Whether you are new to dividend investing or you are a seasoned pro, it's likely that your main goal is to build a long-term portfolio that generates consistent income over time with as little volatility as possible. That said, over the next few weeks we will be publishing a 10-part series which should help you build your own DIY Dividend Portfolio for 2013.
In part 1 (below), we highlight the investment plan and strategy for the portfolio and parts 2-10 will highlight each sector in the S&P 500, including high-rated stocks with in each sector that you should consider for your portfolio. Below is a schedule of the entire series. Please make sure to "follow" us so that you will be notified when each new article is published.
- Part 1: Introduction / Investment Plan & Strategy
- Part 2: Consumer Staples
- Part 3: Utilities
- Part 4: Healthcare
- Part 5: Consumer Discretionary
- Part 6: Financials
- Part 7: Technology
- Part 8: Industrials
- Part 9: Materials
- Part 10: Energy
BUILDING A DIY DIVIDEND PORTFOLIO
The investment plan for our DIY Dividend Portfolio is very simple:
- Identify, research, and invest in dividend stocks with the best risk/reward profiles.
- Identify low-risk entry points for each stock.
- Diversify using strict asset allocation targets and concentration limits (for asset classes, industries, and individual stocks).
- Utilize conservative option strategies and portfolio hedging techniques and to generate additional income and to manage downside risk.
- Maintain a disciplined exit strategy for each stock by closely monitoring changes in fundamental and technical data points.
Based on this simple investment plan, we believe that investors can build and monitor their own DIY Dividend Portfolio that should generate annual income of at least 6% (through a combination of dividend income and option income). While we could dedicate an entire article to each of these key steps, below is a high level summary to get you started.
1. IDENTIFY THE BEST DIVIDEND STOCKS
The bulk of your 6% target yield will be derived through dividend income, so it's very important to identify dividend stocks with the best risk reward profile.
We use a combination of fundamental and technical analysis to determine which stocks to buy and when to buy them. For dividend stocks in particular, we have a proprietary rating system that ranks over 700 U.S. dividend stocks on a weekly basis.
Our composite rating is derived by ranking each stock based on 28 key fundamental and technical data points in five sub-rating categories:
- Risk-Reward Profile (e.g., current yield, Calmar ratio)
- Financial Stability (e.g., sales and EPS growth, ROE, leverage)
- Dividend History (e.g., historical dividend stability and growth)
- Future Dividend Potential (e.g., payout ratio, EPS estimates)
- Relative Strength (e.g., 12-month total return and trends)
Most online brokers offer their clients stock screening software for free. Investors can utilize this software to determine which stocks are the most desirable for their portfolio (using some our key data points as a guide). Note: Our overall rating and each sub-category rating range from 1 (lowest) to 99 (highest). When choosing investments for our own DIY Dividend Portfolio, we tend to target stocks with an overall rating of at least 80.
Below is an example of five widely held dividend stocks that rank very highly in our system.
When analyzing the sub-ratings for each stock, you can see that most top-rated stocks generally have very strong scores (90+) in several of the sub-rating categories as well. As shown in the table below, all of the companies on the list above have long and stable dividend histories (as dictated by their high Dividend History rating).
As a matter of fact, Wal-Mart (NYSE:WMT), Abbott Laboratories (NYSE:ABT), and McDonald's (NYSE:MCD) are all members of the S&P 500 Dividend Aristocrats club, which have followed a policy of increasing dividends every year for at least 25 years. Even though they aren't members of this prestigious group (due to a shorter dividend track record), we still consider stocks like Kinder Morgan Partners (NYSE:KMP) to be very safe long-term investments.
We created our ranking system to help us find the best dividend stocks. If you rank all of the stocks in a universe against their peers on a consistent basis, it becomes clear which companies are the strongest and which offer the best investment opportunities going forward.
2. IDENTIFY A "BUY ZONE" FOR EACH STOCK
We believe that patience is a virtue. Just because a stock has a high rating in our system, it doesn't necessarily mean that you should run out and purchase it that day. We scan the charts of our top-rated stocks daily looking for strong levels of support and resistance, which ultimately helps us determine a target "Buy Zone" for each stock. We believe that patiently waiting for a low-risk entry point for a given stock will drastically improve your long-term investment results.
In other words, we use fundamentals to decide WHICH stocks to buy and we use a combination of technicals and valuation to determine WHEN to buy those stocks.
As we highlighted above, once we have decided that we want to purchase a particular stock, we look for a low-risk entry point to open the position. We call these entry points our "Buy Zones" and they are points at which long-term dividend investors should feel comfortable starting to build a position in the respective stocks. We focus on four key levels of support when determining a "Buy Zone":
- Technical - Support from short and long-term trend lines (i.e, 10-week and 40-week moving average).
- Volatility - Target correction levels based on historical volatility and maximum draw down.
- Valuation - Support levels based on historical valuation multiple.
- Yield - Support levels based on forward dividend yield.
We then average the low end and the high end of these key support levels to determine our target "Buy Zone".
It should be noted that this is how we determine our "Buy Zones", but there are no right or wrong answers here. We encourage investors to think hard about the key levels of support for their own stocks. What is the valuation level that you would feel comfortable buying a certain stock? What yield level makes sense for you? Also, you may want to add different parameters that fit your investment style better. The key takeaway here is that you establish a consistent process for determining a "Buy Zone". Below are links to some our recent articles with specific examples to give you a better idea about how we determine our "Buy Zones".
- Buy Zones: 5 Low Beta Dividend Stocks For Retirees to Consider
- DIY Dividend Portfolio: McDonalds Is In The "Buy Zone"
If you are a new dividend investor and are building your DIY Dividend Portfolio from scratch, don't feel pressured to have a fully diversified portfolio on day one. Dividend investing is a marathon, not a sprint. It's extremely important to be patient when building a long-term portfolio...we can't stress that enough.
3. DIVERSIFY USING STRICT CONCENTRATION LIMITS
Dividend growth investing has proven to have a significant amount of "edge" over the long-term. However, in order for investors to realize that "edge", they need to stay in the game long enough to win. By diversifying your portfolio, you reduce the risk that one stock or industry derails your entire long-term investment plan.
That said, below are our simple Asset Allocation/Position Sizing rules for the DIY Dividend Portfolio:
- Maximum Stock Position (3-5% of total portfolio) - We believe that a diversified DIY Dividend Portfolio should include at least 20-30 high-quality dividend stocks, with no stock accounting for more than 5% of the total portfolio.
- Maximum Industry Position (15-20% of total portfolio) - Ideally, a DIY Dividend Portfolio should include stocks from a variety of industries. However, under no circumstances should one specific industry or sector account for over 20% of the total portfolio.
- Maximum "High Yield" Exposure (20-30% of total portfolio) -Generally speaking, high-yield stocks (i.e., stocks with yields greater than 6.0%) are either speculative in nature or they have different tax circumstances (e.g., master limited partnerships ("MLPs") and real estate investment trusts ("REITs")). Some of these stocks may have company-specific issues that warrant a higher yield or they may operate in a high-risk, volatile industry. While high-yield, speculative stocks are not appropriate for every investor; many of these stocks have strong risk/reward profiles (particularly MLPs and REITs) and can offer good risk-adjusted returns for a diligent investor. That said, we recommend that investors limit their total exposure to "high yield" stocks.
- Maximum Portfolio Beta (less than 0.75) - We believe that low beta dividend stocks offer investors the best long-term risk-adjusted yields. As such, we target a weighted-average beta of less than 0.75 for our DIY Dividend Portfolio. Generally speaking, low beta stocks tend to dampen overall portfolio volatility.
4. UTILIZE CONSERVATIVE OPTION STRATEGIES
While the bulk of our 6% target yield will come from dividend income, we believe that investors can generate an additional 2%-3% per year in option income by implementing the conservative strategies discussed below.
Although the covered call strategy can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value. Investors should consider the following three components when choosing a strike price for their covered call strategy:
- Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). The more volatile the stock, the higher the premium (i.e., the higher the risk).
- Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Note: If the underlying stock does not pay a dividend, the Margin of Safety will be equal to the Premium Yield.
- Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. The more volatile the stock, the higher the expected upside profit.
The table below highlights various covered call options for Microsoft Corp (NASDAQ:MSFT).
Depending on which covered call option you choose, you could enhance your income yield on MSFT by 70-290bps over the next 2-3 months. Clearly, covered calls are a tradeoff between premium yield and upside profit. The higher the premium yield, the lower the upside profit (i.e., the higher the probability that the buyer of the option will exercise his right to purchase your stock).
As a long-term dividend investor, you would obviously like to avoid losing your stock. However, we feel that this is a prudent risk to take in the current market environment. Stable risk-adjusted income yield will continue to be difficult to come by in the years to come and investors should definitely consider implementing a covered call strategy in their portfolio.
We often use a cash secured put strategy to generate income while we patiently wait for the "buy zones" on high-rated stocks that we are stalking. Remember, if you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price above market. That said, below are our two risk management rules of put selling:
- Only sell put options on stocks that you want to own at the price you want to own them. With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
- Don't sell "naked." Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up...don't sell the put.
The table below highlights stocks which have a current yield over 2.5% and are stocks that we would love to add to our portfolio. When choosing a strike price for a cash-secured put strategy, we try to make sure our break-even price on the option trade is in or below our target "Buy Zone". On average, the stocks below have a 2-4 month premium (income) yield of 1.6% with a margin of safety of 8.5%. Note: We prefer utilizing options with expiration dates that are at least 2-4 months out to reduce trading costs.
Clearly, cash-secured puts are a tradeoff between premium yield and margin of safety. Stocks with higher implied volatility, like American Capital Agency (NASDAQ:AGNC), have higher premium yields to compensate the investor for the higher volatility. These stocks will also typically have a higher margin of safety.
5. MAINTAIN A DISCIPLINED EXIT STRATEGY
Even though most investors focus more energy on their entry strategy, your exit strategy is really the driver of long-term investment success. Exiting a bad position or raising cash (i.e., selling winners) at the appropriate time are risk management strategies that you can't afford to ignore.
As discussed above, it's important to diversify your portfolio among various stocks and sectors, paying close attention to any concentration limits that have been set. These concentration limits are the first line of defense when you are monitoring your portfolio on an ongoing basis. For example, if a stock reaches your concentration limit for an individual stock, you will want to take some chips off the table to get back within your limit. Also, if your sector concentration limits are beached, you should lighten up your positions in that particular sector.
Establish Maximum Loss Thresholds
We all make bad investment decisions from time-to-time, it's part of the game. Knowing that, you should never let a few losses destroy your entire portfolio. Establishing a maximum loss threshold for individual stock positions is a great way to mitigate this risk. Depending on the size of your portfolio, we believe that the 0.50%-1.00% of total portfolio value is a good maximum loss threshold range to target.
For example, if you have a $100,000 dividend portfolio with a 0.50% maximum loss threshold, you should limit your loss on any one position to $500 ($100,000 x 0.50%). So if you bought 50 shares of McDonald's at $88.00, you should limit your loss to $10 per share ($500 / 50 shares). This rule should also keep you disciplined with your position sizing!
Have the Disciple to Take A Loss When You Need Too
We can't stress this enough. Most investors have a severe case of loss aversion (i.e., they emotionally can't handle taking a loss), so they end up riding a loser lower and lower with the hope that the stock will one day turn in their favor. If you are following the right metrics, your dividend stocks will show warning signs months in advance of a real problem. The key is to stay disciplined and to get out of a stock when red flags appear...no questions asked (even if it means taking a loss). Trust us, it's a whole lot easier to replace income yield than it is to replace capital (especially in retirement).
Play With The House's Money When You Can
It's important to take profits when you can, especially if you feel that the market is due for a pullback. One strategy that we like to use when taking profits on a big winner is to sell part of our position to get all or most of our initial investment out. This strategy will help you free up some cash while allowing your "winner" to run further.
Building a DIY Dividend Portfolio can and should be simple. The key to success is to establish a consistent investment plan and to follow that plan religiously. As we pointed out in this article, picking the right stocks is only a piece of the puzzle. A dedicated investor should also establish entry and exit strategies for those stocks. In addition, you should remove "buy and hold" from your vocabulary. A long-term dividend portfolio needs to be monitored over time to ensure that your downside risks are being managed appropriately.
Disclosure: I am long AGNC, KMP, MCD, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.