Commentary and Opinion By Henry G. J. G. Godzik
Henry taught in the TDSB Learn4Life Dividend investing for Income and Building Wealth the Dividend Way programs.
The intention of this article is to provide an overview of some basic information that prospective dividend investors would find useful in their pursuit of additional income streams. Although it is not possible to cover every aspect of dividend growth investing within this paper; its purpose is to provide a basic overview of some components that should be considered when deciding if dividend investing is best suited to your specific investment goals. After all, dividend investing is such a detailed comprehensive subject that not only does it require a significant amount of time and dedication to thoroughly understand the material, an article such as this is only serves as an introduction to further explore this investment style. Also, this article is not to be construed at any time, as a form of investment or financial advice, rather a platform of investment education for those interested in pursuing , and perhaps embracing ,the dividend investing philosophy. It is with the understanding that each investor is unique regarding their particular risk profile, needs and goals, therefore each portfolio must be tailored to each investor when dealing with these specific requirements. Throughout the article, there will be subtle reminders to always enlist the help of financial specialists when in doubt about a specific strategy to implement or subject matter that needs further clarification. There are numerous reference materials that can be found both on line, in libraries and business specific TV programs offering a wide variety of opinions, suggestions and strategies on how to construct a dividend portfolio and I encourage you , to explore these options.
From a personal perspective, and as a dividend investor, I can attest to the fact that the implementation of a Dividend Growth strategy to generate income streams does indeed work, but it takes effort, patience and commitment to make it succeed. It is also important to understand that no investment strategy is bullet – proof and there will be those occasions when the markets experience times of turbulence, volatility and momentum swings to rattle even the most seasoned investors. Weathering these market conditions will be less stressful with a well positioned, well managed and structurally sound dividend portfolio in place.
As a result of the COVID-19 pandemic lockdown in 2020, the economy faced unprecedented challenges causing economic activity to experience a severe slowdown resulting in significantly decreased corporate revenues. In order to save cash and maintain business operations, a number of dividend paying corporations decided to reduce, suspend and in some cases eliminate the dividends altogether. Companies only tend to cut their dividends as a last resort when experiencing unpleasant circumstances and cash is needed elsewhere. During the COVID pandemic, there were those investors who began liquidating certain positions in their portfolios out of fear and panic, while other investors who were “ cash heavy” elected to use this crisis as a buying opportunity, anticipating a short lived interruption to their dividend payments and continued to buy undervalued securities. A year later these investors watched as the stock markets returned to almost Pre Covid levels and continued on a bullish trend trajectory. Their portfolios also began to gain back some of the losses they suffered throughout the pandemic . Therefore, the lesson to be learned here is to stay focused on the long term investment objectives, without allowing short. – term market volatility to derail this process.
Many investors will buy a companies stock for the dividend, so if the dividend is suspended or eliminated, investors may loose confidence in the companies ability to recover therefore, resulting in a decision to sell the stock. Historical evidence has shown that in many instances when dividends have suffered, the stock price will drop when dividend cuts are announced. On the other hand, a significant price drop offers the opportunity to purchase a stock at a deep discount especially if the company will successfully ride out the unpleasantries of a ravaged economy.
Before taking a deeper dive into dividend investing, let’s define what a dividend actually is. A dividend is a distribution of a portion of a company’s earnings decided by their Board of directors paid to specific classes of their shareholders. For dividend investors, dividends serve as a popular source of investment income. The company’s that issue dividends consider them a way to redistribute profits to shareholders as a way to thank them for their support and to encourage additional investment. Dividends are issued from a company’s retained earnings and companies that generate consistent profits are the ones that issue dividends with any regularity. When the Board of Directors decides that a dividend will be paid, it is usually a clear indication that senior management is confident in the company’s ability to continue posting profits. In order to pay dividends, the company must have cash on hand; cannot” fake “ paying dividends. That is one reason why embracing the dividend growth strategy is popular among income generating investors. Simply put, dividend growth investing is about buying stocks , which pay dividends that grow over time, while simultaneously building net worth over the long run. As net worth continues to grow, so does wealth and one way of defining wealth is about having your assets provide a reliable source of income year after year. With this investment strategy , providing that the companies you’ve invested in, continue to maintain earnings growth, dividend yield and profitability, streams of income will continue to grow. As a dividend investor, the ultimate goal should be to own only the highest quality companies with a solid future that increase their dividends on a regular basis.If, for example, you don’t need the cash flow from the dividends now, consider reinvesting your dividends to buy more dividend paying stock to enhance your existing income stream. In this way you can focus on growing your portfolio from where it is now, to where you want it to be.
Also, remember that a dividend investors goal, especially if the stock market is “overheated” is the preservation of their initial investment (capital). Even when the market is less bullish and trending downward, preservation of capital is much more important than appreciation of capital. In other words, the return of capital is more important than the return on capital.
The DIMS method
The template that I use is the Dividend Investing Mission Statement, (D.I.M.S. for short ) ,that captures important components while helping investors prepare to structure their dividend portfolio without loosing sight of their investment goals. It outlines the specific investment goals that the investor wants to achieve and the procedures required to attain these goals. D.I.M.S. also includes a personalized statement signed by the investor committing them to this process with the understanding that circumstances do change and D.I.M.S. must have the capability to reflect these changes. Whether the investor uses the D.I.M.S. or another dividend template, capturing various personal and professional lifestyle changes must be documented to maintain the focus on the investment track.
One of the objectives of D.I.M.S. is to establish exactly what the investor is attempting to achieve with their portfolio, strategies needed to implement in order to accomplish these goals and the tracking mechanism used to monitor the progress.
Another D.I.M.S. objective is a “ plan of action” a schedule for measuring progress and its implementation stage. A Plan of Action lays out the basics of constructing a dividend growth portfolio which should be comprised of a variety of large and mid-cap dividend payers. It includes a schedule of timely reviews in case personal circumstances change and adjustments are needed.The most successful dividend investors, know how important it is to implement some type of plan and use it as their investment guideline in order to keep them on track. The D.I.M.S. plan of action reminds the investors of the reasons for investing the initial capital, a time frame tracking mechanism to measure the goals attainability and the investors propensity towards risk. With that being said, there are many variations of investment plans, but what is most important is to actually have a plan. Remember the old adage;’ fail to plan; plan to fail”.
The D.I.M.S strategy lays out the investors intentions when considering the best strategies to accomplish success in the development of dividend income streams. Having only employment income affords investors a certain quality of life , depending of course on the annual amount earned and all the personal and household expenses that need to be paid from this source. Employees know that they have no control over pay increases, promotions, getting fired, laid off or downsized. It is crucial to aspire having multiple income streams which will help to establish a level of investment income to replace and / or exceed monthly expenses. That is why investing in dividend growth companies that increase their dividends year after year will help to build those passive income streams over time.
First and foremost, the D.I.M.S. statement addresses issues surrounding the concept of personal and investment risk. Protecting the portfolios capital investments requires due diligence regarding risk and its potential consequences if not addressed in a timely manner. Never risk money that you cannot afford to loose, but capital that you do elect to invest should be with the understanding that there are no guarantees that the potential for loss is eliminated. When risk is deemed to be low, it is more easily managed by risk control techniques such as insurance or risk avoidance. Managing high risk can also be accomplished by risk control, but carry a higher price tag known as “ risk premium”. It is very important that the investor perceives risk accurately to align investment risk with risk tolerance. Learn to manage the following three important personal risks, namely Risk Tolerance, Risk Capacity and Calculated Risk. Risk tolerance is basically the idea that loss is tolerable to an investor and the amount of tolerance varies with each investor. Ask yourself, how much are you willing to lose without abandoning your initial action plan. Regardless of the daily market mood and volatility, investors should never loose sight of the importance of risk management and that a certain degree of investment risk is needed to accomplish investment goals. However, do be prepared to suffer through some declines( pullbacks in the market) to capitalize on these future gains.
Risk Capacity, another important consideration, is the actual sum of money that an investor is prepared to lose while pursuing a financial goal. It is often difficult for an investor to perceive where they actually stand in regard to their tolerance for risk because they are unable to fully comprehend an amount of loss that feels tolerable. The concept of Calculated Risk is demonstrated by an investor who takes a chance after careful consideration of a possible exposure to loss after weighing the advantages and disadvantages and the probable outcome of investing in a specific security. Once your appetite for risk has been established, building the dividend portfolio should be constructed with this in mind.
From an investment perspective, Risk is described as the volatility of a price or rate of return of a given security over a specified time period, based on anticipated, but not expected changes in earnings and dividend growth. Other types of investment risk that the dividend investor should be aware of but, has no control over are inflation risk which has the potential of eroding a portfolio’s value because the percentage of inflation is greater than the percentage earned on various investments. Historically, dividends have grown faster than inflation and over the years companies that have initiated dividends or increased their dividends have outpaced the companies that have kept their dividends the same or paid no dividends. Fidelity Investment had conducted dividend pattern studies in the market and found that during periods of high inflation, stocks that increased their dividends the most, outperformed the broad market on average. According to historical research, if high inflation were to linger, stocks that have provided sustainable dividends are likely to continue to outperform. When inflation is rising quickly, dividends do have a key advantage as compared to bond coupons; potential for growth even though bonds are still an essential component of an investors portfolio.
Interest rate risk is another type that investors need to be aware of because there are specific investments which are “ interest rate sensitive” such as real estate investment trusts (REITS) , utility stocks that are adversely affected by higher interest rates.The increased interest payments on their debt obligations could prove to be a challenge for these companies to meet in order not to default on their outstanding loans. If considering these securities as an investment option, do perform a due diligence analysis to ensure that the dividend (distribution) is safe and sustainable. On the other hand, financial institutions welcome interest rate increases because their net interest margin has now increased therefore, enabling financial institutions to charge more for their mortgages, loans and credit card rates. (Net Interest Margin is the spread between deposit dollars taken in and the rates that financial institutions charge on loans and mortgages) For example, higher mortgage rates result in a percentage of mortgage applicants not qualifying for a standard mortgage and now require a higher downpayment, mortgage insurance, and must meet stricter criteria such as a stress test to qualify. Another important risk to consider is Liquidity Risk . This risk category relates to the liquidity of the investment and how quickly it can be sold, if immediate cash is required. For example, an investor who holds smaller companies whose shares are not heavily traded might find it difficult to sell them if there is weak demand for the stock and the price begins to decline.
Knowledge Risk (Lack of Experience Risk) deals with the level of knowledge that an investor claims to have when researching potential investment candidates. Many novice, and in some cases experienced investors overstate their level of investment expertise and suffer the consequence of their bad decisions. Too often investors also will realize that they don’t have the temperament to deal with the ebbs and flow of market volatility and need help dealing with it. It is imperative that those investors lacking the investment acumen to make sound investment decisions seek advice from knowledgeable advisers to prevent further portfolio damage. The cost of investing in stocks that are not fully understood far outweighs the cost of employing the services of a financial advisor. Be honest with yourself when it comes to investment failure. If a bad investment decision was made, admit it, accept it and move on. There’s absolutely no shame in admitting to an investment strategy gone awry. It’s happened to the most seasoned, experienced investors and they view it as just another learning experience. There are many more risk issues to consider ( too many to list here) but consider the risk categories that could negatively affect your D.I.M.S. strategy.
Establishing a “time horizon” to review, rebalance (if necessary) and restructure the portfolio is important and should include items such as short/mid and long-term goals. Simply put, ask the question, how long are you willing to maintain your strategy if no results are evident? Another important consideration is the Need for Income, another strategic component of D.I.M.S. Again, ask yourself, are the dividends earned on your present portfolio (if there is one in existence) sufficient to live on? Do they compliment any other sources of income i.e. CPP/OAS, company pensions, other investment income? If dividend income is not required at this time, consider opening DRIP accounts for the company’s that offer them.
The DRIP strategy
For those investors who may not be familiar with a D.R.I.P investing strategy, a dividend reinvestment or D.R.I.P as it is commonly known, is a program allowing an investor the opportunity to reinvest their dividends / distributions in additional shares and/or units of the issuing company. The DRIP program is an important component of the D.I.M.S. strategy and well worth the effort to create. In order to participate in a DRIP program, the investor, must be a registered shareholder of the issuing firm and own at least one share of that company, however; there are some companies that require more. One of the advantages DRIP ownership is the ability to participate in an investment technique known as “ dollar-cost averaging” which enables investors to to buy stock at various times, sometimes at below – average cost and benefitting from market volatility. The focus is to buy shares at a reasonable price while at the same time, trying to avoid higher priced shares. Dividend investors should also consider the strategy of “ averaging into” ( buying) an undervalued stock and “ averaging out” ( selling) an overvalued stock. DRIPs are also a form of “ forced savings” allowing dividends to profit from the compounding effect of reinvested dividends. This powerful compounding effect is the essence of the dividend growth strategy. Albert Einstein called compounding “ the greatest mathematical discovery of all time”. In time, your reinvested dividends buy more shares as the dividend disbursement increases. Canadian companies that offer DRIPS qualify for the Canadian Dividend tax credit and pay tax on just half of capital gains earned.Furthermore, DRIPS, put your dividends to work right away without having them sit in your brokerage account waiting until you have enough money to invest. DRIPS also eliminate the frustration of trying to “ time the market”.
Adjusted Cost Base (ACB)
It should also be noted that DRIPs can create an administrative challenge meaning that overtime as the company reinvests the dividends, your Adjusted Cost base (ACB) changes. The Adjusted Cost Base is the original amount that was paid for a security. It is also known as Book Value. Calculating the stocks ACB is to simply total the amount that was spent to purchase the stocks , then dividing that amount by the number of shares outstanding resulting in the ACB per share. More specifically, the ACB is a form of portfolio maintenance helping to keep track of the stock purchases and sales prices in order to calculate the gains and losses in the portfolio. Holding a variety of stocks in different accounts including DRIPs can prove to be a very challenging task and that is why it is recommended that investors keep detailed records of the ACB paperwork associated with DRIP investing (and other accounts), and if in doubt, seek the professional guidance and advise of a tax specialist, familiar with the DRIP program. The D.I.M.S. strategy clearly states that specific stocks that are chosen for the initial portfolio construction, must pay a dividend, especially those equities that are the “ Core” portion of the portfolio and act as pillars that the portfolio is built on. Stocks that are chosen as core components must meet all the D.I.M.S. criteria and may include Dividend Kings,Dividend Aristocrats, Dividend Achievers and Dividend Contenders. Equities that fall into these categories have reached “star status” when it comes to paying sustainable, growing and non-interrupted dividends for at least 10 plus years.
The Growth portion of the D.I.M.S. portfolio would include growth stocks that may not pay a dividend yet, but aspiring to do so in the future. They could be sector specific, cyclical and/or defensive and meet all the D.I.M.S. criteria except for one or two items.
Portfolio Filler is the third category in the D.I.M.S. portfolio and include the stable, low-volatility, stocks that don’t draw a lot of attention, but perform as expected. They are not necessarily on the top of an analysts hot lists, but continue to demonstrate and maintain solid business fundamentals without taking on too much risk. They also include stocks that have been unmercifully beaten down without any justification. Before including them in the portfolio, research the reasons behind this treatment and draw your own conclusions.
D.I.M.S. classifies “Satellite Stock” as small start-up stocks with perhaps a pending IPO on the horizon. This is a risky area and only a small portion of available capital should be allocated to these securities. These are the type of stocks that peak an investors interest because of the nature of business they’re involved with, i.e tech stock, biopharma stock, healthcare cryptocurrencies biotech etc. Investors are not necessarily purchasing at this time, but keeping these stocks in their “ orbit” for future consideration. Remember that satellite stocks are speculative in nature and should comprise no more than 5% of your portfolio at most. Perform a thorough analysis on these stocks and research other opinions before committing to purchasing this security. Prepare a quick exit strategy if these positions do not work out.
Last, but definitely not least is cash. Keeping cash available to take advantage of market pullbacks and stock price declines is a savvy way to add quality securities to your growing portfolio. As investment opportunities present themselves, allocate a % of cash to these stocks and short – term liquid fixed income securities. Emergency issues can happen at any time so keeping cash available for these situations is smart crisis planning. Also, inflation slowly erodes cashes purchasing power so don’t allow cash to sit on the sidelines for very long. Inflation, even transitory inflation has adverse effects on investors holding cash waiting for the perfect opportunity to invest.
Once again, it is important to understand is that D.I.M.S. is only one possible template by which dividend investors may use to structure their own plans. There are many variations available to explore, so find the best one that’s suited to your needs and go with that. The importance of adding fixed-income products to your portfolio such as GIC’s, T-Bills, Short-term deposits, bonds, fixed-income mutual funds cannot be understated. These investment products can be an important addition to the income allocation of an investors portfolio as added protection to the principal portion of the securities. In other words, those investors who purchase these products will settle for a nominal gain in order to protect their initial principal investment. With pending interest rate increases for 2022, GIC’s could still be a reasonable choice for the investor seeking safety and wanting to take advantage of increased interest rates. After all, GIC’s are driven by and positively correlated to increases in interest rates, therefore as interest rates rise, so does the GIC rate as well. Investors may find that analysts recommend “laddering” the GIC fixed income portion of the portfolio in lieu of pending interest rate increases over the next 12-18 months. Laddering is basically dividing up the dollars available for GIC investment into various terms and upon maturity investing the proceeds into a longer-term with the best rate.
For those investors seeking comfort by adding bonds to their portfolio, it’s important to realize that higher interest rates can be problematic for long-term bonds since bond prices move inversely to interest rates and longer term bond prices are particularly at more risk. Higher interest rates put downward pressure on bond prices, so if adding bonds to the fixed income portion of the portfolio, think of using shorter duration bonds with various maturity dates. Although shorter term bonds earn less interest than their long term cousins, they are less susceptible to capital losses when interest rates rise and they add stability and diversification to the portfolio. Rising interest rates means higher yields on fixed – income securities like bonds and GICs. With this being said, if choosing which bond(s) should be added to the portfolio is still proving to be a major challenge, consult with your investment advisor about purchasing a bond ETF (ETFs are explained in a little more detail later in this article) that would be best suited for your specific investment needs.
What’s you type?
Within the investment community, we often hear discussions about defining the “type” of investors that are out there and how that might reflect on how the portfolio is built. Value, Growth and Momentum investors are common types and much talk takes place around the pros and cons of categorizing investors in this fashion. Deciding which one (or more) you are is a personal choice and the D.I.M.S. program should help you make that decision with more clarity. In basic terms, value investing is simply investors searching for companies that are trading below their inherent worth. The Value investor searches for stocks that have strong fundamentals i.e. cash-flow, earnings, revenue, dividends, book value etc that are selling at a bargain, despite the quality of the company. Value investors search for those “ undervalued “companies that the market has beaten down unjustly and now provides an opportunity to purchase the stock at a reasonable price. Value stocks can be found in any sector; however, they are often located in industries that have fallen on hard times, or have suffered the consequence of negative market reaction based on a short term piece of news. Value investors derive their profits from investing, NOT trading. They look for a market inefficiency analysis that has assigned an incorrect valuation to that stock, however, for example ;when a stock is considered to be undervalued it’s still open to interpretation when based on various indicators that presume the stock is trading below its” intrinsic value” (definition next page) .“Price is what you pay, value is what you get” – Warren Buffett
On the other hand, Growth investors main focus is the future growth potential of a company and less emphasis on its present price. Growth stocks are companies that grow substantially faster than others and are generally younger companies. These investors look for rapidly expanding industries such as Tech, Biotech, biomedical, AI, (artificial Intelligence) Gaming, Cannabis , Cryptocurrencies etc and their profits are realized through capital gains, not dividends. Investors in this category should not confuse growth with share price appreciation, because growth can be defined as a measure of a companies earnings and revenue which is relative to similar industries. Growth investors are not threatened by high P/E ratios, because their justification is that if earnings are growing fast enough, then the higher share price is warranted. These investors look for companies that reinvest their earnings in order to produce new products and innovative technologies and although the stock might be expensive at present, the investment will be worth it in the long run. The companies performance in the present quarter is more concerning than how the same quarter performed 12 months earlier.
Momentum investors, purchase stock whose price has risen ( overvalued) with the hope that the price will continue to rise without any consideration to its financial fundamentals. These investors pay little attention to any specific analysis and as long as there’s momentum, investors will stay in the stock. The Greater Fool Theory, states that no matter how high the stock price goes, there’s a fool who will buy it at an even higher price. Momentum Investing, which can be profitable, is more difficult than it seems and is usually not a recommended strategy for the novice investor. Then there are the investors that seek multiple income channels whether they come from dividends and/ or capital gains and that investing concept is known a total return investing. Total return investing is not limited to choosing only companies that provide reliable dividends, but a large percentage of the portfolio is dedicated to the production of capital gains. Capital gains offer more upside when the markets are functioning proficiently. It is to be noted that during market downturns, dividends from blue – chip dividend paying stocks are more dependable since capital gains can quickly turn to capital losses in a sustained bear market.
Part II to be in Summer 2022 issue of Learning Curves