Dividends are my favorite kind of passive income, probably because they’re one of the few truly passive forms of income. Beyond making the initial investment, there’s nothing an investor needs to do in order to maintain that beautiful stream of income.
Last year was a very solid passive income year for us, with dividend income just under $48k/year. But building that level of passive income was a long slow slog of Earning, Saving, and Investing. Rinse and then repeat. Over and over.
It’s been a long road getting here, but it’s been a very good ride:
As you can see from the graph, our dividend income bounced around as we added or sold investments, but the general trend has been upward growth over the past decade.
Years like 2009 saw us move heavily into cash and earn a paltry $5k. That bet paid off as we re-invested funds near the bottom and realized good rates of return. A mere six years later (2015), our passive income exceeded $100k. (If you’re curious, I have a post that explains this exceptional year)
In future years, I’d like to see that dividend income continue to grow…year after year.
Growing Passive Income
Our passive income covers nearly 90% of our expenses. Eventually, I’d like those dividends to exceed all of our expenses by at least 10%. But we’re not there yet.
In order to get there we’ll need to: Keeping a lid on expenses, and grow dividend income at a rate that exceeds inflation.
Keeping expenses under control is going to be the easy part (we know how to save money), but growing dividends faster than inflation is much harder.
There are really only two ways grow dividend income:
- Deploy additional cash into excellent dividend paying investments.
- Finding investments that grow dividends every year
If we were growing plants, this would be the equivalent of sowing more seeds, or adding fertilizer to keep the plants healthy.
Either method alone can grow dividend income, but having both working in tandem is better.
We’ll be doing both in 2017. We still have approximately 15% of our taxable accounts in cash AND we’ll seek out investments with continued dividend growth potential.
Passive Income Goals for 2017
This year I’d like to see our passive income grow by 10%, from $48k/year to $53k/year.
That’s a big increase. Using our target 3% rule, that means $160,000 of new capital deployed into investments. That’s a lot of money to invest for someone without a source of income. We have the money right now, but in future decades how will we keep our dividend income growing?
The answer is: dividend raises over time.
With inflation hovering around 3%, the lower end of our growth target is already set for us — If we can’t keep up with inflation our income will erode year after year.
In nominal terms, I’ve decided on a long term dividend growth goal of 5%. This means I intent to hold investments that will raise dividends 5% a year (on average).
In real (inflation adjusted) terms, this amounts to a 2% growth in annual income. (Assuming inflation stays around 3%) If this goal can be achieved, it also means we’ll need less cash in order to reach our $53k income goal for 2017. How much less?
Half as much – $80,000 in new investments this year. This seems like an achievable goal.
Finding Good Dividend Growers
Meeting expense targets and growing passive income is only half the answer though, we still have to find good investments that will grow at rates of 5% or greater.
We could load up our portfolio with a bunch of high-yielding junk to meet the goal, but future years would suffer. Most companies need capital to grow, and the high-yield varieties have less cash around because they pay it out as dividends. This means lower growth in future years.
Some of these high yielders also use excessive amounts of debt to fund their business. That’s all well and good when times are good, but when the economy goes bad big debt loads come back to bite you.
To summarize our investment criteria:
- A solid, stable business with a dividend yield around 3%. A little less or more is fine.
- Dividend growth rates at 5% or greater.
- Earnings are reinvested into the business at good returns on capital.
- Reasonable levels of debt.
Sounds simple, right? It’s trickier than you might think. Let me provide a counterexample to this little dividend growth model…
America’s Most Successful Stock
Want to know what America’s most successful stock is? It’s not Google, Facebook or Microsoft. According to Wharton professor Jeremy Siegel, it is … Phillip Morris (now called Altria).
Yes, the cigarette company. Mind blown yet?
Phillip Morris/Altria has grown at an annual rate of 20.6% for the past 50 years, all the while growing dividends and maintaining a high (4+%) yield. That’s pretty incredible when you consider cigarette sales are now far lower than than they were 50 years ago.
Almost nobody I know smokes anymore. It’s a terrible industry, with terrible growth prospects, and high debt levels, yet it’s America’s most successful investment.
How the hell is that possible?
Boring businesses in decline can be beautiful investments. Unlike Google, or Facebook, Altira doesn’t have to spend money to innovate. Other than maintaining machinery, very little capital is retained in the business. Most of it gets shipped off to shareholders in the form of dividends and share repurchases.
Share repurchases have packed a big punch over the years because tobacco is one of those industries everybody hates. Unlike current stock market darlings (I’m looking at you FANG), Altria’s shares are not usually priced high. That means more “bang” for a shareholder “buck” when shares are repurchased. Over time, this matters.
Altria also has some pretty incredible pricing power. I’m not a smoker, but I read that cigarette prices have increased 5 times faster than the rate of inflation. Earnings per share has grown continuously over time (albeit slowly) despite continuous cigarette volume declines. Few companies have this kind of incredible pricing power.
So what can this counter-example teach us about long-term investing?
A few things:
- Industry growth isn’t required for dividend growth. Pricing power can matter more.
- Share repurchases can be done correctly, effectively ‘reinvesting’ in the business but not growing it’s size.
- Chasing growth stocks is one model for long term success. There are other successful models too.
Incidentally, if you’re interested in learning about these ‘long term’ winners and what makes them special, professor Jeremy Siegel wrote an excellent book on the subject. It’s called “The Future for Investors“:
Professor Siegel’s book looks at these kinds of successful investments (which are not necessarily growth stocks), and how they perform over the long term. Well worth a read if you’re even a little bit interested in investing.
In 2017 our goal is to grow our dividend income by 10% (or more). Roughly half of this I expect will come from additional cash invested and the other half will come from dividend growth.
With the S&P 500 only yielding a paltry 2%, getting the same results from an index funds would require $120k of new capital… significantly more than selecting companies with 3% (or soon to be 3%) yields. As we’ve done in previous years, we’ll be selecting our own dividend growth stocks.
Is this a risky strategy? That’s hard to say… it depends upon who you ask. I’ve shared with your our dividend record over the years, and we’re happy with how things have turned out. The results have been a little lumpy, but growing … despite our general focus on avoiding fast growth and high PE companies.
With this same strategy, we’ve weathered downturns in the past. I don’t see why 2017 would be any different.
[Image Credit: Flickr]