Dividend Investing – The Incredible Cash Flow Generator

It’s almost a bit spammy that headline, but it’s not far from the truth. I guess there’s no better feeling than waking up in the morning and money suddenly appearing in your bank account. Well, I’m not quite there yet with dividend investing, but slowly and surely getting there.

dividend investing

When I was staff many moons ago, I remember investing into my company’s share scheme (Bovis). I didn’t know too much about dividends back then. In fact, I found them a bit boring. But I do remember getting a cheque in the post every 6 months and the excitement of ripping apart the envelope to reveal my dividends…which felt like winnings.

Well, what if you had around 30 of these cheques coming through your letterbox at frequent intervals throughout the year. Ok, it wouldn’t come by post anymore (now I’m showing my age). But they would be paid automatically into your bank account. How exciting is that? Boring just got sexy…

Dividend investing now one of my favorite investment strategies. I’ve grown to enjoy learning about different companies, in a broad spectrum of industries and how they operate and make money. But it does require a little more maintenance than alternative passive income streams. I’ve learned to:

  • Re-invest dividends wisely (using my Ranking System)
  • Ensure fresh capital is added consistently (i.e. every quarter)
  • Keep my eyes peeled for any potential dividend cuts
  • Be aware of any defensive companies hitting a downturn, and taking advantage

I treat my portfolio as a consistent wealth building plan i.e. No dipping in and out

Why Dividend Investing?

1. Performance:
Companies that pay dividends outperform companies that don’t pay a dividend. It’s as simple as that (please refer to graphs below).

Companies that pay dividends are known to grow steadily during a bull market. What’s more, they are good at reducing losses during a recession.

Companies that pay dividends shows the company is a profitable and a mature business. It doesn’t require all its capital to grow, it grows well with an allocated portion of capital being reinvested. Hence, it has plenty of free cash flow to distribute to shareholders.

These two graphs below portray the performance of dividend-paying companies versus non-dividend paying companies, over the course of time:

dividend investing

Source: Seeking Alpha and Kenneth French

2. Power of Dividends Investing:

The beautiful thing about dividend investing is what I like to call, the threefold effect.

    • The first effect is defensive, shareholder friendly companies with a long track record increasing their dividends, year in and year out

dividend investing

Source: Reuters

When we talk about companies increasing their dividends, we can take Coca-Cola as an example. A real favorite for aspiring dividend investors. Why? They have been paying increasing dividends for 50+ years, which makes them a dividend king.

Graph – Power of Coca-Cola Increasing Their Dividends

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$27,020 is the inflation adjusted amount after 31 years of investing $2500 in Coca-Cola. Highlighting the power of Coca-Cola increasing their dividends, year after year

This is classic compounding in action.

      • ,The 2nd effect is reinvesting dividends back into your portfolio. Or to be more precise, back into the highest ranking stock in your dividend growth portfolio. I designed a tool to aid with this. Again, this is another example of compounding. Almost like a double compounding effect at this stage.

    Graph – Power of Coca-Cola Increasing Their Dividends AND Reinvesting Their Dividends

    Dividend Investing

    $54,606 is the inflation-adjusted amount after 31 years of investing $2500 in Coca-Cola. Highlighting the power of Coca-Cola increasing their dividends year after year AND reinvesting all their dividends

      • The third effect is consistent, cash contributions. Fresh capital, allocated to the highest ranking stocks, over a set period of time will super boost your compounding efforts.

     

    Graph – Power of Coca-Cola Increasing Their Dividends, Reinvesting Their Dividends AND Consistent, Cash Contributions

    dividend investing

    $622,175 is the inflation-adjusted amount after 31 years of investing $2500 in Coca-Cola. Highlighting the power of Coca-Cola increasing their dividends year upon year, reinvesting all their dividends AND contributing $5000 per annum

    Acting on those three attributes alone will ensure you enjoy a powerful income-generating dividend portfolio.

    3. Protection During a Bear Market:

    It’s inevitable there’s going to be another bear market. We just don’t know when.

    Here’s how it protects you during a down market: “As the stock price falls, the dividend yield goes up because the cash dividend is a larger percentage of the purchase price of each share.

    For example, a $100 stock with a $2 dividend would have a 2% dividend yield; if the stock fell to $50 per share, however, the dividend yield would be 4% ($2 divided by $50 = 4%.) In the midst of a market crash, at some point the dividend yield becomes so high that investors with excess liquidity often sweep into the market, buying up the shares and driving up the price.

    That’s why you typically see less damage to high dividend paying stocks during down markets. Combined with the research done by Jeremy Siegel, this is yet another reason investors may want to consider these cash generators for their personal portfolio.”

    dividend investing

    Source: The Balance

    How to Construct Your Dividend Growth Portfolio

    One word, diversification.

    I base my dividend growth portfolio on a diversified mix of 30 equities. These stocks have been hand-picked from the following stock market indices:

  • S&P 500 (United States)
  • FTSE 100 (United Kingdom)
  • DAX (Germany)
  • But mainly the S&P 500.These are:
  • Solid, defensive stocks with a long track record and a shareholder-friendly management
  • Spread across various industries (preferably no more than 3 equities in the one industry)
  • Equities which have a near equal weighting
  • How Much Dividend Income Can You Generate with Dividend Investing?

    There are some napkin maths you can use, to give you an estimation of projected dividend income.

    ANNUAL DIVIDEND INCOME = PORTFOLIO SIZE x ANNUAL (AVERAGE) DIVIDEND YIELD %

    For instance, if you need to generate 10K per annum in dividend funds, then you would need a portfolio size of just over 285K. That’s based on an average dividend yield of 3.5%.

    For instance…at the moment my dividend portfolio looks like this:

    dividend investing
    Dividend Growth Portfolio

    So, portfolio size is close to 78K and my average dividend yield is 4.76% (taken from Investment Income Report Q1).

    Hence, my dividend portfolio is currently averaging 3712gbp per annum.

    That’s 78000 x 4.76% = 3712gbp
    I do expect that dividend yield to drop over time.

    I’m way off the mark of bringing in 12K per annum of dividends. But I feel I’ve made good progress after 14 months of dividend investing.

    There’s actually a fourth effect. Appreciation of capital. If you pick solid companies with a long track record, your capital should be appreciating also. As you can see from the screenshot above, the capital appreciation is close to 7k.

    If you look again at the first quote I posted above. The plan is not to touch the capital at all. Just the dividends your dividend portfolio spits out.

    Total Returns

    The easiest way to calculate the total return on your dividend portfolio is:

    ANNUAL RETURN + DIVIDEND YIELD = TOTAL RETURN

    So, my total return is currently 9.99% + 4.76% = 14.75%

    The annualized return (return over a set period of time) will look something different. Most probably a little less, due to downturns in the market etc.

    Tax On Dividends

    From 06 April 2016, all dividend income in the UK will be taxed as gross. As the dividend tax rules have changed recently for UK investors.

    If you’re a UK resident and bring in a hefty amount of dividends, you’re more than likely to get hit. You have the option of a tax wrapper such as an ISA.

    These are the dividend tax rules for 2016/2017:

  • Less than 5k: You don’t need to do anything or pay any tax
  • Anything above 5K depends on what income tax band you’re in. We can do some examples in another post (Taxable Income).With S&P 500 stock, there is also a 30% withholding tax on the dividend payout. I hear the sighs.However, if you’re UK resident, you will get a tax reduction i.e 30% is reduced to 15%.
    You just need to fill in a W-8BEN and send it back to your broker.For S&P 500 stock, it all depends on the tax treaty between the US and the dividend investor’s resident country.
    For example, if you reside in Singapore, you will have to pay the full 30% withholding tax (no tax treaty in place)If you’re non-resident UK, you shouldn’t have to pay any tax on your dividends.

    Takeaway

    Dividend investing is one of the most powerful passive incomes you can take advantage of. It does require some time and maintenance i.e. dividend reinvestment on a consistent basis and some thought behind the allocation.

    If you’re willing to put in a bit of time and effort and follow some basic rules, it can pay off handsomely over time.

    Remember to have a plan of action and take into account tax implications. This will depend on where you reside.

    Now I would like to hear from you.

    What were your biggest takeaways? How is your dividend investing working out?

    Let us know in the comments…

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