Taken At Face Value: Upside

Once again, I have taken the Morningstar Dividend Investor newsletter at face value. Last time, I was conservative. This time, I assume that they meet the upside of their growth levels.

Income and Growth Estimates

The Builder portfolio has a current (April 2007 issue) dividend yield of 3.5%. It has a target dividend growth rate of 8% to 10%. The dividend growth rate forecasts of its current holdings range from 7.5% to 10.0% per year.

The Harvest portfolio has a current dividend yield of 6.1%. It has a target dividend growth rate of 2% to 4%. The dividend growth rate forecasts of its current holdings range from 2% to 8%.

Taking the Morningstar Dividend Investor at face value, I assign Stock A an initial dividend yield of 3.5% per year and dividend growth rates of 8% and 10% per year. I assign Investment B an initial dividend yield of 6.1% and growth rates of 2% and 4% per year.

I assumed 3% inflation and 2% (real) interest for the TIPS.

Initial Survey

I started with the previously optimizes condition. It uses the lower end of the growth rates.

Condition A:
Investment A: 3.5% initial yield with an 8% per year nominal growth rate.
Investment B: 6.1% initial yield with a 2% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.590% plus inflation.

Condition B:
Investment A: 3.5% initial yield with a 10% per year nominal growth rate.
Investment B: 6.1% initial yield with a 2% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.680% plus inflation.

Condition C:
Investment A: 3.5% initial yield with an 8% per year nominal growth rate.
Investment B: 6.1% initial yield with a 4% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.710% plus inflation.

Condition D:
Investment A: 3.5% initial yield with a 10% per year nominal growth rate.
Investment B: 6.1% initial yield with a 4% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.710% plus inflation.

Optimized Upside

The earlier conditions were limited to income available during the first year. I put money into the TIPS account to overcome this limitation. I optimized the results at the upper end of both annual growth rates.

Condition E:
Investment A: 3.5% initial yield with a 10% per year nominal growth rate.
Investment B: 6.1% initial yield with a 4% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% investment A, 65% investment B and 20% TIPS.
Withdrawal rate: 6.555% plus inflation.

Combined Strategy

The basic strategy, assuming the lower levels of its annual income growth rate goals, combined with Delayed Purchases (i.e., keeping money on the side until valuations improve) lifts the continuing income stream above 6%.

The basic strategy by itself produces a continuing income stream above 6% if it meets the upper levels of its annual income growth rate goals.

It makes sense to combine the two strategies.

A suitable combination would have a small initial allocation, possibly 10%, for the faster growing, lower initial yielding investment. It would have a TIPS allocation between 20% and 70%. The rest would be in the slower growing investment with the higher initial annual income.

You would add to your equity allocations as valuations become more and more favorable. Although P/E10 would be helpful, your primary focus would be on the income stream (dividend yield) and its reliability (the quality of earnings, smoothed).

Observation and Caution

Taken at face value, this income approach recovers the full (long term) Investment Return of the market in spite of today’s valuations.

This is an adequate reason for optimism and caution at the same time.

These are not reckless numbers. But this is a new approach. There may be dangers yet to be discovered. Diversification can help mitigate risk, but not completely.

Have fun.

John Walter Russell
April 29, 2007