Category Archives: Blueprint

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Food Pyramid For A Dividend Stock Portfolio

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.

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 most stocks 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.

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 (T) & Realty Income (O)

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 may include:

Coca-Cola (KO) & Procter & Gamble (PG)

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. 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.

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

Visa (V) & Starbucks (SBUX)

Conclusion

I’ve personally experienced the benefits and drawbacks of stocks in all three stages.

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 45 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 15 years, 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 (V) is an interesting opportunity.

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Emergency Fund Should Be A Must

An emergency fund can be a vital part of your overall economic and personal finance plan. While I don’t believe in having a large part of your net worth in cash that sits in a bank account, an unforeseen accident or emergency can produce an immediate need for cash. During times of distress cash is King. An emergency fund is basically cash set aside to pay for emergency expenses.

Accumulation Mode

I’m currently in “accumulation mode”. What I mean by that is that I’m currently accumulating assets that will pay me to own them. Hopefully these assets will fund my early retirement. Because of that, cash really does me little good. Cash in large amounts while I’m trying to accumulate equities provides an opportunity more than anything else. At this current time I think of having large amounts of cash as an opportunity to jump on stocks when the market prices them at discounts to their true value. During these times of extremely low interest rates, having lots of money in the bank is counterproductive, as inflation will erode your purchasing power over time.

At this time, because I am in accumulation mode, It would be ideal to keep 4-6 months worth of expenses in cash. I like to think of emergency funds in terms of percentages of your expenses, instead of absolute dollar amounts. Cash is just one part of my emergency fund, the family currently has $10,000+ in a revolving credit line available to us should a large emergency ever present itself. There are few things these days you can’t purchase with a credit card, so this would be a last resort. Of course, we could also sell equities if something truly catastrophic were to happen to us.

An Emergency Fund Should Be Tailored

While I feel the numbers I’m presenting to you today work for me, I think an emergency fund is something that should be uniquely tailored to one’s own situation. Some questions should include:

* Do you have children?

* Do you own your own home?

* What kind of insurances do you have?

* Do you have elderly family members that you may be responsible for?

* What are your monthly expenses?

* What kind of cash flow do you have?

* Do you have a large number of liabilities? Are you drowning in debt?

* How secure is your employment?

Be Honest With Yourself

These kinds of questions will give you a strong idea as to what kind of emergency fund is appropriate for you. I think if you own your own home you should definitely have extra money set aside for household repairs and improvements. A small emergency could be taken care of by the large buffer that someone has between income and expenses and thus save the difference.

I go back and forth with my wife about how just about anybody can save money, in the end they are just irresponsible and their mindset is not in the right place. In the 21st century anybody can save & invest it doesn’t matter if its $10 or $1000 every week or month, people just choose to be consumers and just seem to spend every dollar that they make. In the end its about being honest with yourself and making the right decisions.

Once You Retire 

Once I hit our ultimate goal of financial freedom between 40 and 50, I’ll be saying goodbye to the 9-5 and saying hello to sleeping in, traveling and spending more time with loved ones. Once we become financially independent and decide to part ways with full-time employment, my buffer between income and expenses will likely be gone. This amount will likely change as we get older. I believe in increasing a cash buffer as you get older due to any random things that may happen in our life as we all know.

It would also be nice, in my opinion, to have some money in the bank to fund things like a vacation or an outing that you don’t usually plan on. Once you’re no longer working it may be easier to find things that seem exciting that fall outside the usual budget. These things should be limited, however.

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Mint Is The Way To Go

I think that budgeting is the only true way of actually seeing how much money is coming in and how much money is going out. Until you actually track your budgets for a few months, it’s all guesswork as to how much you actually spend on items. Loose change in the pockets can disappear pretty quickly on trivial purchases that add up over time.

Getting started on Mint is relatively easy and my wife loves it. Using the service Mint has provided my wife to get our finances under control and really “take charge”. You start by opening an account, and then you add links to your bank account, credit cards and other debt holders, auto loan, mortgage, or brokerage. You can also add assets to track your net worth. They do have bank-level security, and you can read more about that on their website.

Once you have all your accounts uploaded, the next thing to do is to create individual budgets or income/expense categories. Once you start earning income and making purchases you file these transactions in the correct budget. After you do this one time, Mint remembers the transaction and will automatically file the transactions in the appropriate budget every time thereafter. This makes recurring income/expenses very easy to track, and really puts your budgeting on auto-pilot.

So, as you can see it’s very easy to track your expenses once you set these individual budgets up. Think of Mint like one of those old-fashioned coin counters where you put the coin in the top hole and the quarters/dimes/nickles automatically sort themselves based on size. That’s what this program does for you. It automatically sorts all your transactions. All you do is create budgets and name them accordingly. The only thing that Mint can’t account for is cash transactions. You have to log on to Mint and post any cash transactions. This could be a painful and time consuming exercise for someone who uses a lot of cash, but in today’s society I highly doubt many people still use cash for most transactions.

Even if you decide to use a different program to track your budgets, or even if you resort to a paper budget, it doesn’t really matter. The point is to track your income/expenses in a manner that makes sense to YOU. If you find it easy, and it works then keep doing it. If you’re not budgeting EVERY SINGLE DOLLAR, then you need to start today. For example, if we look at our budget and realize that auto expenses were accounting for almost 1/3 of all monthly expenses we can decide its time to get rid of that automobile altogether or downgrade and get that spending in that category under control.

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What To Do When One Is Financially Independent

As I continue to save & invest, I often picture what the wife & I will be doing when we are financially free. Let’s take a look at 5 amazing things you can do when you’re financially independent (but are hard to do when you’re employed full-time).

1. Just Say No To The Alarm Clock

Want to go to sleep and wake up whenever you want? Me too. I don’t know about you, but I absolutely hate waking up at 6 or 7 a.m. Nobody likes going to work when it’s dark outside and coming home when it’s still dark outside. It’s nice to know that one day we can choose to wake up at 10 a.m. or later if we want. I also enjoy the thought of staying up late on a work night browsing the internet or watching a good movie.

2. Be Your Own Boss

I think a lot of people have a fantasy of being their own boss. Catering to someone in an  office with every interest other than your own at heart is frustrating and can be emotionally draining. When you’re financially independent, however, you can do whatever you want. Once you no longer have to earn a paycheck to pay basic expenses, you can cater to yourself instead. Take opportunities that seem interesting, or don’t do anything at all. The only one giving you any orders will be you.

3. Long-term Travel

When you have to show up to a fixed location 5 days a week it makes it difficult to just up and travel the world. But, when you’re financially independent you could literally go on a long-term travel spree. You could stay in different cities throughout your own country, getting to know different geographical areas and filling your brain with wonderful memories of experiences that most people can only dream of. Or, you can travel to different countries. There are many ways to travel cheaply, and many countries out there that are likely cheaper than the one you currently live in.

4. Spend More Time With Family and/or Friends

With 40-hour+ workweeks filling your time, and filling the time of your loved ones, it’s hard for everyone to get together and catch up on what everyone has been doing in their individual lives. It can be difficult to maintain relationships with the people you care most about, or form new relationships with interesting people, when the large majority of your free time is filled earning a paycheck to keep the lights on or keep a roof over your head. When you no longer have to fill your time working paycheck to paycheck, you are much more free to explore some of the relationships that may have been slightly stressed as life gets in the way.

5. Cultivate Yourself Through Hobbies.

What do you like to do in your free time? Maybe you enjoy painting or photography. Or, perhaps, you love nothing more than playing video games. Maybe writing is your true passion in life. It’s difficult to fully explore, and enjoy, the hobbies that fill your heart with joy when you don’t have enough time. Unless you just happen to be the lucky 1% and work at a job where your paycheck and hobby are one and the same, you’re likely exchanging vast amounts of your time for money and not for the love it, but for the ability to have shelter, food and life’s necessities.

Limited Only By Your Imagination

These are just five awesome things I thought of off the top of my head. The list can be as long as you want it, and limited only by your imagination. The main necessity for many of the things I listed above, and likely the things you’d like to do when financially independent, is not money. Rather, they require lots of time. Time is the most expensive commodity, as there is a limited amount of it and you have less of it every second that goes by. Would you rather keep exchanging it away for a fancy car, house and furniture? Or, would you rather save the money and invest it for the future so that you can let your imagination run wild and explore the relationships you always wanted to have, visit the places you have always wanted to see and do the things you have always wanted to do?

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My Strategy

My strategy involves buying companies which have a history of consistently increasing their dividend payments going back over as many years as possible. The S&P has several lists which are worth focusing on- Dividend Aristocrats and Dividend Kings. The encouraging thing about the lists is that they show you stocks that have raised their dividends consistently over the past 25+ years. Remember I do not just focus on high-yielding stocks, but Skyy does have some speculative plays(3-4) in her portfolio. A stock which shows you a 10% dividend yield when the average yield out there is 2% is most likely a stock, for which the market is telling you that there is a very high chance that the dividend payment could be cut and your yield would decrease. I would rather buy more of the type of stock that pays me around 2-3% currently, but will increase its dividend payments in the future.

My personal goal is to achieve a significant amount of dividend income to cover the famiy expenses.

Another set of stocks worth focusing on is the Dividend Achievers.  This list gives you companies which have raised their dividends over the past 10 years. There are at least 250+ companies in the US currently, so for an investor like me and possibly you, this is a pretty big list of stocks to pick from. However the Dividend Aristocrats(52 stocks) and the Dividend Kings(17 stocks) on the other hand contain stocks that are much more manageable to follow to me at least.

I will try to diversify across sectors, without being too overweight in a certain sector like financials or utilities. I will also look for an average dividend growth of at least 3% (which is the average long-term inflation rate). However, I might consider buying any stock that shows a growing dividend, provided that the company spots an above average yield. Even though the passive dividend income will rise much slower, your money will compound at a higher rate for a long period of time.

I would also consider selling a stock once it starts decreasing dividends; I won’t sell simply because a company whose stock I already own does not raise its dividend, but I might not add any more money into that particular position.

Also my goal is to achieve an above average yield on cost in the future. For example if me or anyone who was born before 1989 had invested $1000 on Altria(MO) you would have bought 24 shares and had a dividend income in 1990 of $35, and achieved a dividend yield of around 3.5%. If you held your stock until 2006, you would have had a dividend income for 2006 of $239 on 72 shares. That would be close to a 24% annual yield. Your 24 shares would have turned into 72 shares worth $6,179 at the end of 2006. If you had reinvested your dividends the $1000 investment in 1989 would have turned into $18,167.

Once again from my previous post and this one, my strategy involves investing in the Dividend Achievers, Aristocrats, and Kings that provide high yields that show consistent increases in dividends over time and the ability to cover those dividends in the future. I hope that this blog will inspire others and to allow them to build their wealth over time with the right mix of great companies.

-Live Long & Prosper

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