Dividend Portfolios: Diversification Ideas

My post on replacing dividend stocks sold triggered some heated debates by some readers. Some investors believe that by concentrating on their best ideas they could generate the best returns. After all, it is much easier to be up to date on any developments on ten to fifteen companies, rather than focusing on at least 30 individual stocks.

In retrospect, it is easy to identify the best performing stocks over the past two or three decades and develop screening criteria that would have triggered a buy signal. The question is whether this success could be replicated over the next two to three decades. I am highly skeptical of methods that show great promise on paper, because the market is an ever-evolving creature, which tends to fool even the best investors. Even the almighty Warren Buffett has evolved his strategies over the years, from a pure Graham follower, to an avid business owner and stakeholder in some of America’s most successful corporations such as Johnson & Johnson (JNJ), Coca Cola (KO) and Procter and Gamble (PG). Without adapting his methodology to the external environment and his portfolio size, Berkshire Hathaway (BRK.A) would have never made it to what it is today.

Back to sticking to the best investments, I disagree that ten to fifteen companies would provide an adequate diversification for one's portfolio. There are about ten sectors that comprise the S&P 500 alone, which sure leaves you holding just a single stock from each sector if you wanted to concentrate only on your best ideas. Chances are that a concentrated portfolio would not be diversified internationally or diversified into small and mid cap dividend stocks. Over time even the best ideas could take a longer time to live up to their full potential especially if the market ignores a group of stocks such as large caps, while favoring international and mid cap domestic stocks. It is difficult to forecast which would be the best performing sectors or stocks over the next few years

A portfolio consisting of 10 to 15 stocks would likely experience a higher volatility and thus a higher amount of risk in comparison to a portfolio consisting of at least 30 dividend stocks from a diversified list of sectors. Thus, on a risk adjusted basis the more concentrated portfolio would likely underperform a more diversified portfolio consisting of more than 30 individual stocks.

Even if you owned a quality dividend stock from each sector in the S&P 500, your dividend income could suffer greatly if your stock cuts or eliminates its dividends. If you owned Bank of America (BAC) stock and had a 10% allocation to this once high yielding and high dividend growth stock, chances are that your dividend income would have dropped off much faster in comparison to having a 3% allocation to the stock. You also might have not properly diversified your sector risk as well, as you might have picked the worst performer in the sector, even though the other leaders do better.

For example, Coca Cola (KO) has had a horrible ten-year total return in comparison to Pepsi Co (PEP). While the so-called cola wars have swept the globe over the past several decades, predicting which company would be the winner in each decade would have been highly unlikely. Thus, sticking with both competitors in the cola wars could be the best idea for investors.

Now there is another side to this equation and it is that identifying more than 40 quality dividend stocks could be a rather difficult task to handle. My goal has been to diversify as much as possible by holding up to 100 individual securities. This would make my dividend income stream properly diversified and not dependent on a dividend cut by any individual stock. In reality however, requiring a minimum number of companies to own could lead to lowering your entry criteria, which could prove as disastrous for long term performance as concentrating in the best ten stock ideas that you might have.

One thing to add here is that per the paretto principle, I would expect about 80% of my long-term performance to come from 20% of the issues I select. In a 40 stock portfolio that means that about 8-10 companies that I own today would be responsible for most of my gains over time. Since I own mostly dividend growth stocks such as the dividend aristocrats and the dividend achievers I think that this is a fairly accurate statement. In a previous study I found that the percentage of companies that remain in the S&P Dividend Aristocrats index after 10 years is about 30%. In addition to that the average company stayed 6.5 years in the S&P Dividend Aristocrats index from the time of its addition. In addition to that out of 26 initial components of the elite dividend index in 1989, only 7 are still parts of it 20 years later. The companies are: Dover Corp (DOV), Emerson Electric (EMR), Johnson & Johnson (JNJ), Coca Cola (KO), Lowe’s (LOW), 3M (MMM) and Procter & Gamble (PG).

Of course it would have been next to impossible to predict which ones were to remain the index back in 1989. It would be almost impossible to predict which ones would remain in the index 20 years from now as well, due to the limitations of using only past data to reach a conclusion. Thus, by diversifying your risk by spreading your bets to several stocks from as many market sectors as possible, investors would have a higher chance of finding the best dividend stocks, which would generate the most returns for them for the future.

Disclosure: Long EMR, KO, PEP, JNJ, PG and MMM

Comments

[poortorich:]

No need to diversify. Concentrate your efforts on 10-15 of the best companies and keep adding to your position. Dividend machine is right. KO has done nothing because its PE was too high. For something like KO , PEP or JNJ, you will only get good returns if you buy when the PE is reasonable....something less than 20. You would be crazy to buy it when the PE gets over 25

Jun 17 07:54 PM

[qtrinh:]

If you buy great dividend companies with fair price (lower PE), then hold them for a few years while collect your dividend. when the shoot up too high, then sell them collect your profits. Do your research and wait for great company to get cheap before snap it.


On Jun 17 04:52 PM dividendmachine wrote:

> I enjoy the premise of your artyicles and it is clear to me a lot
> of thought goes in your articles
>
> As aperson who has achieved financial independence investing in dividend
> stocks over the past 15 years I would like to make a few comments
>
>
> 1) KO has done poorly over the past 10 years because of teh high
> pe
>
> 2) However if you bought the stock when the PE was under 15 like
> WEB did about 20 years ago you would have a baisis of 5 and an effective
> dividend yield of over 32%
>
> and your appreciation would be about 840% in that time span
>
> Investing is 50% art and 50% science and knowing what companies are
> best takes a certain degree of skill no doubt
>
> Ideally I would like to have 8-10 stocks but when I started 15 years
> ago most of the stocks that are good now were grossly overvalued
>
>
> I have large cap gains n 3 stocks and it would be unwise for me to
> liquidate them for diversity's sake
>
> Today my radar screen contains about 75 stocks and more than half
> of them are suitable for purchase now
>
> I would like to tell you a sure fire way to select a great investment
> at a great price but im afraid a great deal of it is instinct.peace

Jun 18 03:27 AM

[YoYoMama:]

Diversification is good, but it pays to diversify into sectors that are on the rise or have potential for future growth.

For example - there are plenty of publishing companies that pay a nice dividend, but that sector is dying off, so why diversify into that sector?

One needs to apply some common sense to this approach, otherwise you will find yourself holding some real dogs in your portfolio.

Jun 18 09:19 AM

[BigOlDave:]

These are stocks I hold (but will trade if P/E rises) for their dividends, with yields as of today's share price and y-o-y share price appreciation in parentheses (S&P was -31.4% during the last year).

o General Mills Inc.(GIS) = 3.1% (-11.5%)
o CurrencyShares Australian Dollar Trust (FXA) = 4.0% (-15.4%)
o Navios Maritime Partners L.P. (NMM) = 16.4% (-31.8%)
o Tele Norte Leste Participacoes
SA Sponsored ADR (TNE) = 9.4% (-40.9%)
o Himax Technologies Inc (HIMX) = 8.3% (-43.1%)
o AT&T Inc.(T) = 6.8% (-31.1%)

This is a fully diversified portfolio, and it's generating cash for me to use for my "next great pick": I don't reinvest to buy more shares in any of them. Lately, these also defy the reasoning that a high dividend yield means the share price won't appreciate.

But the enormous y-o-y losses more than offset the dividends. Obviously, last year I should have gone 100% into cash and waited for some of these to crater so that I could get some appreciation in share price ...plus the nice dividends.

So take a look at where the price is now and where it is reasonable to assume it will go in the future. P/E is a good measure when used to compare current P/E with both historic ones, and the P/Es of what the experts consider comparable stocks. Obviously, since I'm still hanging onto all the holdings listed, I expect share price apprecfiation, NOT dividends to make up for future decay in share price.

Does anyone have any exciting "next great pick" to recommend? Would anyone recommend dumping any of my picks?

I ask because I'm interested in your responses.

Dave

Jun 18 12:36 PM

[David Van K...:]

In my commment on Dividend Growth Investor's (DGI) earlier article, I specifically stated that I like to concentrate on my 10-15 best ideas, so it looks like this article is a counterpoint to my comment. Disclosure: DGI and I e-mail each other from time to time about dividend investing; I have advertised my book on the Div-Net site (of which he is a founding member); and he has reviewed my book and posted the review on both Div-Net and his own site. So nothing here is meant personally, just a good discussion about dividend investing principles.

In his current article, DGI makes cogent arguments for diversification. In fact, they are textbook arguments for diversification. But not all experts agree on the value of diversification. Andrew Carnegie once said, "Concentrate: Put all your eggs in one basket, and watch that basket." Famed investor Peter Lynch often referred to diversification as "di-worsification."

Here is why I opt for the 10-15 best ideas approach:

--I feel that I can get a well-rounded portfolio from 10-15 stocks. I do not equate "well-rounded" with having a stock from every GIC sector, geographical area of the world, industry, or any other category. I simply aim to do my best job of stock-picking, buying at good valuations, and mixing things up as best I can to achieve a high-performance portfolio.

--The more stocks you own, the more your portfolio will resemble an index. My goal is to beat the indexes, not replicate them.

--I conduct a thorough portfolio review twice per year. I update all information on every stock that I own, then put the burden on each one to "prove" that it deserves to stay in my portfolio when compared with other good stocks available to me. Typically, a portfolio review will lead me to swap out one or two stocks for what seem to be better choices. Thus over long periods of time (which is the investment horizon for a dividend investing strategy), I gradually improve my portfolio.

--I react immediately to "big news" about any of my holdings. "Big news" would include a dividend cut (often reason for an immediate sale) or a major structural change. BAC is a good example. Last year, when they bought first Countrywide and then Merrill Lynch, I put them under the microscope. That on-the-spot examination caused me to sell BAC, as they had changed themselves from a commercial bank to a conglomerate-like money-center and investment bank. I felt there was no basis for evaluating what might happen to the new BAC. I got out well before the subsequent plunge in their price and severe dividend cut.

--I think the 80-20 rule cuts both ways. DGI uses it as an argument for wide diversification. But if 80% of your performance will come from 20% of your holdings (in his example, 8-10 stocks), why not do your best to identify that 20%? I know I cannot nail every one, but I have worked hard on my stock-picking parameters, I'm disciplined enough to buy only at favorable valuations, and I manage my portfolio carefully given reasonable constraints on my time. That gives me a degree of confidence that I can create a very successful 10-15 stock portfolio.

Jun 18 02:46 PM

[notsosmart:]

if you enter @ a good low price,join the drip plan & its a good co. you will be ok.it worked great for me.last year my yield(income) was 7.2%. add ss & the retirement isnt bad.you have to avoid,granite counters,helocs,hummer... vacations,etc.pay off the mortgage as fast as you can.pay the credit card every month. put all that interest you avoid to work for you.

Jun 18 03:37 PM

[BigOlDave:]

David Van Knapp,

Thanks for your comments. I'm going to your site to print out/study other things you've had to say.

Here's some investment advice from King Solomon (Ecclesiastes 11:1-6) which seems to line up with some of the things you've said (though Sol said just pick 7 or 8 that you think will be winners, not 10-15):

Ecclesiastes 11

1 Cast your bread upon the waters,
for after many days you will find it again.

2 Give portions to seven, yes to eight,
for you do not know what disaster may come upon the land.

3 If clouds are full of water,
they pour rain upon the earth.
Whether a tree falls to the south or to the north,
in the place where it falls, there will it lie.

4 Whoever watches the wind will not plant;
whoever looks at the clouds will not reap.

5 As you do not know the path of the wind,
or how the body is formed [a] in a mother's womb,
so you cannot understand the work of God,
the Maker of all things.

6 Sow your seed in the morning,
and at evening let not your hands be idle,
for you do not know which will succeed,
whether this or that,
or whether both will do equally well.


Best regards,
Just another Dave

Jul 23 05:46 PM