Dividends are key in stock selection

If building a portfolio seems like a complicated endeavor full of unpalatable trade-offs and fuzzy concepts like diversification and dividends, as in every other way, stand ready to provide invaluable assistance. Dividends are the ultimate tool for matching stocks with their appropriate owners. Do you need 3% of your portfolio's value every year for living expenses? Put a portfolio together that generates 3% of its value every year in dividends. Need 5%? Then go for a mix of stocks that yield 5% as a group. No need for cash from your portfolio today, but [are you] looking for maximum earning power a decade or two down the road? Then [you've] got maximum flexibility. I look at the process of creating a portfolio driven by dividend income and growth. I'll let others attempt to turn portfolio management into rocket science. As I see it, building a portfolio begins with two simple questions — questions that only the investor can answer: 1. How much income do I need from my stocks for living expenses? 2. What are my tax circumstances? From there, we'll consider how to create an opportunity set, which stocks to buy, and how to manage the portfolio thereafter. The key to all of these concepts is that dividends, not just market prices, are the underlying drivers of all decisions. I have a real-world example to share. From Morningstar DividendInvestor's launch in January 2005 through the end of 2006, its centerpiece was its $100,000 real-money model portfolio. [DividendInvestor is a newsletter by Chicago-based Morningstar Inc.] While I might say good or bad things on any number of stocks in any one issue, this portfolio provided a venue for clear "buy" and "sell" recommendations, whose subsequent performance was then laid bare for all to see. But one portfolio just wasn't enough; some subscribers were looking for low yields with high growth rates, while others preferred stocks offering much higher current income. That's why, at the end of 2006, we added a second model account — the Dividend Harvest Portfolio — with a mission to obtain the maximum level of current income possible without sacrificing safety or the long-term purchasing power of its income. In the process, I found myself with a fresh $ 100,000 lump of cash to invest. How I went about setting goals for this account, and the stocks I chose to buy, provides a useful illustration of my portfolio strategy in practice.

QUESTION ONE: TARGET YIELD

Your personal need for cash from your investment portfolio should set the minimum yield of your portfolio. Attempting to live off fickle capital gains can be hazardous to your wealth. If you need $1,000 a month to supplement other sources of income, design a portfolio that generates at least $ 1,000 a month in income over the course of a year. If you need $2,000, then go for $2,000. In other words, arrange for your portfolio paycheck first! Of all the issues involved in building a portfolio, this is the one I'm least able to answer from afar. I can't tell you how much money to live on. What I can do is describe how much income is available from stocks. It's clear that restricting one's choices to only those stocks yielding 3% and up will quickly shrink the number of stocks the investor has to consider. At the extreme, yields of 9% and up, very few offer dividends that I would consider safe. Excluding these outliers, however, this is actually a high-quality set of investment opportunities. With dividends signaling durable earnings, financial strength and shareholder-friendly management teams, this stands to be highly fertile ground. Now for the big question: What's the highest yield an investor can expect to earn from a reasonably well-diversified portfolio? This, too, is a matter of trade-offs. From where I write today: An average yield of 4% isn't hard to extract from current markets. There are lots of banks, utilities, real estate investment trusts and energy master limited partnerships to pick from in this range, and a 4% portfolio average is low enough to include some 2% and 3% yielders from stocks like Johnson & Johnson (JNJ) that offer much faster dividend growth than their high-yield kin. Five percent is a bit more of a stretch, but still reasonable. Most utilities are yielding less than 5%, as are most banks. But plenty of REITs and energy MLPs yield more than 5%, and there's still a bit of room for some lower-yielding names with double-digit growth potential. If you don't mind having a portfolio comprising mostly banks, REITs, and energy MLPs, 6% is achievable. To get to 7%, one must be willing to tolerate a portfolio that is heavily weighted in REITs, MLPs and specialty financials. Furthermore, it would be tough to keep the income of a 7%-yielding portfolio growing faster than the rate of inflation. Expecting a portfolio of equities to deliver more than a 7% average yield, at least from where we stand today, is not a good idea. Up in this rarefied air, the stocks you'd be stuck owning would almost certainly include some whose dividends are likely to be cut at some point, or at the very least offer no prospect of keeping pace with inflation over the long run. This 7% yield limit that I suggest is certain to change as inflation, Treasury yields and the yields offered by low-quality, high-yield corporate bonds all fluctuate over time. (It's worth noting that these junk bonds are natural competitors for investment dollars that might otherwise flow into stocks, even though the income paid by junk bonds is fixed, while high-yield stock dividends can and do grow over time.) The concept of a yield limit presents an obvious problem to the investor of limited means. From where I write today, someone who needs $25,000 in annual income from a $250,000 account is extremely unlikely to find safe yields in this range. I'd go so far as to say it is impossible. Rather than court high risks to your future income, it's better to scale down your lifestyle or find another way to supplement your income. Painful and inconvenient as these options are, such choices are preferable to a portfolio that reaches for yield by taking too much risk, or one that sells off stock to fill the gap, diminishing future income in the process. For the Harvest Portfolio, I considered the range of available yields with acceptable levels of safety and growth, and set a target yield range of 6% to 8%.

QUESTION TWO: TAX STATUS

All else being equal, there's no reason to pay taxes on income that you don't plan to spend. How this affects your investment choices is a function primarily of where your money is held. While there are many different titles a brokerage account might take, they all fall into two basic categories: Tax-deferred accounts and taxable accounts. The catch-all category of tax-deferred accounts includes traditional individual retirement accounts, Roth IRAs, 401(k) plans, Keogh plans and profit-sharing plans. Older folks tend not to have much money in these accounts, [because] tax-deferred accounts came along too late for most of today's octogenarians to accumulate sizable assets in them. But for those in their 50s and 60s, tax-deferred accounts can easily represent the bulk of their retirement wealth. These accounts share one key benefit: Investment income, whether dividends, capital gains, interest or whatever, is not taxed when it is earned. Only when money is withdrawn from the account does the investor owe tax — except for Roth IRA and Roth 401(k) accounts, where even withdrawals are tax-free! This is a huge advantage: They allow the investor to reinvest 100% of dividends and capital gains, with no tax drag involved. Compounded over decades, this is a huge boon for long-term wealth accumulation. A $10,000 investment returning 10% annually will bloom to nearly $1.2 million in 50 years. That same investment, if clipped annually for 15% of its returns in taxes (for an after-tax return of 8.5%), ends up being worth only half that. Nor does it take 50 ---years for an appreciable gap to show up: Even after 10 years, a similar tax-paying account would be worth only 87% of what a tax-deferred account [would be]. However, there are several trade-offs involved. For one thing, withdrawals from a tax-deferred account (except Roth accounts) are taxed at higher rates than are dividends and long-term capital gains in a taxable account. Another drag, one that is particularly important for investors seeking maximum yields, is the fact that tax-deferred accounts are effectively prohibited from owning certain types of stocks. Most of these prohibited stocks are master limited partnerships, which are otherwise quite attractive high-yield securities to own. For those seeking 5% to 7% yields from a tax-deferred account these days, the inability to buy MLPs creates a diversification problem. To provide the maximum range of choices, including MLPs, I treat the Harvest Portfolio [just] like [I would] a taxable account. Whatever money isn't in a tax-deferred account is, by definition, taxable. When the investor cashes a dividend check or sells shares at a gain, the government gets part of the profit. For investors who are still in accumulation mode, the obligation to pay taxes on investment income that is reinvested will be a drag. However, this is much less of a problem for investors who are in withdrawal mode. The tax rates on income earned in taxable accounts are generally lower than on withdrawals from tax-deferred accounts. A taxable account also has the flexibility to own anything, including potentially lucrative high-yield MLPs.