It’s the holy grail. Earning income while you sip Mai Tais with warm tropical ocean water lapping at your toes.
If you do a Google search for “passive income” the first thing that pops up is Smart Passive Income by Pat Flynn. The main theme is building an online business that will require a lot of work, time, and effort up front but then will generate income and cash flow with minimal work going forward. Passive income. For the most part.
I think one the best ways to build a truly passive income stream is through dividend growth investing. No income stream is 100% passive. Some work is needed but with dividend growth investing the large publically traded companies are doing the grunt work. We just have to find the cheap to fairly priced high-quality businesses that can invest our capital, compound it, and pay us an ever increasing dividend off the proceeds.
Inerestingly enough in episode 174 of Pat Flynn’s Smart Passive Income Podcast our two worldviews combined. Pat and his guest Ryan Moran talk about their strategies for reinvesting the income they receive from their online businesses. After reinvesting income back into their businsesses or into new businesses, Mr. Moran’s second choice is investing in “ever increasing dividend paying stock”.
He is talking about Dividend Aristocrats and investing for dividend growth.
There are about 100-200 stocks that are publically traded that have increased their dividend every year for at least 10 years…
They’ve increase the amount that shareholders are getting in the form of cash flow. Even if the stock is going down they incease their dividend as a way to keep investors happy.
One of the dividend aritstocrats mentioned by Ryan Moran was Coca-Cola (KO). Putting aside whatever your views are on the future of Coca-Cola, it is a great example of the power of dividend growth investing, the reinvestment of the dividends, and compound growth to build future passive income.
Dividend Reinvestment vs. Spending Your Dividends
The short version, for the casual readers of the site: Imagine you had two identical investors, James and Thomas, both of whom bought $10,000 worth of Coca-Cola stock in mid-June 1962. James reinvests his dividends, Thomas does not.
- Thomas without Dividend Reinvestment. Thomas bought $10,000 worth of Coca-Cola in mid-June 1962. This resulted in 131 shares in his account. He ignored the stock. Over the past 50 years, he collected $136,270 in cash. That is more impressive than it appears because $1 in dividend income back in the 1960’s had significantly more purchasing power. Adjusting for inflation, the current dividend equivalent of the cash income he was paid is $193,350. On top of this, his 131 shares of Coca-Cola have grown into 6,288 shares of Coca-Cola with a market value of $503,103.
- James with Dividend Reinvestment. James bought $10,000 worth of Coca-Cola in mid-June 1962. This resulted in 131 shares in his account. He reinvested all of his dividends over the years. He never added to nor took away from the position over than those reinvested dividends. Today, James is sitting on 21,858 shares of Coke stock with a market value of nearly $1,750,000. His annual cash dividend income is nearly $22,000.
The real world example is Warren Buffet who first purchased Coca-Cola (KO) in 1988.
Over the years, Coke has split its stock many times. Now Warren Buffett’s original purchase price is around $3.25 per share (split adjusted). In 1988, Coke paid a dividend of $0.075 per share (split adjusted too). Coca-Cola now pays $1.22 per share, which represents a 38% current annual yield on Buffett’s original investment. By staying in Coca-Cola’s common stock, a high-quality dividend growth company, Berkshire-Hathaway receives a 38% cash return every year on its original investment just in dividends!
Geese That Lay Golden Eggs
If you’re buying the right dividend growth companies and letting them compound over time for the next 10-20 years then it is like what Ryan Moran said, “buying geese that lay golden eggs”.
Dividend Growth Over Current High Yield
Ryan Moran adds a value component to his buying criteria. He is only looking for companies that yield 4%. This is where we differ. Everyone has their own systems to reduce the universe of equity investments to choose from. However, the yield requirement is excluding a lot of great dividend growth companies. Companies that may only pay 1-3% but can grow their dividends at compound annual rates in the double digits.
Abbot Labs is great past example. It has not approached a 4% yield but it has grown its dividend at above average annual rates for a very long time. Abbot Labs dividend growth is what made Grace Groner a very wealthy woman not its high current yield.
Visa and MasterCard are two current portfolio holdings that we expect to produce tremendous dividend growth over the foreseeable future. We think they both can do 20% per year or more. Both of them currently yield less than 1%.
You also have to be wary of companies with high current yields because the market may be discounting slower dividend growth or worse, a potential dividend cut. We’ve seen it recently with Kinder Morgan (KMI). Its yield got over 10% as its stock sold off because investors were expecting a dividend cut. Kinder Morgan’s debt load and dividend policy where unsustainable at the current price of oil. Then Kinder Morgan cut their dividend by 75%.
While we disagree with Ryan on the current yield criteria, we don’t disagree with him on this point. If you truly want to build passive income from your savings then start now. Don’t flip the switch once you retire. Start buying dividend growth stocks and reinvest your dividends. Let the companies compound your money over a very long time. As each company increases their dividend you will buy more stock which increases your dividend income which allows you to buy more stock which increases your dividend income. So on and so forth until you have built up a truly passive income stream.