Thursday, September 20, 2012

DGI vs. No DGI Scenarios

Okay SA "cool kids,"  here is my dilemma:  My premise is that it's better to focus on total portfolio return while accumulating for retirement, then trade the big nest egg I've amassed at retirement for a high yielding, dividend growing portfolio once I need the income to live on.  Several articles I've been reading seem to suggest that maximizing yield in your portfolio now vs. at retirement is the best way to maximize retirement income.  I don't think so, but maybe I'm missing something, so let's go to the spreadsheets (yee-ha!).

1st, I built my assumptions (inputs) that can and will be varied in the analysis:









I'm analyzing two stocks, XXX, a "growth" stock with no dividends vs. YYY, a dividend champion.  Here is an example of the inputs for these two companies, from which I'll generate a spreadsheet:






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In this scenario, XXX share price (=EPS Growth) will grow at a CAGR of 13% and pay no dividends, while YYY share price will grow at a CAGR of 8%, pay a starting yield of 3%, and grow the dividend at a CAGR of 5%.  I'm hoping to retire 15 years from now, so I'll run the analysis for that time duration.  Below is the spreadsheet I've built showing the two stocks and the final outcome in year "16," the start of my retirement (click to enlarge).


In this first scenario, the 13% appreciation trumps the the 8% appreciation + 3% initial yield + 5% annual dividend growth.  At retirement (year 15) stock XXX is worth $645k vs. YYY worth $437k.  If I sell all my XXX and buy as much YYY as I can, I'll have 19,716 shares paying the same dividend as the 13,800 shares in the DG scenario.  More shares = more income, $11.7k vs. $8.2k.  I know, I know, I can hear several respected commentators from SA saying "but your assumptions are wrong!"  I agree the inputs have a huge effect, so here are six different scenarios varying the inputs.  I think looking at these results, I can draw a few conclusions.


           

The results compare annual income from dividends in for the two scenarios in each case.  Case 1 shows the positive effect of dividends vs. no dividends with same price appreciation (growth).  No doubt, dividends help.  Case 2 increases the growth rate from 8% to 11% for the non-dividend stock.  The two outcomes are pretty close;  interestingly, the 11% growth of XXX = 8% growth + 3% yield of YYY.  Case 3 ups the growth of XXX to 13%, the example in the spreadsheet up above.  XXX is a clear "winner" here.  Case 4 increases the rate of annual dividend growth.  Interestingly, both income streams benefit at retirement because the YYY stock is paying a much higher dividend in year 16, but we can still buy more shares with the XXX proceeds.  

Case 5 is very interesting.  By increasing my starting yield in year 1 to 5% from 3%, then growing the dividends every year by 10% vs. a growth stock at a respectable annual 13% growth rate, the dividend grower wins!  This surprised me.  The extra income from the higher yield, then compounded at 10% every year had a bigger effect than I anticipated.  But hold on, let's look a one last case.

In case 6, I exchanged capital appreciation in YYY for yield.  The 5% starting yield with a share price growth of only 5% (think utilities, or COP).  The dividend grower got beaten pretty badly in this scenario.

Conclusions (my humble opinions) 
  • Size of the egg at retirement is the only factor of importance, not how you got there
  • You can get their either way, or a combination of both ways (Growth & DGI)
  • For the growth route, you have every 1% of total return makes a huge difference in the outcome.  
  • For the DGI route, investors need to monitor three things closely:  share price growth, total portfolio yield, and dividend growth of the portfolio.  
  • When DGI investors in the accumulation phase say they are ignoring share price fluctuations, that is fine in the short term, but over the long haul, earnings growth and subsequent (highly correlated) share price growth cannot be ignored.
  • Its really about total return on investment.  If you think dividend paying, high yielding stocks will grow and give a better total return in the long run, then they are the logical choice for the portfolio.
  • Maximizing yield as a goal prior to retirement, and forfeiting growth in favor of yield, results in reduced income when you retire.  The only way maximizing yield before retirement makes sense, is if you believe the ultimate total return will be greater as a result.
  • Michigan is going to wallop Notre Dame this weekend.  Go Blue!


6 comments:

  1. I would agree that it doesn't matter how you get there as long as your portfolio is tax deferred. Otherwise, you need to pay attention to the differing tax treatment of dividends and capital gains.

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    1. True, I tend to forget about taxes because this is an IRA. That helps explain why DGI investors in taxable accounts build their portfolios over years, and never sell the stocks. Good point for a canuck

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  2. Also, one could say by buying at undervalued price Dividend Growth Stock can get better total return. I guess the 8% growth is for co bought at fair value.

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  3. I agree Grox, I always assume you are buying at or below fair value. Your statement is true pretty much universally. For purposes of the analysis, assume you are buying (at the start) both stocks at fair value. Interestingly, upon retirement, when converting the growth portfolio to income, price is still important because you want to buy the maximum possible dividend producing shares.

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  4. I understand the basis of your analysis and I agree with you that what is important is to get as fast as possible, without too much risk, to a point before retiring with the maximum dollar value from which to get dividend.

    My thought was that if buying a dividend stock at undervalue price like TEVA or AFL, these dividend stocks can bring much higher return then 8%. I agree that it is the same for a growth stock if one can buy it at undervalued price, but I am incline to think it is easier to find undervalued dividend stock than growth stock because of cycles and risk! I may be wrong!

    This line on thinking brings me to the strategy of rebalancing stocks and thus especially for the dividend stocks. Buying at undervalued price, selling at overvalued price and buying another one with greater prospect should create better growth. How much more I don't know, but I think it is interesting enough for me to consider it.

    What do you think?

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  5. I'm thinking the same thing Grox. It seems logical to me that selling some of your overvalued stocks and deploying into undervalued stocks makes a lot of sense, and probably makes a big difference in returns over several years.

    Your other question is really interesting - I think total return is the goal (given this is a tax deferred IRA), but can I get the same returns with AFL or TEVA - both undervalued and paying a nice growing dividend vs. a very undervalued "value" stock, or a "growth" stock? I'm betting that I can get good or maybe very good returns, but with LESS RISK due the financial health and excellent management that dividend paying companies demand.

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