world and political events rather than be based on actual company financial metrics.  Tracking growth of cashflow is pretty easy to understand and we don't have to follow the stock prices or compare with how the market is doing.  In fact, since we are reinvesting dividends to buy more stocks for cash-flow, we don't mind when the market takes a dive because it means we can pick up good stocks with even higher yields than before.

Every year for the last 10 years, our cashflow from existing assets has increased.  Every year! And Every year it has gone up above the rate of inflation.  The lowest growth rate was about 5% in 2009 and the highest has been about 15%.  Thats a pretty good record if you ask me.  This year is turning out to be a good one, we expect about a 10% increase in total this year if we keep going the way we're going.  Three quarters of our dividend producing stocks have increased their dividends this year and the rest probably will within the next 3-6 months, and we just keep rolling those dividends back into the portfolio buying more cash-flow-producing stocks, furthering the compounding.  This increase also does not include any new monies that we put to work in this strategy.  Include the new monies, and our conservative leveraging strategy and we're increasing our cashflow above our 8% per year target relatively easily.  Do I care how this all compares to what the stock market performance is doing these days?  No, I don't.

Rule #12 Use Leverage for MORE positive cash-flow!

Under the right conditions, we are very comfortable using leverage to buy stocks.  Big amounts too.  A lot of people will warn against doing this.  I don't advocate that you necessarily do it, unless you understand the risks and are comfortable knowing what the possible outcomes are, and of course if the investment makes sense in the first place.  If the investment value craters, you are still obligated to pay your debt, so do your due diligence and make sure your really understand what you're getting into before borrowing to invest.    An example of a trade gone wrong would be Research in Motion.  If you borrowed to buy RIM a few years ago you would have lost your shirt on that trade by now as the stock is down 95% off its 2008 high, yet you would still be required to pay back everything you borrowed with literally nothing to show for it. Yes, it really can be that bad.  I would not have invested in RIM because they pay no dividend.

If you are starting to use leverage I would suggest you start in very small amounts until you become comfortable with it.   With all of that said I still don't consider it quite as risky as most will tell you it is, IF you pick stable conservative investments and NOT put all you eggs in one basket.  I have also observed that most people have been conditioned to believe that leverage on investments is risky, yet borrowing (leveraging) to buy a home is not.  I view leverage on a house to be just as risky as using leverage on stocks, perhaps even more risky.  This has to do with my view of a home being a liability.  It pays you nothing, and if it drops in value you are still on the hook to pay for it.  Buying something that is overpriced or built on shaky ground, whether its a house or a stock, can lead to a loss, and leverage can amplify those losses if you sell at the bottom.

I will tell you how I use leverage to increase our cash-flow and pay for itself, while minimizing the risk of the loan over time.  I do not try and hit home-runs with large capital gains, I try and hit base-hits.  Lots and lots of base hits, by creating a cash-flow positive situation while borrowing money to juice it up.  To be clear, what I am talking about is borrowing money, most likely from a bank, to purchase income producing assets.  I prefer Canadian stocks that pay dividends, but you can use a similar strategy to buy an income producing property such as a house or multi-family building, or any other investment with an income stream.  Usually its difficult to find investments with a high enough yield to use the strategy I use, but do your research and you may find some opportunities out there.   Note that I have no experience in rental properties, so I will give an example from a stock that I watch.

There are four basic criteria I use when using leverage.

1. I typically leverage for 50-60% of the position... that is to say that I only borrow when I am willing to put up 40% of the money myself
2. The dividend/distribution must be stable, preferably growing, and never have been cut.  
3. The cost of borrowing must be relatively stable or be going down in the next 1-2 years.
4. The leveraged investment portion must have a positive and growing cash-flow that covers the cost of borrowing today. If it doesn't make sense today to make the investment, I don't rush it.

So here's an example of a leveraged position I might take.  I will use an example for a corporation I follow call Leisureworld Senior Care (LW on the TSX).  They own Retirement Luxury condos and Full-Service Retirement Homes.  Full disclosure: They are on my watchlist, but I do not own any LW and I am NOT suggesting you buy any...  I am just using them as an example.  Lets go down my criteria

#1 I am willing to put up $4000 to purchase some LW stock, I will also borrow $6000 from the bank to make a total investment amount of $10000.  

#2 The retirement home industry is a stable one and will likely grow in the future as Boomers move into retirement lifestyle living centres, I would expect the dividend to be stable and likely grow at or near the rate of inflation.  At present, the dividend yield is 7% 

#3 At present, I dont see interest rates rising much, if at all, within the next 1-2 years due to the slow growth situation right now with the economy... rates are at all time low.  Now may be a good time to use leverage.  RBC currently has a Home Equitly Line of Credit that is set at prime +0.5.  With Prime at 3%, thats an interest only loan for 3.5%.  Thats pretty low.  You could also lock in a rate of some sort through other lending products at the banks, but I typically use a HELOC as you tend to get the best rates, although they are almost always variable and may fluctuate abruptly.

#4 I would get paid a dividend of 7% annually, and use that cash-flow to pay the loan interest of 3.5%, leaving a spread of 3.5% in positive cashflow. This means on the $6000 that I would borrow, I am making $210 annually.  Congratulations, the leveraged portion of this investment is is cash-flow positive!  The Dividend would have to be cut buy 50% or the loan interest rate double before it becomes neutral to cash-flow negative.  Sounds safe in the near term.  

Now that I've established this as a candidate, how might this look with respect to cash-flow?  In most cases I use the cashflow from the total position (both borrowed portion and my own portion's cashflow to pay down the loan).  As the cash-flow pays down the loan, no additional monies need to be injected into the position.  We treat the whole position as a closed system until it pays off the loan.  You can essentially start saving new monies for your next investment as this one pays itself off.  Here's a  spreadsheet showing what happens whey you use the money to pay down the loan assuming no change in dividend or interest rate.  

After 10 years, the loan is paid off and you have $10000 of LW stock.  This spreadsheet DOES NOT consider the likelihood that LW will increase the dividend, or that the annual interest rate will rise into the future.  Both considerations are quite likely... you can test different scenarios in your own spreadsheets.  This spread just shows that if left alone the dividends will pay off the loan in about 10 years and then you will have about $700 a year in free cash-flow from your initial personal contribution of about $4000.  Thats a 17% yield on the money you put up.  Not bad. Not bad at all.

This strategy works well on stocks that are in conservtive sectors with healthy stable cash-flow and if you don't go hog wild with leverage all at once.  I would never use this strategy on a company that doesn't have a healthy balance sheet, a sustainable dividend or if its in a volatile sector like high tech.. its just too risky.  With that said, I believe using leverage conservatively and under the right conditions can be very profitable.

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.  ThePassiveIncomeEarner.com 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.