This is a guest contribution written by Ben Reynolds at Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically build high quality dividend growth portfolios. Please let me know if you would love to guest post on RFI.
I define financial independence as the point at which your passive income covers all of your expenses.
We tend to see this as one large goal. For example, say you live on $4,000 a month – generating $4,000 a month in passive income is quite a goal for an investment portfolio. It takes most people decades and decades of saving and investing to reach this goal.
What if instead we looked at financial independence as a series of small steps? Instead of trying to replace $4,000 a month, what if we tried to create income streams (that grew over time) to cover small everyday purchases?
This would create many small wins – much like the famous debt snowball approach – while still inching us ever closer towards the ultimate goal of financial independence.
The Toothpaste & Toothbrush Example
We all brush our teeth (I hope you do…). A new toothbrush and toothpaste is not going to break anyone’s bank. But small costs can add up over time.
A normal size toothpaste tube has around 120 ‘servings’ in it and costs around $4.00 (depending on the brand and style). Your toothbrush should be replaced around 4 times a year and costs around $3.00 (again, depending on a lot of factors).
If you brush your teeth twice a day, this comes to around $36.00 a year ($24.00 for toothpaste and $12.00 for toothbrushes).
In this example, let’s say you are brand loyal to Colgate-Palmolive (CL). How much Colgate-Palmolive stock would you need to own to cover your $36.00 a year in tooth brushing care?
Colgate stock pays $1.56/share in dividends a year. To cover $36.00 a year, you’d need to buy about 23 shares. At current prices, 23 shares of Colgate-Palmolive stock comes to $1,647.
For $1,647, your tooth brushing is covered forever. Saving up over $1,000,000 for a retirement portfolio is a daunting task. Saving up $1,647 in Colgate-Palmolive stock to cover your tooth brushing isn’t such a tall order.
If you do so, the company you used to pay will be paying you instead. But here’s where things get interesting:
Colgate-Palmolive is a member of an exclusive group of stocks called the Dividend Aristocrats. There are only 50 Dividend Aristocrats. Each one has paid increasing dividends for 25 or more consecutive years.
It is exceptionally likely that Colgate-Palmolive pays you more in dividends next year than it does this year. This means your tooth brushing will be covered – and then some.
What’s more, it’s likely that Colgate-Palmolive continues to pay rising dividends over time. That’s because the company has a strong and durable competitive advantage. It owns well-known brand names and has a global distribution network that makes competing with the company difficult. Further, it’s very likely that people will still need toothbrushes and toothpaste far into the future.
Buying What You Know
Peter Lynch is one of the greatest investors of all time. He averaged returns of 29% a year while running a mutual fund for Fidelity.
Lynch recommends investors ‘buy what they know’ – Colgate-Palmolive stock in the example above. In truth there’s a bit more to investing than that.
Buying Colgate-Palmolive stock is a good idea – sometimes. There’s little doubt Colgate-Palmolive is a high quality shareholder friendly business. This is evidenced by its amazing dividend growth streak and presence in the Dividend Aristocrats Index.
But Colgate-Palmolive is not a buy at any price. In fact, it isn’t a very good buy today. The company has an adjusted price-to-earnings ratio of around 25, above the market’s price-to-earnings ratio of 23.4. The company is likely somewhat overvalued at current prices.
Toothpaste aficionados may want to look at the company’s largest competitor – Procter & Gamble (PG). Procter & Gamble is also a Dividend Aristocrat, but it trades at a more reasonable adjusted price-to-earnings ratio of 21. The company owns the Crest brand (among many others). Further, it has a higher dividend yield of 3.3%.
Replacing your expenses one category at a time can make the difficult challenge of saving for financial independence more manageable.
Investing in companies that sell the brands you know can be a good idea – sometimes. It’s important to make sure they are high quality businesses trading at fair or better prices before investing for the long-run.