How much money do you really need to retire with dividend stocks?

Many investors are being told that in order to retire, one needs to accumulate a minimum nest egg of $1,000,000. Some advisers do recommend that even one million dollars might not be enough to ensure comfortable retirement to individuals, given higher life expectancies or variability of investment returns. This is discouraging many investors, who are starting to believe that they would be working forever. Instead of focusing on the amount of money one needs to accumulate however, I think that a much better way should be to focus on the income from your investments.

After all, a million dollar investment in your home would most likely lead to thousands of dollars in annual property taxes, but no income. Thus, having even a million dollars invested in the wrong asset might not be enough to ensure a comfortable retirement. If that same investor purchased dividend stocks, which increase distributions regularly, they would be able to generate and inflation adjusted stream of income, which would be sustainable for extended periods of time.

If our dividend investor built a portfolio consisting of stocks which yield 10% on average, they should be able to generate $100,000 in annual pre-tax income on that $1,000,000 nest egg. Companies which yield more than 10% include American Capital Agency Corp. (AGNC), Hatteras Financial Corp. (HTS) or Annaly Capital Management, Inc. (NLY).

If our dividend investor build a portfolio consisting of dividend stocks yielding 6% on average, they should be able to generate a $60,000 annual pre-tax dividend income on the $1,000,000 nest egg. Companies yielding more than 6% include Universal Health Realty Income Trust(UHT) and Kinder Morgan Energy Partners, L.P. (KMP).

While it is possible to find companies yielding much more than 6% in today’s market, investors have to look at those investments with a questioning mind. It is highly unlikely that a company which pays a 10% dividend is able to reinvest anything back into growing the business. In addition to that, chances are that such a company is also using a special corporate tax form, which might add in further to the risk of income depletion provided that this income tax form is disallowed. Many investors in the Canadian income trustshave suffered huge losses in income and principal since 2006, when Canadian government announced that it would be phasing out the tax advantaged income trust structure in 2011. Many US investors have allocated excess amounts into Master Limited Partnerships, Business Development Companies or Real Estate Investment trusts, all of which pass through all of their income to the individual holders. A change in the tax code could certainly jeopardize these investors. In addition to that, most of those corporate structures have not been around for as long as common stocks, which makes it difficult to backtest their performance during various market conditions.

Common stocks on the other hand, have been around for several hundred years. Some studies suggest thatspending 4% from your portfolio annually should ensure maximum longevity for you. Given the fact that dividend yields were typically around 4% during the time of the studies, I have concluded that a starting 4% average portfolio yield should be sustainable for at least four decades. A portfolio yielding 4% could include high yielding stocks with low or average dividend growth such as Kinder Morgan (KMP), Realty Income (O) or Royad Dutch (RDS.B). It could also include low yielding stocks with high dividend growth such as Archer Daniels Midland (ADM) or Family Dollar (FDO). The portfolio could also include stocks in the sweet spot such as Coca Cola (KO),McDonald's (MCD) or Johnson & Johnson (JNJ). As a result, a $1,000,000 investment could result in $40,000 in annual dividend income.

Truth however is that investors do not truly need $1,000,000 in order to retire. If you focus on companies which regularly raise distributions, it is possible to construct a portfolio with much less than $1 million dollars. For example, let assume that one wants to retire in 24 years and assumes a 3% inflation rate. Let’s also assume that this individual also requires $40,000 in dividend income in 2010. Using the rule of 72, a 3% inflation rate would erode the purchasing power of $40,000 in 2010 dollars by half by the year 2034. As a result the investor would need to generate $80,000 in 2034. Let’s assume that this investor is able to purchase a well rounded portfolio of dividend growth stocks, which currently yield 4%, but which will increase distributions by 6% for the next 24 years. This is not an unreasonable dividend growth rate, since it slightly exceeds the 5.4% average dividend growth rates achieved by Dow Jones Industrials average for the 85 year period ending in 2005. This means that our investor needs only $500,000 to invest at 4%, which would generate income of $20,000 in year one, $40,000 in year 12 and $80,000 in year 24.

Of course if our investor decides to reinvest dividends for 24 years they would need much less in start up costs in order to generate sufficient dividend income. Most strong brand names which sell consumer products have been able to generate such returns over time.

The type of stocks that enterprising dividend growth investors should be focusing on include:

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The company yields 3.40%, but has managed to grow dividends at 13.50% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 29.10%. (analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. The company operates in three global business units (GBUs): Beauty and Grooming, Health and Well-Being, and Household Care. The company yields 3.00%, but has managed to grow dividends at 10.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 22%. (analysis)

Chevron Corporation (CVX) operates as an integrated energy company worldwide. The company yields 3.30%, but has managed to grow dividends at 7.90% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 17%. (analysis)

McDonald’s (MCD) franchises and operates McDonald's restaurants that offer various food items, soft drinks, coffee, and other beverages. The company yields 3.10%, but has managed to grow dividends at 26.50% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 28.30%. (analysis)

Abbott Labs (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. It operates in four segments: Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Vascular Products. The company yields 3.50%, but has managed to grow dividends at 9% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 20.70%. (analysis)

Coca Cola (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. The company yields 2.80%, but has managed to grow dividends at 9.90% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 18.20%. (analysis)

Pepsi Co (PEP) manufactures, markets, and sells various foods, snacks, and carbonated and non-carbonated beverages worldwide. The company yields 3.00%, but has managed to grow dividends at 12.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 18%. (analysis)

Clorox (CLX) engages in the production, marketing, and sales of consumer products in the United States and internationally. The company operates through four segments: Cleaning, Lifestyle, Household, and International. The company yields 3.50%, but has managed to grow dividends at 9.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 21%. (analysis)

Colgate Palmolive (CL) manufactures and markets consumer products worldwide. The company yields 2.80% t has managed to grow dividends at 11.30% annually over the past decade. The yield on cost ofa 1989 investment in the company would be a staggering 34.40%. (analysis)

At the end of the day those dividend machines would not only generate substantial yields on cost but they would most likely generate substantial capital gains as well. Dividends are typically taxable in the year they have been received, whereas capital gains are only taxable when you sell your stocks. If someone inherits company stock, their basis is increases to the fair value at the time of the transfer. As a result investing in these dividend growth stocks is similar to planting a tree, and then harvesting its fruit for decades, without having the necessity to cut the branches you are sitting on.

Another reason for companies to pay dividends

I am a firm believer that companies that pay dividends by default represent an elite group of sound enterprises which should comprise an investor’s watchlist for further research. The second criterion should be focusing on fundamentals in order to determine whether the company could afford to not only generate enough cash to grow and maintain its business, but also to be able to distribute any excess to shareholders in the form of dividends. The third criterion that I use is that the company has been able to grow distributions for at least ten consecutive years. These criteria pretty much decrease the list of eligible dividend stocks to less than 300.

Nonbelievers of dividend investing often claim that only poorly managed companies or companies which are in decline tend to pay dividends. This group of investors often is under the false belief that a company will be able to reinvest all of its earnings back into the business, while achieving high incremental returns on investment. The problem with this strategy is that in the real world of corporate governance, it is extremely difficult for companies to reinvest all of their earnings back into the business and still maintain high profitability on any excess reinvested dollars. This is because of constraints in the utilization of these assets, management’s desire to build an empire at all costs, expensive acquisitions, bad timing of capital allocations and simply because not all investments are guaranteed to earn a profit. Warren Buffett is often cited as the type of manager who has been able to allocate funds to profitable ventures, and thus has avoided paying dividends to shareholders of Berkshire Hathaway. The only issue with this analogy is that unfortunately few CEO’s have the business acumen of the Oracle of Omaha who built a small struggling textile mill into a diversified conglomerate with a market cap of over $200 billion.

The main issue with the Warren Buffett analogy however is that while he doesn’t like paying dividends to Berkshire Hathaway (BRK.B) shareholders he does enjoy investing in companies that pay dividends. Some of the top holdings of Berkshire Hathaway pay over $1.5 billion in dividends, not including the preferred dividends from Goldman Sachs (GS), General Electric (GE) and several other firms. In his 2007 letter to shareholders he explained the best type of business to own:

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire. After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.

As seen above however, few companies can do this for extended periods of time. Most companies keep growing for a while, after which they are bound to generate excess cash flows, which fills their coffers. After a while this extra cash is bound to be misspent, the same way that many individuals in the US recklessly spend their income on things they don’t need. Some examples include Vivendi, which was transformed from a sleepy water utility into a media conglomerate through expensive acquisitions that almost bankrupted the company. Incidentally the water utility operations were spun off in early 2000s as Veolia (VEO) and they have outperformed the media empire they created.

Other examples of companies with extra cash that spent too much on projects that didn’t generate much in excess returns include Microsoft (MSFT), which has been able to dominate any technology for over two decades. The main driver of its earnings growth in the meantime however continue being the Windows operating system. Even tech giant Google (GOOG) was misallocating cash in 2007 when it announced the $30 million Google Space program.

Typical companies that don’t pay dividends besides new companies in existence for less than a decade, include either firms that need to reinvest all of their earnings back into the business in order to maintain their business or companies that are so weak that they cannot afford to pay dividends. The first type will generate returns to shareholders only if someone buys the business at a premium. If they do all the work and all they could show at the end of the year after all the work has been done is no more cash than what was in the coffers at the beginning of the year, then intelligent investors should definitely ignore them. Technology companies generally fall into this category, because of rapid product obsolescence, competition and weak consumer loyalty. While Altavista and Yahoo (YHOO) were popular internet search engines in the late 1990’s, Google (GOOG) was able to overthrown them by offering a better solution to customers. The second type of business that cannot afford to distribute any cash because of its inherent weakness includes such industries such as Airlines or US Automakers.

Just because a company pays dividends, doesn't mean that it cannot grow earnings in the process. Companies like McDonald's (MCD), Wal-Mart (WMT), Procter & Gamble (PG), Altria Group (MO) and Abbott Labs(ABT) are examples of that.

McDonald's Corporation (MCD), together with its subsidiaries, operates as a worldwide foodservice retailer. This dividend aristocrat has raised dividends for 33 consecutive years. Yield: 2.90%(analysis)

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. This dividend aristocrat has rewarded shareholders with higher dividends for 36 years in a row. Yield: 2.30%(analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. This dividend king has boosted dividends for over half a century. Yield: 3.10%(analysis)

Altria Group, Inc. (MO), through its subsidiaries, engages in the manufacture and sale of cigarettes, wine, and other tobacco products in the United States and internationally. This dividend champion has rewarded shareholders with higher dividends for 43 consecutive years. Yield: 6.30% (analysis)

Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. The board of directors of this member of the S&P Dividend Aristocrats index has approved dividend increases for 38 consecutive years. Yield: 3.40%(analysis)

One issue with dividend stocks is that income earned by corporations is taxed twice. It is taxed first at the corporate level and then it is taxed at the individual shareholder income level once dividends are distributed. As a result of this double taxation some believe that investors are worse off. This being said I am a firm believer that if a company can reinvest all of its earnings in projects that would enable it to increase earnings while maintaining its returns on invested capitals it should not pay a dividend.

Unfortunately few investors realize that the IRS could tax companies on accumulated but undistributed earnings of corporations at its own discretion. The so called Accumulated Earnings Tax is imposed on regular C corporations whose accumulated retained earnings are in excess of $250,000 if improperly retained instead of being distributed as dividends to shareholders. To avoid unreasonable accumulation of earnings there should a specific plan for the use of accumulation. Otherwise the IRS will assess the tax at a flat 15%.

A record 22 companies boost dividend payouts

Over the past week twenty-two companies announced that they would be rewarding shareholders withhigher dividend payouts. Several solid blue chip companies such as IBM, Costco and Exxon Mobil raised their payouts as well.

In order to make it easier to read through the list, I have separated the number of companies into three lists: Dividend Achievers and Dividend Aristocrats; Master Limited Partnerships; and Dividend Growth Stocks.

Dividend Achievers and Dividend Aristocrats

Dividend Achievers are companies which have boosted payouts for at least ten consecutive years. Companies that are members of the elite Dividend Aristocrats index, are members of the S&P 500 and have raised distributions for over a quarter of a century.

International Business Machines Corporation (IBM) is an information technology (IT) company. The company increased its dividend by 18% to 55 cents/share. This is the 15th year in a row that IBM has increased its quarterly cash dividend. This dividend achiever yields 2%. (analysis)

W.W. Grainger, Inc. (GWW) and its subsidiaries distribute facilities maintenance and other related products and services in the United States, Canada, Japan, and Mexico. The company raised its quarterly dividend by 17% from $0.46 to $0.54 per share. This is the thirty-ninth dividend increase in a row for this dividend aristocrat. The stock yields 2%. (analysis)

Exxon Mobil Corporation (XOM) engages in the exploration, production, transportation, and sale of crude oil and natural gas. The company raised its quarterly dividends to 44 cents/share, up from 42 cents/share. This is the twenty-eight consecutive annual dividend increase for this dividend aristocrat. The stock yields 2.60%. (analysis)

Chevron Corporation (CVX) operates as an integrated energy company worldwide. The company raised its quarterly dividends by 5.90% 72 cents/share. This is the twenty-third consecutive annual dividend increase for this dividend achiever. The stock yields 3.50%. (analysis)

Cullen/Frost Bankers, Inc., (CFR) through its subsidiaries, provides various banking and financial products and services primarily in Texas. The company increased its quarterly dividend by 4.70% to 45cents/share. This is the seventeenth consecutive annual dividend increase for this dividend achiever. The stock yields 3%.

Community Bank System, Inc. (CBU) operates as the holding company for Community Bank, N.A. that provides various banking and financial services to the retail, commercial, and municipal customers. It offers loans and accepts deposits. The Company’s Board of Directors approved a $0.02, or 9.1%, increase in its quarterly dividend on its common stock, to $0.24 per share. This is the seventeenth consecutive annual distribution increase for this dividend achiever. The stock yields 3.70%.

Master Limited Partnerships

Williams Partners L.P. (WPZ) is a limited partnership formed that owns, operates and acquires a portfolio of energy assets. This master limited partnership announced that the distribution its unit holders receive has been increased to $0.6575 per unit, a 3.5% increase over the previous dividend of $0.635. The partnership has consistently raised annual distribution since 2006. The units yield 6.30%.

Inergy Holdings, L.P. (NRGP) is engaged in the investment in propane and other natural gas liquids companies. This master limited partnership announced an increase in its quarterly cash distribution to $0.975 per limited partner unit, which was a 3.7% increase over the previously declared quarterly distribution. Inergy has boosted distributions since 2006. The stock yields 5.40%.

Holly Energy Partners, L.P. (HEP) operates a system of petroleum product and crude oil pipelines, storage tanks, distribution terminals, and loading rack facilities. This master limited partnership declared an increase in its distribution to $0.815 per unit, up from $0.805 that was distributed last quarter. Holly Energy Partners, L.P. has consistently boosted distributions since 2005. The units yield 6.90%.

Sunoco Logistics Partners L.P. (SXL) engages in the transport, terminalling, and storage of refined products and crude oil, as well as the purchase and sale of crude oil in the United States. The company increased quarterly distribution to $1.11 per share, from $1.09 prior. This master limited partnership has consistently raised distributions almost every quarter since 2002. The units yield 6.60%.

Alliance Holdings GP, L.P., (AHGP) through its subsidiaries, produces and markets coal primarily to utilities and industrial users in the United States. The company announced a boost in its quarterly distribution to 46.5 cents/share which represents a 12.0% increase over the $0.415 per unit distribution (for the quarter ended March 31, and an increase of 2.8% over the fourth quarter 2009 distribution of $0.4525 per unit. This master limited partnership has consistently boosted distributions since 2007. The units yield 5.60%.

Future Dividend Growth Stocks

EarthLink, Inc. (ELNK) is an Internet service provider (ISP), providing nationwide Internet access and related value-added services to individual and business customers. The company's Board of Directors has increased the amount of its quarterly cash dividend on its common stock from $0.14 per share to $0.16 per share. This is the first dividend increase since EarthLink initiated a dividend policy in 2009. The stock yields 7.40%.

Ameriprise Financial, Inc. (AMP) provides financial planning, products and services that are designed to be utilized as solutions for its clients' cash and liquidity, asset accumulation, income, protection, and estate and wealth transfer needs. The company raised its quarterly dividend from $0.17 to $0.18. The company has had higher annual dividend payments for four years in a row. The stock yields 1.50%.

Costco Wholesale Corporation (COST) operates membership warehouses that offer a selection of branded and private label products in a range of merchandise categories in no-frills, self-service warehouse facilities. The company approved a quarterly increase from $0.18 to $0.205 per share. This is the sixth consecutive dividend increase since the company initiated a dividend policy in 2004. The stock yields 1.40%.

Kellogg Company (K), together with its subsidiaries, engages in the manufacture and marketing of ready-to-eat cereal and convenience foods. The Company's Board of Directors announced plans to increase the quarterly dividend by 8% to $0.405 per share beginning with the third quarter of 2010. This would have been the sixth consecutive dividend increase for the company. The stock yields 2.90%.

International Paper Company (IP) operates as a paper and packaging company with operations in North America, Europe, Latin America, Russia, Asia, and North Africa. The company approved an increase in its quarterly common stock dividend from $0.025 per share to $0.125 per share. This is the first dividend increase since the company slashed distributions by 90% in 2009. The stock yields 1.70%.

Celanese Corporation (CE) is an integrated producer of chemicals and advanced materials. The company approved a 25% increase in the company’s quarterly dividend to $0.05 per share. The stock yields 0.60%.

Legg Mason, Inc., (LM) through its subsidiaries, operates as a diversified group of global asset management firm serving individual and institutional investors worldwide. The company’s Board of Directors has declared a quarterly cash dividend on its common stock in the amount of $0.04 per share which is a 33.33% increase over the previous dividend of $0.03. This is the first dividend increase for the company since it slashed dividends by 87.50 % in 2009 and lost its status as a dividend aristocrat after just one year in the elite index. The stock yields 0.50%.

Valmont Industries, Inc. (VMI) produces fabricated metal products; pole and tower structures; and mechanized irrigation systems in the United States and internationally. The board of directors increased the Company's quarterly cash dividend by 10% from $0.15 to $0.165 per share. This is the ninth consecutive annual dividend increase for the company. The stock yields 0.80%

Sturm, Ruger & Company, Inc. (RGR) engages in the design, manufacture, and sale of firearms in the United States. The company increased its quarterly dividend by 55% to 9.3 cents/share. The stock yields 2.10%.

TransAlta Corporation (TAC) operates as a non-regulated electricity generation and energy marketing company. The company raised its quarterly dividends by 6.40% to 29 cents/share. This is the third consecutive annual dividend increase for the company.The stock yields 5.60%.

Duff & Phelps Corporation (DUF), through its subsidiaries, provides independent financial advisory and investment banking services worldwide. The company increased quarterly dividend by 20% to $0.06 per share. This is the first dividend increase for the company since its started paying dividends in 2009. The stock yields 1.50%.

The list of dividend increases should not be viewed as a buy recommendation. Readers are advised to use it only as a starting reference point for further research, provided that any of those companies interest you.

Four Percent Rule for Dividend Investing in Retirement

The four percent rule is commonly used by financial planners in order to estimate the optimum amount of money to withdraw from client portfolios each year. The goal is to ensure longevity of client portfolios in retirement. Retirees are typically expected to sell a portion of their portfolios each year and adjust their withdrawals for inflation.

The possible reason for selecting 4% as a “safe” withdrawal strategy could be the fact that dividend yields have typically been around 4% on average for the decades covering the study.
In contrast, dividend investors tend to create portfolios which are concentrated around generating asustainable income stream each year. By owning a diverse mix of income producing assets, dividend investors would ensure that a hiccup in one sector of the economy would not have lasting effects on their lifestyles in retirement.

Another positive of dividend portfolios is that investors tend to live off solely from the income that the basket of stocks produces each year. In contrast, the four percent rule contains an inherent risk because of the possibility of selling off portions of ones portfolio during a flat or down market, which could deplete the portfolios much faster, leaving retirees to rely solely on social security. By concentrating only on spending a portion of the income that the portfolio produces, investors are leaving their invested capital intact and letting it grow overtime. This is similar to having your cake and eating it too as well.

The research behind the four percent rule is still sound however, especially since index funds tended to yield approximately four percent on average over the study period. Thus I believe that a portfolio which yields between three and four percent would provide investors with adequate income for a lifetime. Even if ones income portfolio generates a starter yield which is higher than four percent, it would still be wise not to spend more than 4%. This would leave some room for maneuvering in case the income generating assets in the higher yielding portfolio cut distributions.

If I were starting an income portfolio today, I would break it down to four equally weighted basic components.

The first component would be fixed income securities such as 30 year Treasury Bonds. Having some stability in the principal and income would provide at least some cushion in certain catastrophic events such as reliving the Great Depression of 1929-1932 in US or the lost two decades in Japan between 1989 to 2009. In both scenarios stocks lost 80% of their values.

The second component would consist of higher yielding stocks with low dividend growth. Likely inclusions in this list include Master Limited Partnerships such as Kinder Morgan Partners (KMP), Enbridge Energy Partners (EEP) or Energy Transfer Partners (ETP). These companies have stable revenues from transporting natural gas and petroleum products through their pipelines. Another sector could include Real Estate Investment trusts such as Realty Income (O) or National Retail Properties (NNN). These companies also tend to generate stable cash flows from their long-term property leases. A third high yielding sector for current income could be utilities such as Con Edison (ED) or Dominion Resources (D).Utilities are natural monopolies in their specific geographic area, supplying electricity, water or natural gas to consumers.

The third component of the portfolio would include mature companies which offer yields similar to average market yields, but which have enjoyed solid dividend growth. Examples of such companies include consumer products giant Johnson & Johnson (JNJ), fast food giant McDonald’s (MCD) or Kimberly-Clark(KMB).

The last component will include companies with low current yields, which have the ability to generate double digit earnings increases. This could generate solid dividend growth in the future. Companies that fit this criteria include Walgreens (WAG), Becton Dickinson (BDX) and Medtronic (MDT).

The last two portions of the portfolio might only end up yielding between 3% and 4%, although they would provide the growth factor that would insulate the dividend income from inflation.

Colgate-Palmolive (CL) Dividend Stock Analysis

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. It operates in two segments, Oral, Personal, and Home Care; and Pet Nutrition. The company recently increased its quarterly dividend by 20.40% to 53 cents/share. This is the forty-seventh consecutive dividend increase for Colgate-Palmolive, which is a dividend champion.

Over the past decade this dividend stock has returned 4.30% per annum.

Earnings per share have increased by 11.10% on average since 2000. Since 2000 the number of shares outstanding has decreased from 625 million to 525 million, or an average decrease of 1.90% annually. Analysts estimate that EPS would grow by 9.80% to $4.80 in FY 2010. FY 2011 EPS are expected to increase by 11.40% from there to $5.35.

Sales outside North America accounted for two-thirds of the company’srevenues. The company’s strong competitive advantages in the oral healthcare field plus the low capital requirements have enabled it to generate high returns on capital.

Returns on Equity have been truly phenomenal, having never fallen below 80% since 2000.

Annual dividends have increased by 11.80% on average over the past decade, which is slightly higher than the growth in earnings.

A 12 % growth in dividends translates into the dividend payment doubling every six years on average. If we look at historical data, going as far back as 1976, Colgate Palmolive has actually managed to double its dividend payment every eight and a half years on average.

The dividend payout ratio has consistently remained below 50%, with the exception of a brief spike to 50.80% in 2006. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

The company trades at a P/E of 18.80 times earnings and has an adequately covered dividend payment. The current yield of 2.60% is below my 3% entry threshold. If we look at the yield from the past decade however, CL has yielded more than 3% only during the lows in early 2009. Because of this I initiated a position in Colgate recently. I would look forward to add to this position on dips below $71, which would be my ideal entry price.

Universal Corporation (UVV) Dividend Stock Analysis

Universal Corporation (UVV), together with its subsidiaries, operates as the leaf tobacco merchants and processors worldwide. It engages in selecting, procuring, buying, processing, packing, storing, supplying, shipping, and financing leaf tobacco for sale to, or for the account of, manufacturers of consumer tobacco products. This dividend champion has raised dividends for 39 consecutive years.

Over the past decade, Universal has delivered a total return of 11.60% to shareholders.

At the same time earnings per share have grown by 1.50% on average since 2000. Analysts expect UVV to earn $5.25/share in 2010 and $5.63/share in 2011. This is an increase over the $4.32/share Universal earned in 2009. The slow growth in tobacco consumption worldwide and risk of increased taxation and regulation in the sector represent one of the major risks for the company going forward.

The annual dividend has increased by 4% annually over the past decade. A 4% growth in dividends translates into the distribution doubling every 18 years. The current quarterly dividend of $0.46/share is double what it was in 1993-1994. The latest dividend increase was for 2.20% in November 2009.

The return on equity has generally decreased from a high of 22% in 2000 down to 15.30% in 2009. I generally like to see a stable value of this indicator over time.

The dividend payout ratio has generally remained below 50%, with the exception of 2006 and 2007, which struck as outliers.

Overall Universal Corporation does appear to be attractively valued, trading at a P/E of 9, yielding 3.90% and having an adequately covered dividend. The main problem for the company is the slow earnings growth, and concentration in the tobacco industry, which comes with its own inherent risks. I already have exposure to the tobacco sector through my position of already, Altria (MO) and Philip Morris International(PM). However I would consider initiating a position in UVV on dips whenever I have extra cash on hand.

When to break your rules

As a dividend growth investor, my strategy is picking the right stocks that provide a decent balance between dividend yield and distribution growth. Thus I have maintained a rigid requirement for a 3% initial yield before investing in a dividend growth company’s securities.
Most dividend investors look for yield when purchasing income securities. Most dividend growth investors purchase securities so that they could enjoy a rising stream of dividend payments over time. Thus, maintaining a proper balance could be a challenge that could make or break your portfolio.

I realize that using a strict yield criteria I could miss out on potential dividend growth stories such as Wal-Mart (WMT) for example. Wal-Mart has never yielded 3% since it went public in the 1970s. The 29.1% annual dividend growth since 1975 has been truly spectacular however. This means that Wal-Mart’s dividend has doubled every 2.5 years for 34 consecutive years. Wal-Mart has delivered a 23.40% dividend growth since 1985 and a 20.20% dividend growth since 1995. Check my analysis of Wal-Mart.

My rationale behind selecting a minimum yield is to provide me with an adequate margin of safety should the stock stop raising dividends and should the stock price fall or remain flat for a large period of time. In the case of Wal-Mart, the stock has been trading in a range over the past decade. Back in 1999 the stock fluctuated between $70.25 and $38.68 and closed at $69.12. The stock wasn’t yielding much back then – about 0.30%. Even if the dividend were doubling every 2.5 years, it would take a retiree almost 13 years in order to reach a yield on cost of 10%. At the current dividend rate, the stock is actually yielding 1.60% on cost, assuming that you purchased it on the last day of 1999. The actual dividend growth over the past decade comes down to 20.80% per annum, which translates into the dividend payment actually doubling every three and a half years.

Now the down side to my having a strict initial yield requirement for entry is that I would miss out on some huge gains, which could lead to early financial freedom. If one had purchased Wal-Mart stock at the end of 1984, the tenth year in a row in which it increased its dividends, their entry price would have been $1.18 (adjusted for five stock splits) and their initial yield would have been only 0.55% at the time. Fast-forward 25 years and the yield on cost comes out to almost 100%.

Many dividend growth investors tend to project past dividend growth rates into infinity, which seems unsustainable to me. If a company with $1 billion in profits enjoyed a 15% annual growth forever, it would double its net income almost every five years. In reality, as the companies grow larger they would find less opportunities that could sustainably earn them higher incremental returns on investment. For example, with a company like McDonald’s (MCD) people could only eat so much burgers and fries. After a company hits a plateau, EPS growth could largely be sustained by increasing efficiencies, raising prices, repurchasingshares or buying other competitors.

This analysis is not meant to be used as a weapon against Wal-Mart or McDonald’s, which are fine companies. It just goes to show that once shouldn’t solely rely on past data in their investment decisions. Furthermore, projecting past data into the future, without adding a what if analysis of your common sense could prove costly in the long run. In addition, purchasing stocks solely for the dividend growth is as dangerous as chasing high yielding stocks blindly.

As far as my strategy is concerned, I am considering lowering the entry yield criteria to 2% for stocks, which appear to have a sustainable above average dividend growth ahead of them. My target allocation for such stocks would be half of what I would normally allocate to such dividend growth champions such asJohnson & Johnson (JNJ) or Procter & Gamble (PG) however.