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Where We Left Off

I closed Part IV of this series with several questions about moving forward:

  • How would we adjust our portfolio in an intelligent and productive way?
  • Does the balance of our asset classes make sense?
  • Do we need limits on our position sizes and if so, what should they be?
  • What about sector sizes -- do we need limits on these, too, and if so, what should they be?
  • Is our sector diversification sufficient? How do you know when it's sufficient?

These questions and others like them remained unexamined.

As is so often the case with articles in Seeking Alpha, readers' comments gave me many ideas, not only about what I needed to do, but also how I might best go about it.

Perhaps one of the most pertinent suggestions came from Dave Van Knapp when he wrote: "My reaction to your article is a single suggestion: STOP." He continued with suggesting, as did others -- for example, Bob Wells, PendragonY, Geminvestor, and dendv -- that I work on a plan, that I define our goals and strategies, and that I determine the tactics to use to carry out the strategies in order to achieve the goals.

And stop I did. I didn't do any of the selling and rearranging that I had planned for the following week. Instead, in preparation for making a plan, I did a lot of reading and thinking about what I was doing and how I could go about it in a more focused and effective manner. That period of reading and reflection resulted in some important insights for us. And one of the most important had to do with one of the core goals I previously had, a goal that was influencing my actions to a great degree, and which had a profound impact on much of our investing activity.

That insight had to do with my having written that "we need a stream yield of about 8%. And I can't lose sight of that."

Obviously, as Bob Wells pointed out in a comment and Philipsonh discussed with me in a message, trying to maintain an 8% income stream means assuming much greater risk than a more modest stream would entail. So that motivated me to take a closer look at our income and expenses, and I found something that really surprised me. We don't need an 8% stream to maintain our lifestyle. Rather, we could do just fine with 5%-5.5% (assuming some dividend growth for inflation).

I realized that I wasn't taking the marginal utility of money and its diminishing value into consideration at all. The 8% would have been very nice to have and would have allowed for a lot of special treats, but for each position I might acquire with a higher risk factor as the price for a higher yield, I would have subjected us to the possibility of a loss of capital that would have meant more to us than the increased income would have meant in our situation.

In other words, that increased income was something we truly didn't need. It was just gravy in a manner of speaking, and the price of that gravy was simply not worth it.

Making The Plan

At this point, I began to write our plan. I had many models and examples to refer to. I used the one outlined by Bob Wells in his article, "Revising My Portfolio Business Plan," which you can find here.

I also carefully read the criteria outlined by Parsimony Investment Research in detail here.

I found Dave Van Knapp's article, "Rebalancing My Dividend Growth Portfolio For Diversification And More Yield" very helpful (read it here).

Of course, I also read Dave's great book, Top Dividend Growth Stocks For 2013.

In addition, many people who commented on my Muddling Through series volunteered useful information about the plans they follow.

Rather than reproduce the plan here in its entirety, especially because so much of it closely resembles the sources I've cited in the preceding paragraph, I thought I'd just outline what I think the highlights are and some of the differences; and I'll talk a bit about some of the decisions we had to make and what influenced them.

The Plan's Primary Goal

The primary goal is straightforward: to produce sufficient income from dividend-paying stocks (common and preferred), interest-paying municipal bonds, and mutual fund distributions to supplement our income from Social Security and pensions so that we are able to maintain our lifestyle without reducing our principal, and in this way, will be able to leave our portfolios' full value to our children.

Asset Allocation And A New Portfolio

One of the first things I took a look at was our asset allocation ratio. In my previous article, I mentioned that we had a 65/35 split between stocks and bonds. Additionally, we had a tax-free bond fund and a global dividend income fund. We also had one preferred position. Although the preferred position and the income funds weren't fixed income, they're certainly different from our dividend-paying stocks. So that's when I got the crazy idea to create a new account at Fidelity and transfer all of these bonds, funds, and the preferred position to that new account, which I named "Fixed Income."

I also mentioned that we had decided to acquire some more preferred holdings. We bought four more preferreds and transferred them to the so-called "Fixed Income" account, too. I like this arrangement because it lets me concentrate all my dividend stocks in one account (now called "Dividend Investing"). The time I spend on each of these accounts will vary quite a bit, and it's easier for me to focus on the different types of investments this way.

There is one anomaly in the fixed income portfolio. In my previous article, I mentioned our large position in Raytheon (NYSE:RTN), and explained the reasons that it would never be sold unless we became destitute. So I decided to move that stock to the fixed income portfolio, too. Its anomalous position had to be accounted for somehow in our plan.

Dave Van Knapp said in relation to RTN and writing our plan: "Work the holding of Raytheon into [the plan]. Goal: Never sell the Raytheon. That's fine. Given that, what does that mean for the rest of your goals and plans?" So we decided to treat RTN as a fixed income instrument and to hold it until "maturity" (our deaths).

Now our allocation is 56% dividend-paying stocks and 44% "fixed income," not too far from the standard 60/40, not that we were aiming for that. We find that we feel comfortable with this split and with our lower-risk, rather dependable "Fixed Income" account.

As I shaped these two accounts, I also decided that the two income funds in the fixed income portfolio would be the only funds we'd have in our portfolios. Although the monthly income from funds is nice to have, I prefer to have more control over all the positions we maintain. I didn't know whether this was the best decision to make, but I was encouraged when I read in Top Forty Dividend Growth Stocks that Dave Van Knapp, in his list of "Strategies and Practices Not Used," included not using mutual funds or ETFs.

When I talked about the ratio of stocks to bonds above, I was doing the calculation without mentioning cash in the Dividend Investing portfolio. The 56%:44% is only calculated based upon invested funds. If I include uninvested funds, then cash is at 23.6%, which is very high.

The reason it's so high is because we sold several positions to enable the reallocations and rebalancing, and have not yet redeployed all of those proceeds. Our plan is to keep about 10% of the portfolio in cash so that we can take advantage of good buying opportunities as they arise.

There is also cash in the Fixed Income portfolio. Essentially, that's where our dividend and interest income go. As dividends come into the Dividend Investing account, we transfer them to the Fixed Income account, where the income from that account also gets swept.

As we need cash to supplement our monthly income, we transfer it from Fixed Income to our checking account. The bulk of the cash in the Fixed Income account is our emergency fund.

Position Size And Dividend Investing Style

Now that we had our asset classes set up, we turned to maximum position size. I've read lots of suggestions as to maximum position size, ranging from about 1% to 8%. But clearly, as many point out, that percentage is really based on the maximum amount of money one is prepared to risk losing in a given position.

In the dividend investing portfolio, our position sizes range from 0.6% in Two Harbors Investment Corp. (NYSE:TWO) to 7.4% in AT&T (NYSE:T). The average position size is 2.18%, which is within our risk tolerance level. I would say that (a very flexible) 3% is about the maximum we're willing to risk. I say "very flexible" because one has to take the riskiness of the position itself into account.

T, for example, is a large position, but with its beta of 0.69, its stability as a company, and its position within the industry, I'm not concerned that we'll suffer any huge loss. Not to mention the fact that T -- as much as any stock can be -- is really a "hold forever" stock for us. Additionally, as dividend investors, we're not going to be unduly dismayed at the position's price fluctuations -- for us, it's the dividend's reliability and, to some degree, growth that matter.

This prompts me to talk a little about dividend growth. I call myself a dividend investor in the title of these articles, but not a dividend growth investor as far as our investing style is concerned. I mentioned in another article that because of my perceived investing time frame -- about 5 more years -- and the fact that I'm retired, dividend growth doesn't figure that greatly in our stock picking.

And by that I mean that I don't limit myself to stocks in the CCC lists. That being said, however, I do want to point out that I certainly consider dividend growth carefully when I pick stocks because of the need to keep up with inflation. Nevertheless, I'm more concerned with the cutting of dividends, and try to avoid positions that show a history or tendency to cut. I'm fine with a good company that has perhaps not raised dividends in the last couple of years, as long as it hasn't cut its dividends.

A quick check of our Dividend Investing Portfolio shows that out of 35 positions, 15 of them have raised dividends annually from 3 to 12 years. That should help with inflation concerns.

The entire portfolio is listed below so you can get a more detailed look at our yields, position sizes, and sector sizes.

Diversification: Number Of Positions And Sectors

And mentioning sector size brings me to the question of diversification in our Dividend Investing Portfolio, that is, diversification through the number of positions we have and also in the number of sectors.

There's quite a bit of diversification in positions: there are currently 35 positions in the Dividend Investing Portfolio. In the last article's comments, there was some discussion about whether I had too many positions or not enough. I'll just say that I feel comfortable with this many and believe that I can handle more when necessary. I'm looking at about 50 positions eventually.

As far as sectors go, I've kind of made up my own definitions -- much the way I played with what I'm calling Fixed Income in the other portfolio.

Here's the way the sectors look in the portfolio now: Consumer Discretionary; Technology; Health Care; Telecommunications; Utilities; Energy (both MLPs and Stocks); Financials - Asset Mgt. (both BDCs and Stocks); Equity REITs; Mortgage REITs.

So given my classification scheme (for example, lumping MLPs and stocks together or separating equity REITs from mortgage REITs), we have nine sectors, not evenly balanced at all. As you can see from the portfolio below, they range from 2.2% for one sector to 17.1% for another. One of the many questions I still have to solve is what kind of cap, if any, to place on sector percentages. I just don't know whether or not entire sectors collapse at once. I expect they can and do.

The only sector I'm really concerned about at this point is the mortgage REIT sector, which is my largest at 17.1%. Even though I have a great deal of diversification with nine different positions, a significant rise in interest rates could wreak havoc on all of them.

I've already modified my holdings in this sector by reducing some of our positions. I'm just going to have to give this more thought before reaching a decision. It's not an acutely time-sensitive question, because I don't think anyone believes that interest rates are going to zoom up in the very near term. In the meantime, we're collecting some nice dividends.

Nevertheless, now that I realize that my overall yield need is much less than I thought, I'm sure I'll begin trimming our mortgage REIT sector size and use the money from that to invest in other sectors, both by increasing some of we already have and by creating positions in some unrepresented sectors -- Consumer Staples, for example.

The Portfolio

Here's the Dividend Investing portfolio as it stood a few days ago:

Symbol

Sector & Symbol Description

Current Yield

Position Percentage

Sector Alloc.

Cash

23.6%

Consumer Discretionary

DRI

DARDEN RESTAURANTS

4.33%

2.2%

2.2%

Technology

CA

CA INC COM

4.07%

2.2%

INTC

INTEL CORP

4.41%

2.1%

STX

SEAGATE TECHNOLOGY PLC

4.77%

2.2%

6.5%

Health Care

AZN

ASTRAZENECA

6.20%

2.2%

MRK

MERCK & CO INC

4.0%

2.2%

4.4%

Telecommunications

T

AT&T INC COM

5.0%

7.4%

VOD

VODAFONE GROUP

6.0%

2.5%

9.9%

Utilities

PPL

PPL CORP

4.8%

2.2%

SO

SOUTHERN CO

4.4%

2.3%

4.5%

Energy (MLPs & Stocks)

TOT

TOTAL

5.1%

2.6%

LINE

LINN ENERGY LLC

7.5%

1.3%

QRE

QR ENERGY LP UNIT LTD PARTNERSHIP INT

11.2%

1.8%

VNR

VANGUARD NAT RES

8.8%

4.8%

MMP

MAGELLAN MIDSTREAM PARTNERS LP

4.1%

1.7%

MWE

MARKWEST ENERGY PARTNERS LP

5.8%

1.0%

13.1%

Financials - Asset Mgt. (BDCs & Stocks)

EFC

ELLINGTON FINL LLC COM

11.6%

3.2%

PNNT

PENNANTPARK INVT CORP

9.7%

2.0%

PSEC

PROSPECT CAP CORP

11.8%

1.2%

6.4%

Equity REITs

LSE

CAPLEASE INC

5.0%

1.0%

MNR

MONMOUTH REAL ESTATE INVT CORP

5.5%

1.9%

STAG

STAG INDL INC COM

5.2%

1.4%

EXL

EXCEL TR INC COM

5.1%

0.9%

ROIC

RETAIL OPPORTUNITY INVTS CORP

4.4%

0.9%

HTA

HEALTHCARE TR AMER INC

5.0%

0.8%

OHI

OMEGA HEALTHCARE INVS INC

6.5%

5.5%

12.3%

Mortgage REITs

AMTG

APOLLO RESIDENTIAL MORTGAGE INC

18.7%

1.5%

ARR

ARMOUR RESIDENTIAL REIT INC

14.5%

1.1%

DX

DYNEX CAPITAL INC

11.1%

2.2%

MFA

MFA FINL INC

9.1%

0.9%

MITT

AG MTG INVT TR

12.6%

2.0%

MTGE

AMERICAN CAP MTG INVT CORP

14.1%

1.7%

NCT

NEWCASTLE INVT CORP

8.1%

3.7%

TWO

TWO HBRS INVT CORP

17.6%

0.6%

WMC

WESTERN ASSET MORTGAGE CAPITAL

17.0%

3.3%

17.1%

8.1% Average Yield

76.4%

Conclusions

Looking at the portfolio, the allocation problems that I spoke about in the text above become readily apparent.

One striking thing is the 8.1% average yield (though that figure is not weighted -- sadly, because I don't know how. The very next thing I'll do is find out how to determine a weighted average yield).

Because we discovered that anything above 5.0%-5.5% in yield is not worth the marginal utility we'd get, clearly we are now able to reduce some more of the risk in the portfolio and acquire sounder, more stable positions and still be able to achieve our income goals.

We're on our way now. I don't think I'm deceiving myself in thinking that we're in a much better position than we were when I began this series of articles on January 28th. We still have a great deal to do, but the path to doing it is a lot better illuminated now.

What I meant most when I said we're in better position now is how much I've learned by writing these articles.

I've learned because of the focused thought I've had to apply in order to describe clearly what was going on in our learning how to invest and thereby, discovering our dreadful mistakes.

But I've learned the most from attentively studying the generous and thoughtful comments from those who read the articles, and took the time to address my problems and provide many avenues for understanding and study based on their own experiences.

As time goes on, I'll continue to post and describe our ongoing process of sculpting, sharpening, and better defining our goals, strategies, and tactics. I'll be closely tracking the results of our efforts, and am looking forward to sharing them with you.

Source: How One Retiree Is Muddling Through Dividend Investing: Part V - On Our Way