Rebalancing My Dividend Growth Portfolio For Diversification And More Yield

Includes: DRI, JNJ, MCD, OHI, PEP
by: David Van Knapp

I had not planned to write another article about my demonstration Dividend Growth Portfolio [DGP] until the next formal Portfolio Review in April. But a couple days ago, I did a rebalancing on the portfolio along the lines anticipated in my January article, "Rising Dividends: My Dividend Growth Portfolio 2012-2013 Report." I thought that perhaps people would be interested in what I did, why I did it, and what the outcome was.

As I wrote in that prior article:

[I]n 2012, I came to understand that the…primary goal of dividend growth investing - increasing the income stream - makes wider diversification more desirable. If you focus on the dividend stream, you come to see that you can get basically the same results from a variety of stocks, so why not spread the risk of possible dividend cuts across more of them, simultaneously reducing the amount of income at risk from any one of them? I don't see it as trading risk for rewards, but rather as reducing risk without reducing the dividend rewards. I was greatly influenced in this conceptual shift by several writers and commenters here at Seeking Alpha.

So I began in 2012 to use my normal portfolio maintenance processes to add some diversity to the DGP. [I]n 2012….I added a net two stocks to the portfolio…The DGP went from 10 stocks at the beginning of the year to 12 at the end.

…As I look forward to 2013, I think I will be doing some creative destruction on this portfolio as I continue to pursue more diversification and a little higher yield. As many of you know, I believe that dividend growth investing (any investing) is best done in a businesslike fashion. The DGP has what I call its Constitution, which I examine at least once a year and amend as I learn more. (You can read the portfolio's full Constitution here.)

I just finished this examination process, and it resulted in a couple of changes:

  • The target number of positions in the DGP was raised from 10-15 to 20-25.
  • The maximum position size was reduced from 20% to 15%.

It turns out that I have two positions that violate the second bullet point: McDonald's (NYSE:MCD) is about 16% of the portfolio, and PepsiCo (NYSE:PEP) is about 17%.

Since I wrote that, MCD rose to 17% of the portfolio and PEP stayed at 17%. So to comply with the new constitutional provisions, and to increase the number of stocks in the portfolio, I decided to trim those positions and purchase two new stocks, provided that I could find two replacements that met all my purchase criteria, including not being overvalued. Here's what I did, step-by-step.

First: I decided to trim the two positions to 12% of the portfolio, giving myself a little cushion under the 15%-max guideline. That proportion (12%) also matches the size of the next two largest positions: Johnson & Johnson (NYSE:JNJ) and Realty Income (NYSE:O). So now I will have four stocks at about 12 % of the portfolio.

Second: I noted that the two stocks being trimmed have yields of 3.3% and 3.0%. So I determined to look for replacement stocks with higher yields, as increasing the portfolio's yield is one of my goals.

Third: I use my own Top 40 eBook as my shopping list for each calendar year. I went through the 40 stocks, checking each one's F.A.S.T. Graph from the links in the eBook. Checking all 40 took about 5-10 minutes. I found 10 that are fairly valued or undervalued at the present time.

Fourth: I took that list of 10 and looked up each of them on Morningstar for their star ratings (which is Morningstar's way of conveying valuation) and yields. After doing this, I was able to eliminate 4 candidates. Three had Morningstar ratings of 2 (meaning overvalued) and one, Microsoft (NASDAQ:MSFT), had too low a yield. This step took about 5 minutes.

Fifth: I examined the Company Quality scores that I had given each stock. All had decent scores, so this became a non-factor. This took about a minute. I was not aware of any news on any of them that would have changed their score.

Sixth: I checked the betas for each stock. This took about a minute. I decided to go with lower-beta stocks. This was a subjective decision. Beta is a new scoring element for me this year. I do not have a target maximum beta for the portfolio nor for any individual stock. That said, I decided I wanted to add two new stocks with betas less than 1, meaning that their prices are no more variable than the S&P 500 itself.

Seventh: I selected my two new stocks.

  • Darden Restaurants (NYSE:DRI), with a yield of 4.3% and a beta of 0.84.
  • Omega Healthcare Investors (NYSE:OHI), a REIT with a yield of 7.0% and a beta of 0.89.

Eighth: I examined the dividend dates for all 4 stocks. Here I found some bad news. The two stocks I am selling have not paid their first dividends in 2013 yet, while I have missed the first dividends for the two stocks I am buying. This bit of bad luck forced me to consider whether to hold off the transactions until March, which would have allowed me to get the dividends on the two stocks I am selling. I did some back-of-the-envelope calculations and determined that even if I make the buys and sells now, I will get more in dividends in 2013 from the new stocks than I would be losing from the sold stocks. The differences in their yields make this possible. So I decided to be a little impatient (and lock in current valuations and yields) and go ahead and do it now. All of this took about 5 minutes.

Ninth: I entered all the orders with E-Trade, where the DGP is maintained. I made sure the sells were executed before the buys. Net of commissions, I sold about $6300 worth of MCD and PEP and purchased about the same amount of DRI and OHI. This took a few minutes.

All of the research and execution took less than half an hour. But that trivializes what is going on. I have been thinking about and turning toward a new strategic direction for this portfolio for over a year. I understand that many readers will think that the portfolio is still way too concentrated. But I intend to approach the diversification with deliberation. In less than a year, the portfolio has gone from 10 holdings to 14 without losing its essential character in any way. Over time, my intention is to get it to at least 20 positions.

While it was not my main mission here, the transactions also accomplished something else that is consistent with my guidelines: Both MCD and PEP are currently overvalued per F.A.S.T. Graphs (they are fairly valued per Morningstar). So these changes allowed me to trim a couple of overvalued positions, increase the portfolio's yield, and improve the portfolio's overall valuation profile, as well as accomplish the main goal of increasing its diversity.

Here's a before-and-after look at the Dividend Growth Portfolio:




Number of stocks



Next 12 months indicated income*


$2506 (+5%)




Yield on cost



Size of maximum holding



*Indicated income as calculated by E-Trade's Income Estimator. The tool uses all currently known information. It does not account for unannounced future dividend changes nor for changes in the composition of the portfolio.

So I feel that I increased the portfolio's likely dividend rewards while decreasing its dividend risk. As Benjamin Graham taught us, increasing risk is not always necessary to gain increased rewards. I like to think that these changes demonstrate that in a concrete example.

Disclosure: I am long MCD, PEP, DRI, OHI. 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.