For anyone who lives off investments, 2017 was an excellent year. The market was up again, returning a nice 20% (with dividends reinvested). But 2017 is behind us — Only the future matters. It’s time to start setting investing goals for 2018!
Just like last year, I’m going to plan our dividend income and capital allocation goals for the year.
If you’ve read this blog for very long at all, you’ll know that I don’t rely on market movements to provide for our family’s lifestyle. Speculation on the direction of the stock market isn’t our game. We’re mostly farmers, not hunters.
So how does the Tako family pay for our lifestyle?
Mainly with passive income earned in our taxable brokerage accounts. Last year we generated a total of $53,504 in passive dividend income, meeting our goal of 10% dividend growth for the year. This was a fine result, and it covered the majority of our annual expenses. Capital gains and other income covered any shortfalls.
Passive income is what allows us to enjoy the easy life of financial independence. Dividends just happen to be my favorite form of passive income — Taxes on dividends are low, and it costs me absolutely nothing to collect those dividends (i.e. no transaction fees).
Unfortunately when stock prices are high, growing that dividend income isn’t easy…
High Markets Are Bad For Dividends
While some investors cheer each new daily high, real investors know this is nonsense — You’re simply paying a higher price for the exact same asset. Paying higher prices is a bad thing!
Don’t get it? Imagine you buy groceries at the same supermarket every day. Would you cheer if you saw higher prices each day? No, of course not! You’d rejoice only when you saw groceries on sale!
There are actually a few legitimate reasons why prices of groceries could rise — inflation and larger ‘portion sizes’ are two prime examples.
What do I mean by larger ‘portion sizes’?
Imagine for a moment you regularly buy a can of pinto beans at the grocery store. One day the supermarket restocks your favorite pinto beans and the container is 10% larger. The can now holds 10% more pinto beans, so you’d expect to the price to rise by 10%. Right? Not 20% or 30% more!
This same concept is the difference between market prices and the intrinsic value of a company. Intrinsic value grows as companies reinvest earnings and grow the value of the business. Dividends will typically grow at a rate that tracks this growth in intrinsic value fairly closely.
Over time, market prices are supposed to reflect this change in intrinsic value.
Unfortunately, stock market prices have become unhinged from intrinsic value. Stocks are rising 2-5 times faster than intrinsic value. This is not good for investors who like dividend income.
Finding decent yielding investments has become really hard — The S&P 500 now yields 1.72%, and has a PE of 26.52 (at the time of writing).
So what’s an investor to do?
Investors can either buy an index fund and stomach the high prices (and realize tiny returns on intrinsic value) OR they can choose to be much more selective.
If we think back to our grocery store example — these options are the equivalent of picking-up a preselected basket of groceries at “market prices” OR hunting around the store for items on sale.
How Will We Invest In 2018?
Being an opportunist, I’m going to take a two-pronged investing strategy. First, I’ll be hunting for sales. There might be a few opportunities in retail stocks or other beat-up sectors. I’ll keep my eyes open (and let you know if I see juicy bargains).
Second, where valuations are reasonable I’ll be adding to our existing long-term positions. These investments tend to earn good returns on capital, and pay out a good portion of their earnings as dividends. These stocks represent the bulk of our taxable portfolios and will continue to earn good returns well into the future.
These two investing strategies represent our best opportunities for growing dividend income this year, but yields aren’t going to be great. The better options only yield around 3%. Several banks and energy companies fit this bill.
Yes, I know that higher yielding investments do exist… but at the cost of considerably increased risk (or poor growth prospects). I usually avoid high-yielding stocks because they tend to be value-traps. Don’t chase value traps if you want to sleep well at night.
If you do find yourself chasing high-yielding investments, I recommend extreme caution. Value traps are usually the first to cut dividends (or head into bankruptcy) when the market turns.
Occasionally though, I do find a few gems.
Passive Income Goals for 2018
Besides expensive markets, the Tako family faces another challenge in 2018 — Many of our preferred share positions were called at par value last year. These positions yielded in the 8-15% range. They were purchased “on sale” and replacing them will be near-impossible.
These redemptions collectively represent $60k in capital that needs to be reinvested. In past years these preferred shares earned us about $6k in annual income. Without those preferred shares, our portfolio will generate $47k annually.
Using our target 3% rule, recovering that lost income represents about $200k in fresh capital that needs to be invested just to maintain last year’s dividend income. That feels like a stretch, and it’s far more cash than I want to invest right now. (I prefer to keep a large cash balance)
Knowing these facts, I’m setting our dividend income goal very conservatively for 2018 — Our goal is to reach $53,000 again!
My plan is to reach this level of dividend income by investing $100k in new capital. This will generating roughly $3k in new dividend income. The remaining $3k should come from regular dividend increases.
Yeah, I know… it’s not really an exciting goal!
Growing dividends over the long term isn’t really a sexy strategy, but it provides for a stable income. This strategy has worked out pretty well for us.
Some years there are going to be bumps in the road where dividend income doesn’t grow. This year is going to be one example of that. But, if you look over the long term our passive income has generally trended upward.
The stock market can and will do anything. Sometimes it’ll even stay flat for decades…
We’ll just keep compounding money, year after year, regardless of whether the market is up or down. That’s really the key — always be compounding and isolate yourself from the swings of the market. Eventually, good things happen.
To quote Charlie Munger, “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”