The 10-11-12 System

THE 10-11-12 SYSTEM

Now it’s time to put all of this knowledge to work and create a portfolio that is going to generate increasing amounts of annual income and create real wealth over the years.

The three important criteria to picking dividend stocks that, in ten years, will generate 11% yields and 12% average annual total returns are:

1. Yield
2. Dividend growth
3. Payout ratio
4. Yield

As we discussed, you don’t want to chase yield. Never buy a stock simply because its yield is attractive. That being said, it’s a critical component of investing in dividend stocks. Starting out with a high enough yield will be vital to reaching your goals.

Just as, on one end of the spectrum, you wouldn’t buy a stock with a 10% yield that was not growing or was unsustainable, you also wouldn’t buy a low-yielding stock just because it is growing the dividend rapidly and the dividend appears safe.

A low-yielder might be attractive if it’s a stock you’re interested in for capital growth (you think the stock price is going significantly higher), but you wouldn’t buy it for income.

Obviously, any stock you buy, even if it’s for income purposes, you’ll buy because you think that, over the long haul, its price will rise. If you think a company is a dog in an obsolete industry, you probably don’t want to own it regardless of its historical dividend increases. If you believe the company is in trouble, you won’t be able to sleep at night. And letting you sleep at night is exactly what the kind of stocks I’m talking about in this book are designed to do.

A company with a 1.4% dividend yield that has a low payout ratio and is raising its dividend by 10% per year is not going to get you where you want to go.

Even with a 10% dividend boost every year, your yield will only be 3.3% in ten years.

That’s not a terrible yield to start out with today, but we want much more than that ten years from now.

Dividend Growth

The stock market is all about growth. Investors buy stocks whose earnings and cash flow are growing. Income investors want rising dividends. CEOs try to grow their sales and margins.

A key component in the formula is dividend growth. Without it, the dividend will lose its buying power due to inflation. Even with low inflation, over the years, the money won’t buy as much as it used to.

A company that raises its dividend by a meaningful amount every year typically has rising earnings and cash flow. It’s a sign of a healthy business and, just as important, shows that management understands its fiduciary duty to shareholders.

The historical average dividend growth of the S&P 500 is 5.6% per year. That’s not bad considering the average inflation rate of 3.4%. So investing in the S&P 500 has kept investors ahead of inflation and preserves their buying power.

But we want to be way ahead of inflation. Inflation isn’t always going to stay low. In some areas of the economy, it’s already pretty darn high. Gas, food, college tuition are just a few segments where prices seem to rise significantly every year, no matter what government statistics say.

Therefore, we want strong (but sustainable) growth in our dividend every year.

Payout Ratio

It’s all about safety. Before you dive in and pick great stocks that will generate huge amounts of money, you want to ensure that the stocks will stay great and help you meet your financial goals. If the company’s finances are not in good shape, it’s likely to disappoint you sometime down the road. So be sure the company can continue with its dividend policy.

Warren Buffett’s first rule of investing is “Don’t lose money.” His second rule is “Don’t forget rule #1.”

Dividend investors should heed Buffett’s words. In order for the compounding machine to gain momentum every year, the dividend needs to grow. If the company can’t maintain dividend growth and has to slash the dividend, that derails the train (and probably the stock price). You’ll most likely have to sell your stock at a lower price and start over with a new one.

By looking at a company’s payout ratio, you can avoid most of the problem stocks that could lead a portfolio off the rails.

Formula

To achieve 11% yields and 12% average annual returns in ten years, we’ll need to make some assumptions. We’ll also change those assumptions so you can see what you’ll need to alter to obtain the 10-11-12 results you’re looking for.

As I stated earlier in the book, I don’t believe in dogma. Anyone who tells you that you should never, or always, buy a stock above or below a certain valuation, yield, payout ratio, technical indicator, etcetera, is either lying to you or themselves.

That’s a pretty strong statement considering how many people out there profess to have all of the answers to the investment world. But the markets just don’t work that way.

Stocks have a tendency to stay overbought or oversold, to move farther in a direction than most investors are prepared for. The market is a living, breathing animal that has a mind of its own and doesn’t concern itself with gurus’ hard-and-fast rules.

That said, we still can use guidelines to shape our strategy and use historical figures and averages as points of reference. Very often stocks do revert to the mean, so if you buy stocks trading below their historical average price/earnings (P/E) ratios, chances are, somewhere down the road, the stock will trade at that historical average once again.

Keep all of this in mind as I give you guidelines for the stocks that will create a great portfolio of income-producing assets designed to provide you in ten years with a yield of 11% and generate an average annual total return of 12% over those ten years.

If you discover a stock that you like but it is two tenths of a percentage point below my suggested minimum yield, remember, the rules are not set in stone. If the payout ratio is 3% too high but you have good reason to believe earnings and cash flow growth will be strong over the next few years, go for it. These numbers are meant to be a guide. They’re good ones, but they’re only a guide.

Before I give you those guidelines, here are those assumptions.

Assumption 1. Unless otherwise stated, over the next ten years, the stock will appreciate 7.48% per year, equal to the historical average of the stock market since 1961.

That 7.48% return includes the Great Recession, various market crashes and run-of-the-mill bear markets. It also includes good times like the bull market of the 1990s.

I know there are lots of bears out there who believe this time it’s different. That our country and the world has dug itself a hole so deep, it will never be able to get out of it. Maniacal world leaders now have nuclear weapons, housing isn’t likely to bounce back soon, we’re running out of oil, and every other scary thing out there is going to cause the stock market to fall.

Maybe it will. I don’t forecast the market. What I do know is that we’ve had some pretty bad times before. While Hitler’s army caused unspeakable carnage in Europe and 60 million people—2.5% of the world’s population—died during World War II, the stock market performed extremely well.

As I mentioned earlier, in 74 rolling 10-year periods, the market has been negative only seven times. There has been a lot of calamity in those 84 years. Wars, assassinations, civil unrest, scandals, shortages, horrible political leadership—and through it all the market was positive 91% of the time after ten years. And significantly positive, at that. On average, investors more than doubled their money every 10 years in the market.

Yes, the world has some problems right now. Some are extremely serious. But I’m going to side with history and assume that the next 10, 20, and 30 years are going to be similar to the last 50—and that stocks will rise in line with its average of 7.48%.

And keep in mind that, dividend stocks, particularly those with solid yields, that are growing their dividends, historically have outperformed the market. So our 7.48% assumption may be conservative. I don’t think it’s unreasonable to expect a 9% or 10% average annual price increase from these types of stocks if the general market is hitting its average of 7.48%.

I’ll run some scenarios where the market underperforms the average and even some where the market stays flat or loses money to show you how the formula performs in all types of markets.

Assumption 2. The averages are consistent. In the financial model that we’ve built to analyze these prospective portfolios, we have to assume that the average stock performance and dividend growth is consistent. That will certainly not be the case in real life.

Even if stocks go up an average of 7.48% per year over the next ten years, your stock is obviously not going to do that every single year. It might rise 10% this year, 5% next, fall 4% the following, be flat, climb 20%, and so on. Those price moves will have an impact on your total returns.

If you’re reinvesting your dividends for the long haul, the best- case scenario is actually a weak stock market where your company is still growing earnings and dividends. That way you get to reinvest the dividends at lower prices. The only time you should care about the stock price climbing is if you want to sell. If not, let your stock stay in the dumps and be undervalued—as long as the dividend is growing and sustainable.

It feels very contrary to every emotion we’ve ever had about the market, but I actually get annoyed when one of my dividend stocks goes higher.

One of my stocks popped over 10% after strong earnings and a dividend hike announcement. Now instead of reinvesting my dividends at around $29 per share, I have to reinvest at $33. It’s nice to have a $4 gain in the stock, but it doesn’t really matter to me now since I’m not planning on selling it for 20 years. I’d rather have it be at $29 (or $25) so I can buy more shares every time a dividend is issued.

We have to model the averages as a consistent number because we have no idea how the market will play out, even if it does perform according to averages.

You can play with the dividend calculator, which is available for free at www.getrichwithdividends.com, and change the variables to see how the investment will perform when the inputs change.

If you’re especially bearish or bullish, try to resist tinkering with the average return of the stock. Even the professionals—or, should I say, especially the professionals—get it wrong. How many times have you seen a previously bullish analyst downgrade a stock after the company missed earnings and the stock cratered? How many times have you seen a prominent Wall Street money manager be completely wrong on the direction he predicted stocks were going to move?

It happens all the time, so do yourself a favor and stick with the averages. If you want to change the average to see what happens in bullish or bearish scenarios, that’s fine (and I’ll do that for you in the pages that follow), but resist the urge to change the stock’s price each year based on what you think is going to happen.

Ditto for the dividend growth figures.

So here’s the moment you’ve been waiting for: instructions on how to set up your own 10-11-12 portfolio.

As they say, “safety first.” The first item we’re going to look at is designed to keep your portfolio safe and to ensure that the stocks you buy will continue to be able to pay and grow their dividend.

Payout Ratio: 75% or Lower

Not including Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs), I look for companies whose payout ratios are 75% or lower, with growing sales, earnings, and cash flow. Of any of the guidelines, this is probably the one you want to stick to the closest, because we’re talking about the stability of the dividend. If you go outside the boundaries on yield or dividend growth and things don’t work out right, you may make a little less money than you thought.

But if the dividend is cut, chances are your stock is going to fall, maybe significantly. And you probably won’t want to be invested in it anymore and may sell for a loss.

In this entire strategy, the reliability of the dividend is the most important factor. If you’re relying on dividends for income, you may not be able to afford a cut.

A reduction in dividends may set a wealth-building program back a bit, which wouldn’t be as devastating as it may be to the investor who needs the dividends to meet living expenses, but it still would be a hindrance to achieving your goals.

Of course, if you find a stock with a payout ratio of 50%, you have plenty of margin for error. Even if business stinks and earnings fall, there should be plenty of cash to continue to pay the dividend.

Should that happen, keep a close eye on the payout ratio. Management may be reluctant to cut the dividend, especially if the company has a long track record of raises. But if earnings are on a downtrend and the payout ratio is increasing, management may be forced to lower the dividend paid to shareholders. If the payout ratio starts moving higher, it may be a hint that a cut or a halt to the raises is coming.

Ultimately, you’d like to be invested in a company with sales, earnings, and especially cash flow that are on the rise. With a reasonable payout ratio, that gives management plenty of room to continue to increase the dividend.

Don’t get bent out of shape if the company has a bad year or two, particularly if the payout ratio is low enough that the dividend isn’t threatened. But if a company has year after year of negative sales, earnings, or cash flow growth, you might want to start looking elsewhere. It’s not going to be the healthiest company, even if the payout ratio is low and the dividend continues to grow.

In a perfect world, I’d like to see 10% or more growth in sales, earnings, and cash flow, but that is not always easy to find, particularly in mature, stable companies that have a long history of dividend growth. So be sure to keep an eye on the company and look for at least some growth in those areas.

By following the payout ratio and noticing that it’s redlining (75%+), particularly if it has risen in a hurry, you should be able to bail out before things hit the fan.

Let’s look at an example of a company that cut its dividend and see if we could see any warning signs.

Table 8.1 and Figure 8.1 show the dividends paid out by Vulcan Materials Company (NYSE: VMC), which cut its quarterly dividend in half in the third quarter of 2009 to $0.25 from $0.49 per share. I’ve included the payout ratios based on net income, cash flow from operations, and free cash flow.

Free cash flow: Cash flow from operations minus capital expenditures. Including capital expenditures as a cost of doing business on the cash flow statement makes sense because it is cash that is being spent in order to run/ grow the business.

Could we have foreseen a cut coming?

You can see that the payout ratios, according to net income and cash flow from operations, were all in a very safe area until 2008 when, due to a net loss, the payout ratio based on earnings is not meaningful (and falls to zero on the chart). Based on cash flow from operations, it was still 50%, which is normally fairly stable. However, this sudden doubling of the payout ratio rather than a nice steady trend upward should have set off some alarm bells.

Free cash flow gave us a warning even earlier, when the payout ratio hit 100% of free cash flow in 2006. That should have put investors on alert. Dropping down to 80% in 2007 may have changed it to a code yellow from code red, but shareholders still ought to have been watching it carefully. Then in 2008, dividends exceeded free cash flow. At that point, investors should’ve thought very carefully about whether Vulcan was a stock that still belonged in their portfolio.

Of course 2008 was when the financial crisis hit, and it was a bad year for everyone. But the sudden pops in the payout ratio served as a warning that the dividend was in jeopardy.

Table 8.1 Vulcan's Payout Ratios

Figure 8.1 Vulcan’s Payout Ratio Spikes

Notice that the dividend wasn’t cut until the second half of 2009. When things get bad, management typically is reactive instead of proactive. It will try hard not to cut the dividend even if bad earnings numbers are expected. Companies often wait until the last possible minute to avoid further angering shareholders who might already be steamed by the weak profits and performance of the stock.

Very often, the warning signs are there a few quarters before the cut occurs, giving vigilant investors time to make changes to their portfolios.

Vulcan’s fourth-quarter 2011 dividend was cut to $0.01 from $0.25. That’s no surprise considering:

Payout ratio on net income: Not Meaningful-the company has been profitable in only one of the last eight quarters.

Payout ratio on cash flow from operations: 65%, up slightly from 2010’s spike.

Payout ratio on free cash flow: 135%, up 25 percentage points from 2010’s already high level. Over the past year, Vulcan has paid out $129 million in dividends. It currently has $152 million in cash and has been paying more in dividends than it has in earnings or free cash flow.

Analysis on the payout ratio should have kept any dividend investor out of the stock regardless of its yield, which was 3.2% before the cut.

Yield: 4.7% or Higher

You might be reading this book in 2030 after your parents or grandparents insisted on it because it made a huge difference in their financial well-being.  

It’s the reason your parents are able to send you to that fancy school of yours, or why you live in the nice house with the two jetpacks in the garage, or how come Mom goes on cruises every year in retirement.

I can see into the future and believe those things really can come true by following the ideas in this book.

What I can’t see is where interest rates will be in the future. In 2030, you might be getting 17% in your savings account. A mortgage might be 22%. I have no idea.

In the current low-interest-rate environment, a 4.7% yield on a stable company is pretty solid. You can go down to 4% if you need to, especially because as investors have started searching in earnest for yield, they have been buying up the dividend-paying stocks, sending the yields lower.

But even that 0.7% difference, which seems pretty small, can make a significant impact on your portfolio.

For example, if you own a stock with a 4.7% yield that increases the dividend by 10% every year, after ten years, your yield will be 11.1%. Using the same growth scenario but starting with a 4% yield, your yield a decade later will be 9.4%. On a $10,000 initial investment, you’ll collect $1,100 more in dividends over the ten years with the 4.7% yielder than you will with the 4% stock.

If you reinvest the dividends, after ten years, the stock with the 4.7% yield will be worth $20,993 (assuming no price movement of the stock) versus $18,815 when you start at 4%.

So you can see, even with a stock yielding 4%, the results aren’t bad over the long haul. You still end up with a 9.4% yield on your original investment and, if you reinvest the dividends, and your investment grows by 88% (again, assuming no stock price movement). But that 0.7% does add up over time.

Remember, 4.7% is not a hard-and-fast rule, but it’s above the historical average annual U.S. inflation rate of 3.4% since 1914.

So in today’s current low-interest-rate environment, a 4.7% starting yield should be enough of a buffer above inflation to ensure you’re not losing purchasing power. And then by starting above the inflation rate, as long as the dividend grows, you should be able to stay ahead of inflation over the years.

Of course, there could be a few outlier years, as we experienced in the late 1970s where inflation soared into the double digits. If you own dividend stocks with decent starting yields and strong annual dividend growth, it’s quite possible you’ll stay ahead of even abnormal inflation rates.

A stock with a 4% yield that grows by 10% per year will yield double digits by year 11 and will yield 20% by year 18. And if the stock, on average, climbs higher, just a little, your average annual returns will be in the low to mid-teens after 10 years and significantly higher after 15 and 20. So if your time horizon is long enough, chances are you’ll have nothing to worry about even in a high-inflation environment.

And if inflation stays anywhere near historical norms, imagine how happy you’ll be with a 20% yield down the road.

As a general rule of thumb, try to find stocks yielding at least 4%, although 4.7% is the goal. If you can’t find one or discover a stock you like but the yield is too low, you can wait for it to come down while you search for others or, if you’re comfortable with put selling, sell puts on it and collect income while you wait for the stock to reach the price you’d like to buy it at. We’ll talk about options in Chapter 10.