Dividend Investing: A Seven Step Guide

Dividend investing for intermediate and serious investors has been the topic of my blog since I started it in 2013. I love the slowness during the last week of the year because it lets you step back and get philosophical about the big picture of what you’re trying to accomplish. As a service to new readers, I thought I would create a seven-step guide to dividend investing to offer as much of my condensed investing philosophy in a short period of time as I can.

Step 1: Determine whether dividend investing best fits your circumstances.

One of the most important things you need to recognize is that wealth gets created by finding the greatest amount of net-of-tax returns. This makes dividend investing a poor fit for high earnings in taxable accounts, particularly those in high-tax states like California. A lawyer in California has no business buying AT&T stock so that he can pay 23.8% taxes to the federal government for each dividend and 13.3% to the state of California as well. Someone putting 100 shares of AT&T into a retirement account might earn 10% annually while the California lawyer only reaps 6-7% on the exact same asset.

This also applies to investment in real estate investment trusts (REITs). If you are thinking about buying a REIT, it will make very little sense to put this type of stock into a taxable brokerage account because REIT dividends are taxed at ordinary income rates that can force you to pay about 40% of your distribution in tax.

If a dividend is a big component of the total return, and your holdings are subject to a high tax rate, dividend investing is probably best not suited for you. That’s okay–there are investments like Berkshire Hathaway and O’Reilly Automotive that are perfectly fine vehicle to build long-term wealth. If you are in a no tax state, a low tax bracket, or are looking to make an investment in a retirement account, then dividend investing may be appropriate for you.

Step 2: Use dividend investing to permanently improve your household liquidity.

One of my favorite quotes from Warren Buffett that you don’t hear too much, taken from his 2014 letter to shareholders of Berkshire Hathaway: “At a healthy business, cash is sometimes thought of as something to be minimized–as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.”

If you live in Texas and have amassed 4,000 shares of AT&T stock over a lifetime of DRIP investing, your life is going to have a sweet teach when AT&T deposits $1,920 into your bank account every ninety days. It can help you pay the mortgage. It can help you send your kids to school. It can help you build up a cash reserve. Absent a legal judgment against you that forces you to sell, you will collect income from AT&T every ninety days until you die or the corporation becomes insolvent. Once you buy a share of something, it remains in your ownership from now until kingdom come.

The reason I gravitated towards a dividend strategy is because it allows you to benefit while you own it. If you own AT&T stock for thirty years, your benefit is going to be 120 dividend checks. Your other benefit is the rise in the stock’s value. But you don’t get to realize that value until you sell it.

If you own a share of Berkshire Hathaway, you must sell that share–relinquish your ownership–in order to reap a benefit. I suppose you could technically take on debt and borrow against the shares, too, but that would require interest payments that would flip the cash-generating nature of investing into a cash-sucking endeavor.

I don’t want you to have to kill the golden goose to get rewarded. I want you to get rewarded over and over again once you exert the initial effort to buy the shares.

Step 3: The successful practice of dividend investing involves insisting on quality and paying attention to the investment’s payout ratio.

It would not surprise me if shareholders of Nike stock never see a dividend cut during my lifetime. Why do I have that conviction?

First, there is a huge gap between the current dividend payout and the company’s net profits. It is paying out $0.60 per share to Nike shareholders while it is earning $2.16 per share in profits. What does this mean? Every year, Nike sees $3.6 billion in profits get shipped to accounts run out of the Beaverton, Oregon headquarters. Of this, only $1.0 billion gets shipped out to shareholders as a dividend. This represents an enormous margin for profits to fall in which the dividend payout could still continue. Nike could experience a horrendous collapse that sends earnings spiraling downward 67% and it could still bring in enough cash to pay its shareholders at the current rate.

And has anything that catastrophic ever happened to Nike stock? Heck no. I just reviewed the past twenty-five years of Nike’s business and it has never seen its earnings decline on a year-over-year basis. Even during the Great Recession of 2008-2009, profits grew. The worst comparison period I could find was 2000-2001 when earnings only grew a penny from $0.26 per share to $0.27 per share.

When earnings have never declined in almost three decades, and you have enough latitude for earnings to get cut by two-thirds, that is about as much safety as you can hope to find by investing in actual businesses.

Your job is to go through life finding two or three dozen businesses that share Nike’s characteristics of extreme safety.

Step 4: When you first get started with dividend investing, you should try to get some “cash cows” under your belt that you can use to perpetually fund new investments.

Imagine that it is 2008 and this is the first year that you get started with investing. You make $60,000 per year and manage to save $20,000. You see Philip Morris International stock trading at $33 per share and, aware of Dr. Jeremy Siegel’s research that it is the best performing stock in the history of the stock market, you decide to purchase 600 shares of the international tobacco giant.

What has happened? If you collected your dividends as cash, you have received $27.90 per share. This means that you have received $16,740 in cash payments over the past eight years to make new investments. If those $16,740 got put into stock yielding 3%, those Philip Morris International dividends alone would have created another income stream generating $40 per month for you.

Meanwhile, those original 600 shares would be paying you $2,496 per year in dividends. Instead of having $20,000 to invest each year, you now get $22,496 to invest each year. Warren Buffett said that the only way to get rich is to make money while you are sleeping. Well, at this point, a dividend investing strategy has allowed 10% of your annual investing amount to come from cash generated while you’re snoozing.

Step 5: Although there is no official dividend investing rule on this, you should probably automatically reinvest your dividends until you are generating $1,000 per month in passive income.

When you are just getting started out, your focus should be on increasing savings rate. Your primary goal should be trying to get your portfolio size into the six digit range. Maybe this means increasing your monthly savings from $600 to $1,200. Maybe it means cutting your spending by $300 per month. Maybe it means finding a way to work overtime so that money can be shoveled away into a cash-generating blue-chip stock.

Sometimes, I get e-mails from people with 25 shares of Coca-Cola that wonder whether they should reinvest that $8.75 into more shares of KO or pool it together in an account that looks for value investing. That Coke dividend will barely buy you a case of Coke. You shouldn’t be worried about where those $8.75 get allocated.

Your focus should be on turning that 25 share Coca-Cola position into a 250 share position. Automatically reinvest that thing. Take some of your salary and buy more shares while you’re it.

Once you look across your portfolio and see that you’re making $1,000 per month from dividend investing, then you can start to pay attention to how you allocate those dividends. Then you can automatically deposit those KO dividends into an account for further investment.

I’ve written over 1,700 articles on this topic. Lord knows I love analyzing the intricacies of dividend investing. But my view is that you should let a snowflake build into a snowball by itself and then worry about selecting the right hill to create an avalanche.

Step 6: Somewhat ironically, the more money you earn from dividend investing, the less you care about your starting dividend yield.

When you’re trying to get the initial building blocks in place, it is understandable why low-yielding dividend stocks would get ignored. In 2000, Colgate Palmolive only yielded 1%. Even if you had $100,000 to invest, you would only be able to create an $83 income stream out of it. When you’re trying to become a capital allocator / member of the capitalist class, that is not going to help you lay the foundation so this type of stock might prudently be excluded from your practice of dividend investing.

However, imagine if you are generating $36,000 per year in dividends. Every month, you have $3,000 coming in aside from what you set aside from your primary occupation. You find yourself creeping into a higher tax rates. You have more latitude to start thinking about the life cycle of an income investing. It starts to make sense on paper for you to accept low dividend income now in exchange for a great likelihood of higher income in the future.

At this stage in your life, your practice of dividend investing might include a stock like Colgate-Palmolive. Between 2000 and 2016, Colgate-Palmolive grew its dividend from $0.32 per share to $1.56 per share. That’s almost a quintupling of the dividend. Every $1,000 in Colgate dividends grew into $4,875 in annual income. When you have a high income base established, your style of dividend investing can permit you go to on offense with the inclusion of fast-growing high yielders.

Step 7: Wise dividend investing recognizes the limitations of the payout ratio.

When the U.S. dollar is strong, the economic reality of international earnings gets understated. Many of the big multinationals that have been responsible for driving U.S. stock market returns find themselves mis-stating their earnings power because their profits get reduced when they are reported in United States dollars.

In 2015, Procter & Gamble saw its earnings get reduced by $0.30 due to the outperformance of the U.S. dollar compared to an international basket of currencies. What does this cause? Dividend investors that pull up a stock screen look and see a $2.59 dividend against $4.02 in earnings and worry whether the 64% dividend payout ratio is too high.

Well, the “real earnings” at Procter & Gamble were around $4.32. That $2.59 dividend was only around 59% of earnings, which gives you a little bit more breathing room. Geraldine Weiss addressed this very concept in her classic work “Dividends Don’t Lie.” There, she argued that smart beginner investors think they are being wise by selling dividend stocks with high payout ratios. What they fail to realize is that currency movements ebb and flow and a year will come when stocks like Procter & Gamble report 10% earnings growth in U.S. dollars even while their “true earnings” only grow by around 6.5%. Unless you think the strength of the U.S. dollar will be permanently fixed at this elevated rate for your investing lifetime, you are most likely misreading the future of the business.

Concluding Caveat: You will note that my guide to dividend investing did not mention anything about a stock’s dividend history. I debated whether I should include dividend history as a criterion in the guide, but I ultimately decided against it.

Why? Because earnings, not history, are the greatest signal for future dividend growth. In 2008, General Electric had a seventy-year dividend history. You had CEO Jeffrey Immelt speaking to elderly grandmas at investor conferences promising that the dividend would not be cut. Then, the earnings were compromised, and the dividend had to be cut.

Dividend history is useful for telling you which kinds of businesses are stable and resistant to technology and therefore good candidates for investment. But it is not the dividend history per se that is responsible for this, but rather, the fact that earnings have always been able to support the payout. So I say, focus on that.

At the most fundamental level, dividend investing is about finding companies that pay out less cash than they earn, and have records of earning profits in nearly all economic conditions. If you maintain that, rather than dividend history, as the north star guide of your dividend investing strategy, then you won’t find yourself getting fooled by the dividend cuts at firms like GE.