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A Multistage Rocket Model For A Dividend Growth Stock Portfolio

June 18, 2014

I view the construction of a portfolio of high-quality dividend growth stocks as a lot of fun, and something of an adventure all in itself. Now, I’ve made my fair share of mistakes over the years, and I’ll likely make many more before I’m all done. But I suppose that’s some of the fun, and every mistake makes me a more experienced investor.

One experience of note is that it’s possible to think of your portfolio as a rocket ship with multiple stages, each of which propel your portfolio in different ways. Each stage has its own unique engine, and each of these engines is comprised of different types of dividend growth stocks with different yield and growth characteristics to serve different purposes within the portfolio.

I’ve found that there are three general classifications of dividend growth stocks. Now, these aren’t hard and fast rules, and some stocks can move from one classification to another as companies mature and/or change, while other stocks may be a blend of more than one category at a time. But you’ll find that moststocks will fall under one of these three categories.

Stage 1 – High Yield, Low Growth

So if one were an engineer building a multistage rocket, the first thing you need to do is make sure the thing can actually get off the ground. And that’s where stocks that have a higher starting yield fit in. These stocks get your dividend income off the ground and into the lower atmosphere.

You see, stocks that have a higher entry yield provide plenty of propellant to really get your passive income rocketing from the get-go. While many stocks with a higher initial yield have lower growth profiles, the current income these types of stocks can provide allow a dividend growth investor plenty of regular, fresh cash with which to reinvest into other areas of the portfolio. Keep in mind you wouldn’t want your entire portfolio to be allocated to Stage 1 stocks only because the lower growth means your income will have a hard time keeping up with inflation over the long term.

So you might be able to build a nice Stage 1 chock-full of higher-yielding stocks and use that income to bolster your holdings in other stages. Typically, you’ll find stocks that fit well in this stage come from telecommunication companies, real estate investment trusts, utilities, and master limited partnerships, among other areas.

A couple of stocks that might provide the propellant to get things off the ground include:

AT&T Inc. (T) – Provides a 5.26% entry yield on shares right now. However, a five-year dividend growth rate of just 2.4% is barely treading water when it comes to increasing your purchasing power. But 30 years of dividend increases and a 53.6% payout ratio means this telecommunications giant is likely to continue increasing dividends for the foreseeable future.

Realty Income Corp. (O) – Offers investors a 5.04% yield on shares based on the current price of $43.47 per share. And 20 years of dividend increases on the back of ever-increasing funds from operations (a measure of profitability for a REIT) gives me plenty of confidence that the payout from this real estate investment trust should continue rising for years to come. However, a five-year DGR of just 4.8% is the trade-off for the higher yield.

Stage 2 – Moderate Yield, Moderate Growth

Stage 2 stocks offer a more moderate yield and growth profile, and if you’re busy reinvesting your heavy dividend income from the big payers in Stage 1 into these companies you’ll find yourself rewarded well. These stocks can take you from the lower atmosphere into the stratosphere and beyond with their more attractive growth profiles.

This is the “bread and butter” of many dividend growth portfolios, with mine being no different. Stocks that offer yields of between 2.5% and 3.5% or so offer moderate current yield, but also offer pretty attractive growth rates. You’ll often find many of the stocks in Stage 2 have dividend growth rates of 7-12%, which means your purchasing power increases well over the rate of inflation over time, allowing you to compound your wealth over and over again as you reinvest this income.

The reason these stocks typically don’t have sky-high yields is because investors tend to bid up the stocks to the point where the yields aren’t as attractive as some of the stocks you’ll find in Stage 1. And this is because they offer a lot of attractive qualities. Many of the companies that are able to grow dividends by 7-12% per year for decades on end have wonderful business models and sell products and/or services that people across the entire world want and/or need every single day. Think beverages, food, toothpaste, gas, cleaning supplies, toilet tissue, and literally bread and butter.

While many of the companies you can invest in that offer moderate yield and growth have great business models that are easy to understand and also sport lengthy dividend growth streaks, the trade-off is that neither the current yield nor the growth rates are particularly earth shattering. There are benefits and drawbacks to anything in life, but because many of these businesses are very defensive and traditionally deliver stable and secular profit growth, my portfolio is allocated heavily to stocks in Stage 2.

Two stocks that are great picks to get you into the stratosphere when Stage 1 growth doesn’t offer enough include:

The Coca-Cola Company (KO) – The world’s largest and most well-known beverage company offers investors an attractive yield of 3% right now, and that yield is backed by a five-year dividend growth rate of8.1%. So you can see that you’re getting a pretty decent yield to start with, but the growth rate well above inflation is where a lot of the value is. Plus, they offer a very easy-to-understand business model, and 52 years of dividend increases is one of the most impressive currently available.

The Procter & Gamble Company (PG) – A consumer goods powerhouse that boasts 25 $1 billion brands and products in more than 180 countries, this is about as stable a company as one can invest in. The 3.23%yield on shares right now is pretty solid considering the low risk that you’re taking on when investing in PG. The company has given shareholders dividend boosts for the last 58 years, with a five-year DGR of 8.8%.

Stage 3 – Low Yield, High Growth

Stage 3 is perfect for down the road when your portfolio is comfortably off the ground and well into the stratosphere. While you’re cruising around thousands of feet off the ground, you’ll eventually want to get into outer space. And the growth these stocks can offer can do just that.

I personally don’t have a lot of allocation to these stocks myself, and that’s because I’ve been busy getting my dividend income off the ground and into the stratosphere. But now that I am up there I’m also interested in adding a better growth profile to really push my income growth possibilities. While many of the stocks in Stage 3 do not offer a lot of current income, their potential for huge dividends down the road means you’re trading off dollars today for even greater dollars years from now.

The big question, however, is whether these stocks can grow as fast as they may indicate. Potential is one thing, but living up to it is quite another. As such, I’ve tended to gravitate towards a little more bird in the hand, while also leaving a little in the bush as well. But I also know that many of the stocks that are currently Stage 2 stocks were once Stage 3 stocks that eventually slowed down. The key is to latch on to these stocks early enough to not only capture that eventual maturity and stability, but also that early growth as well. I would say that picking and valuing Stage 3 stocks is a bit more difficult because you’re doing a lot more forecasting.

I’m currently looking at adding a couple Stage 3 stocks to my own portfolio now that I’ve got plenty of exposure to high-quality dividend growth stocks that are pumping out thousands of dollars in dividend income.

Two stocks that offer lower current yield, but plenty of potential growth include:

Visa Inc. (V) – A global payment processor and one of the premier companies one can possibly invest in. A flawless balance sheet and a ton of growth over the last five years makes this an attractive investment candidate. The entry yield of just 0.76% means any current dividend income is negligible, but the company has a five-year dividend growth rate of 45.9%. Mighty impressive, but one has to balance that current income against expected growth, and therein lies the risk.

Starbucks Corporation (SBUX) – A global coffee retailer that currently operates in 60 countries, and perhaps the most well-known coffee marketer around. This company has grown like gangbusters, and investors who bought in five years ago are now doing very well. The stock offers a yield of just 1.39% right now, and they’ve only been paying and raising a dividend since 2010. But since then the company has raised its dividend four times. The compound annual growth rate in the dividend over the last four years is26.98%, which is very solid. The question is whether they can maintain this growth and will they be the next Dividend Champion with 25+ years of dividend growth?

Conclusion

I’ve personally experienced the benefits and drawbacks of stocks in all three stages. I’ve allocated most of my portfolio to Stage 2 stocks because I feel they offer the best blend of current income and growth for future growth in that income as well, but the other stages offer unique characteristics that can be really attractive depending on your individual needs as an investor and the goals you’re attempting to attain.

Keep in mind that you can build a rocket to your specifications. You are your own engineer! If you’re an older investor much closer to retirement then you might want to focus more on Stage 1 stocks. You need more current yield which will generate more dividend income to pay your expenses now. The future growth of that income doesn’t matter quite as much, but it’ll be helpful if you can at least keep up with inflation to keep your purchasing power intact. Conversely, if you’re a really young investor then you might want to sway your interest a bit more toward Stage 2 and especially Stage 3 stocks as you have plenty of time for the growth stories to play out and eventually attain huge annual dividend income totals because you’re runway for takeoff is so long.

I’m personally aiming to become financially independent by 40 years old via the dividend income my portfolio generates. Therefore, it’s imperative that my portfolio not only generate sufficient current income which I can live off of in just eight years (I’m currently 32), but also must be able to grow that income enough so that inflation doesn’t eat into my purchasing power. Thus, I’m interested in selective opportunities in Stage 3 stocks as valuations make sense. Currently, I think Visa Inc. (V) is an interesting opportunity.

Full Disclosure: Long T, O, KO, and PG.

What about you? Do you have allocation to all three stages? Do you prefer one over the other?

Thanks for reading.

Photo Credit: digitalart/FreeDigitalPhotos.net

About the author:

Dividend Mantra
Trying to retire by 40 by investing in dividend growth stocks and living frugally, valuing time over money.

Visit Dividend Mantra's Website


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