Investing Compass: Structuring your portfolio for income
Mark speaks about how he has structured his portfolio for income.
Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
So I am sitting across from a smiling Shani.
Shani Jayamanne: I’m always smiling.
LaMonica: You are not always smiling, but you are smiling because you are about to go on vacation for two weeks.
Jayamanne: I am yeah – you just came back from vacation for two weeks, but I’m in a much better position because I’m going.
LaMonica: Yeah, yeah, no – that is true. So, you are going to Sri Lanka.
Jayamanne: I am yeah. So, this is the longest I’ve been away from Sri Lanka, Covid kind of cooked things so.
LaMonica: Yeah I mean there’s been like a coup since you left. So you think anything is going to be different?
Jayamanne: I don’t know, I mean I’m just sort of holing myself up at the beach and drinking coconuts.
LaMonica: And apparently eating sandwiches because Shani sent me a photo a couple minutes ago of a sandwich that had fried rice in it.
Jayamanne: It’s very strange. I’m not going to be eating the sandwich but it’s very strange.
LaMonica: Doesn’t scream out Sri Lankan food to me but anyway, why don’t we get into the episode because the faster we finish this, the faster you can go on vacation.
Jayamanne: I don’t think it works like that but let’s get going.
Jayamanne: So Mark talks about income investing and dividends on this podcast quite a lot. And that is because it is the main goal of his investing strategy – to receive dividends.
LaMonica: That’s right Shani. So there are not many things that I have in common with John Rockefeller – I mean at least I don’t think so. But Rockefeller loved dividends Shani so that’s one thing we do have in common. And he has this quote, I don’t have any good quotes about them, but he has this quote that says, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
Jayamanne: Okay and if the world’s first billionaire was a fan of dividends, who are we to argue, right Mark?
LaMonica: Yeah, no I don’t think it should be us, but I think my view on dividends is a bit more nuanced than Rockefeller’s. And I guess I derive maybe some joy from seeing a dividend come in but the actual joy comes from of course spending those dividends. And I will provide little bit of context here so - I began my income investing journey when I was 22 years old. And that was during the wreckage of the .com crash and I was still a really new investor. And of course it was a crazy environment, there was all this irrational exuberance and nonsensical hype and it was crashing down around me and every other investor and I was just looking for something more tangible. And what is more tangible than a dividend?
Jayamanne: I can’t really think of much, Mark. A dividend is a reminder that what we are doing as investors is real. We own real companies that generate real profits and a portion of those profits are shared with us as the owners of the business.
LaMonica: And that’s really the appeal that I saw in dividends. So I was immediately hooked, and in this moment of clarity, I saw dividends as a pathway to independence at an age where I didn’t really want to work for my entire life.
Jayamanne: And here you are 20 years later.
LaMonica: Yes, and I am still working – but my dividend income is also contributing to traveling which is something I enjoy a lot, not that that’s exactly unique. But it allows me to travel in a manner and quantity that I wouldn’t be able to if I was just supporting that by my income. So that’s a form of independence, right Shani?
Jayamanne: Yeah, so today, what we’re going to do is outline the steps that Mark follows to build his income portfolio. And underpinning all of this is a common theme. There’s a common theme in the approach to income investing – or any investment strategy – and that is time.
LaMonica: Yeah and really successful investing is all about accruing the benefits that come with the passage of time and not wasting the opportunity that time affords. Saving and compounding for years and years is the pathway to success.
Jayamanne: So with that out of the way – let’s get to step one. Balance dividend growth and current yield. Everything in life involves trade-offs and income investing is no different. Many income investors search for shares with the highest current yield thinking that is the way to develop an income stream.
LaMonica: If you have time before you need that income, a better approach may be finding shares with a long runway of dividend growth ahead of them. So my revelation on dividends may have been a eureka moment for me, but developing my strategy took a lot of time in a spreadsheet. And what I initially used the spreadsheet for was to try and see the tradeoff between dividend growth and a higher current yield.
Jayamanne: And high current yields can indicate a dividend trap where the market has bid down the share price because of fears that the dividend is unsustainable and will be cut. It is obvious that those situations should be avoided. But a high current dividend yield is often the result of a high payout rate. That means that more of the earnings generated are paid out in dividends. This can leave less money to reinvest in the business which may hamper future earnings and dividend growth.
LaMonica: And it is worth noting here that there are some differences between the Aussie market and global markets. Because of franking credits there is even more incentive for Australian investors to buy dividend paying shares. And so companies of course respond to this and they pay high dividends compared to the rest of the world.
Jayamanne: But these high dividend yields mean high payout rates. And historically the dividend growth has been lower in Australia.
LaMonica: So, let’s give an example of this trade off. And we’ll use Genesis Energy, so that is a share with the ticker symbol GNE. It’s currently yielding a really healthy 5.9%.
Jayamanne: Alright so let’s compare this to one of Mark’s recent purchases – American Tower, listed on the New York Stock Exchange with the ticker symbol AMT – it has a current yield of 2.68%. As an investor looking for the highest possible income stream in 10 years the current yield may not be the key driver of total income in a decade’s time.
LaMonica: So, let’s say you invest $10 000 in each share, you would have a current income of $590 from Genesis, and $268 from American Tower. Over the past 5 years Genesis’ dividend went from 17 cents a share to 15 cents a share. So if we assume they reverse this trend and manage to grow the dividend 2% a year for the next decade your total income in 2033 would be $719 a year.
Jayamanne: To match that with American Tower, you would need dividend growth of 10.38% a year. That does sound like a pretty tall order – but we can see that American Tower has managed to grow their dividend at an average of just under 19% over the last 5 years.
LaMonica: And predicting future growth in dividends is not easy. They are after all a product of management’s willingness to keep growing the dividend and the underlying performance of the company to support that growth.
Jayamanne: The point of considering this trade-off is to understand that building an income portfolio may involve a mixture of high yielding shares, and shares that have the opportunity to grow their dividends. Relying too much on the former can stunt your overall dividend growth.
LaMonica: And it’s important to point out that just because you don’t need to withdraw income over the next 10 years or so doesn’t mean that it serves no purpose and has no use. The beauty of pre-draw down income investing is that you can turbocharge growth by dividend reinvestment.
Jayamanne: And that brings us to the next step of the process. This is compounding your income growth. Rising dividends is one source of income growth in your portfolio, but there’s another powerful driver – and that’s using dividend income you receive to buy more shares. Those additional shares will also pay a dividend which will grow your income further.
LaMonica: This can be done either through a dividend reinvestment plan, or a DRIP, which will give you more shares of the company paying the dividend or by collecting the dividends and investing them in other companies. This is compounding for income.
Jayamanne: And we love examples here at Investing Compass, so let’s give another one.
LaMonica: Okay so we’ll take you back to 2013. So, Shani was in Uni and I was already an old man and I bought 860 shares of Cisco, so that is a share listed on the New York Stock Exchange of the ticker symbol CSCO. I turned on the DRIP plan and have left it on ever since. So, I now own 1,654 shares without having ever made another purchase. So, in 2013 Cisco paid $0.68 a share in dividends. If the dividend stayed the same my income would have grown from just over $584 a year to $1,124 a year. Luckily for me the dividend did not stay the same and Cisco paid $1.52 a share in 2022. That represents dividend growth of 8.28% a year. Yet my income from Cisco was $2,514 a year in 2022 which is a growth rate of 15.72% per year. I’ve almost doubled my per year income growth through the compounding effect of dividend reinvestment.
Jayamanne: But I do I think an important disclaimer to make here is that Mark has cherry picked this position to illustrate the impact of compounding.
LaMonica: Yeah no, exactly it’s like a flower still standing in the rubble right of the rest of my portfolio. But I thought giving a personal example would be more powerful but like every investor there have obviously been misses in my portfolio. Dividends have been cut and growth that has never materialised. And I’m not a fan of manifesting Shani if that surprises you, but understanding what success looks like can help identify potential opportunities while maintaining the patience to see them through.
Jayamanne: Alright so far, we’ve covered off two sources of income growth with dividend increases and the compounding effects of dividend reinvestment. The third is new contributions you make to your portfolio – and that is another source of income growth in your portfolio.
LaMonica: Exactly so the more you save and invest, the more you grow your income. The market cap weighted dividend yield of the ASX is currently around 4.5%. So if you contribute $10k a year to your portfolio and you will add $450 in income and that’s of course assuming you achieve the average yield). So my initial goal was to grow my total dividend income by 10% a year. And initially this was easily achievable. So my contributions were relatively large in comparison to my total portfolio size.
Jayamanne: If we expand on the example above, if you have a $100k portfolio that matches the approximate 4.5% yield of the ASX you will have total income of $4,500 a year. Investing $10k and getting $450 a year in additional income gives you 10% growth, before accounting for dividend increases or the impact of reinvestment. But that becomes harder to achieve when your portfolio grows. For example, if you have a $500k portfolio generating $22,500 in income, you will need income growth of $2,250 to hit that 10% goal.
LaMonica: Even if your contributions double to $20k a year, you’re still only adding $900 of income per year, based on a 4.5% yield, which leaves a shortfall of $1,350 to be made up from dividend increases and the impact of reinvestment. I personally confronted the reality of this math after several years of investing which sent me back into a spreadsheet to try and solve this problem.
Jayamanne: Unfortunately, there is no formula for this reality of income investing. So, Mark – how have you thought about this with your portfolio?
LaMonica: Well I basically realized that a tiered approach to income growth is more realistic. Maybe a double-digit goal is possible as you are just starting out but that will get lower over time. So you can account for this in any projections you’re making. So it’s worth exploring the source of income growth in your portfolio. Figure out how much you can contribute and how much additional income that gets you. Then look at the growth achievable from dividend reinvestment. The quick way to do that is looking at the total expected yearly dividends and the yield of your current portfolio.
Jayamanne: This will slightly underestimate the total income growth from dividend reinvestment as you will get a quarterly compounding effect from quarterly dividends and semi-annual compounding effect from semi-annual dividends. The remainder will come from dividend growth. Okay – so we’re onto our last step – and this one is our favourites – and we think it will be yours as well.
LaMonica: Okay so everyone has different goals and circumstances. For me, I made the decision that I would start to spend part of my dividends to fund travel. I did this for several reasons. Primarily, I was comfortable with my pathway for building a retirement nest egg. For retirement I will take a total return approach and fund withdrawals with both asset sales and income. And part of the reason why I made this decision was because I didn’t have an overwhelming desire to retire at 50 which was my original goal.
Jayamanne: This is a concept that Morningstar Investment Management Portfolio Manager Jodie Fitzgerald recently discussed on our podcast Investing Compass. We’ll pop a link to this episode in our resources page.
LaMonica: But I’m on track to achieve my retirement goal provided I can stay employed and that’s a big if as Shani continually tells me. I’m also comfortable that I have enough of a cash buffer in my emergency fund to ensure that a period of unemployment won’t derail my plans. And finally, I’ve used a bit of mental accounting as encouragement to keep saving in non-retirement accounts. I’m of course aware that in a rational sense putting more money into one account nets out when I’m withdrawing money earned in dividends from another. But I do find this approach mentally comforting. It’s kind of like steps right Shani? So like many people we both track our steps but you’re in competition with your family.
Jayamanne: I am, yes.
LaMonica: And you know then you feel like you haven’t’ really done anything if you take a walk without your phone and you’re not tracking your steps. So that’s like my mental accounting.
Jayamanne: Alrighty then.
LaMonica: Okay Shani is looking at me like I’m crazy, but anyway, what I’ve done is I’ve set up a situation where every 5 years I turn the dividend reinvestment off in an account and add another source of funds to my travel income stream. I then direct my savings into the next account that will go through this transition and try and grow the income as much as possible before that time. And as I previously stated, this makes little sense as I could simply fund travel with my salary but there is something about passive income that just makes it a little more special than labouring to get it. Maybe this is simply a mental trick to for self-encouragement, but it works for me.
Alright, so there we go. Shani is one step closer to her vacation and that sandwich with fried rice in it. So thank you very much for listening. If you have any questions or comments, my email address is in the podcast notes. And of course, we always love comments and ratings in your podcast app. Thank you.