Weighting Portfolios: Equally, Variably Or By Dividends Generated?

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 |  Includes: AFL, DE, GIS, KMR, MAIN, MCD, MO, OHI, WBA, WMT
by: Mike Nadel

Choosing the best system to allocate funds within a Dividend Growth Investing portfolio is a frequent topic in this corner of Seeking Alpha. Although I have used a tiered method instead of equally weighting all positions, I hadn't really delved into the reasons for my decision ... until now.

For this study, I use tables to illustrate three different methods to weight a $600,000 portfolio of 30 companies. I have not cherry-picked these names to strengthen any particular point of view; they are my actual holdings as listed in the wrap-up of my recent four-part series on DGI portfolio construction. I even use the terminology from that series again in this article to describe my three tiers of quality: DGI Superstars, Role Players and Prospects.

In my actual portfolio, I combine Kinder Morgan Management (NYSE:KMR) and Kinder Morgan Inc. (NYSE:KMI) to form one position but have chosen KMR for this study because of its higher yield. I also eliminated 3M (NYSE:MMM), my lowest yielder, to give this exercise an even 30 companies for ease of computations. Finally, for the sake of privacy, I have not used dollar figures from my real portfolio.

EQUALLY WEIGHTED

Company Cost

Price

Shares Div/Sh Div Pd
Walgreen (WAG) 20000 48.07 416 1.26 $524
Procter & Gamble (NYSE:PG) 20000 77.70 257 2.406 $618
Coca-Cola (NYSE:KO) 20000 38.18 524 1.12 $587
Philip Morris (NYSE:PM) 20000 83.44 240 3.40 $816
Chevron (NYSE:CVX) 20000 120.43 166 4.00 $664
ExxonMobil (NYSE:XOM) 20000 87.16 229 2.52 $577
Johnson & Johnson (NYSE:JNJ) 20000 86.41 231 2.64 $610
McDonald's (NYSE:MCD) 20000 94.36 212 3.08 $653
General Mills (NYSE:GIS) 20000 49.32 406 1.52 $617
DGI Superstars TOTAL 180000 $5666
Kinder Morgan Mgt 20000 79.84 125 5.28 $660
Royal Dutch Shell (NYSE:RDS.A) 20000 64.59 310 3.60 $1116
ConocoPhillips (NYSE:COP) 20000 66.30 302 2.76 $834
Altria (NYSE:MO) 20000 33.88 590 1.92 $1132
Southern Company (NYSE:SO) 20000 41.62 481 2.03 $976
Realty Income (NYSE:O) 20000 39.50 506 2.178 $1102
Kimberly-Clark (NYSE:KMB) 20000 93.48 214 3.24 $693
Wal-Mart (NYSE:WMT) 20000 72.98 274 1.88 $515
Aflac (NYSE:AFL) 20000 57.79 346 1.40 $484
Wisconsin Electric (NYSE:WEC) 20000 41.04 487 1.53 $745
Deere (NYSE:DE) 20000 83.64 239 2.04 $488
Target (NYSE:TGT) 20000 63.31 316 1.72 $544
Role Players TOTAL 240000 $8842
Health Care REIT (NYSE:HCN) 20000 61.44 326 3.06 $998
Omega Healthcare (NYSE:OHI) 20000 28.40 704 1.88 $1324
National Health (NYSE:NHI) 20000 54.90 364 2.94 $1070
National Retail (NYSE:NNN) 20000 30.63 653 1.62 $1058
Main Street (NYSE:MAIN) 20000 29.12 687 1.86 $1278
BCE (NYSE:BCE) 20000 40.96 488 2.2824 $1114
General Electric (NYSE:GE) 20000 23.14 864 0.76 $657
Waste Management (NYSE:WM) 20000 40.44 495 1.46 $723
Vodafone (NASDAQ:VOD) 20000 32.35 618 1.5807 $977
Prospects TOTAL 180000 $9199
TOTAL 600000 $23707
Click to enlarge

(Key -- Cost: size, in dollars, of each position. Price: per-share price as of Aug. 30 market close. Shares: number of shares purchased for each position; Div/Sh: annual per-share dividend. Div Pd: annual dividends paid for the number of shares held in each position.)

This is the preferred method of many investors I deeply respect. It also happens to be one I do not favor.

As DGI practitioners, we want to own high-quality companies with long histories of inflation-beating dividend growth. We have made our choices carefully because we are understandably demanding; in addition to being great businesses, we insist that these companies increase income payments to us for decades to come.

Why, then, would an investor assign the same cash value to a dependable heavyweight such as General Mills and a borderline speculative company such as Omega Healthcare? The former is a blue chip that has paid dividends for 114 consecutive years. The latter has been highly sensitive to Fed activity and has been called a "lower quality" company posing potentially dangerous risks by Seeking Alpha REIT expert Brad Thomas.

Equally weighting Omega Healthcare and General Mills smacks of paying an unproven kid the same salary as a multiple MVP-winner in the prime of his career.

I'm not saying, "Forget the unproven kid." I'm saying, "I'm OK with him being part of my team ... but I won't pay him MVP money until he proves himself worthy."

My DGI Superstars aren't exactly top-secret names I unearthed through years of detective work. There's a reason these brands are investors' favorites: They are the creme de la creme. So why would I want to count on nine third-stringers -- companies I literally might sell tomorrow -- to generate 38% more in annual dividends than nine companies I expect to be core positions for decades?

I wouldn't, which is where the next table comes in.

WEIGHTINGS BY "QUALITY TIER"

Company Cost Price Shares Div/Sh Div Pd
Walgreen 30000 48.07 624 1.26 $786
Procter & Gamble 30000 77.70 386 2.406 $929
Coca-Cola 30000 38.18 786 1.12 $880
Philip Morris 30000 83.44 360 3.40 $1224
Chevron 30000 120.43 249 4.00 $996
ExxonMobil 30000 87.16 344 2.52 $867
Johnson & Johnson 30000 86.41 347 2.64 $916
McDonald's 30000 94.36 318 3.08 $979
General Mills 30000 49.32 608 1.52 $924
DGI Superstars TOTAL 270000 $8501
Kinder Morgan Mgt 20000 79.84 125 5.28 $660
Royal Dutch Shell 20000 64.59 310 3.60 $1116
ConocoPhillips 20000 66.30 302 2.76 $834
Altria 20000 33.88 590 1.92 $1132
Southern Company 20000 41.62 481 2.03 $976
Realty Income 20000 39.50 506 2.178 $1102
Kimberly-Clark 20000 93.48 214 3.24 $693
Wal-Mart 20000 72.98 274 1.88 $515
Aflac 20000 57.79 346 1.40 $484
Wisconsin Electric 20000 41.04 487 1.53 $745
Deere 20000 83.64 239 2.04 $488
Target 20000 63.31 316 1.72 $544
Role Players TOTAL 240000 $9289
Health Care REIT 10000 61.44 163 3.06 $499
Omega Healthcare 10000 28.40 352 1.88 $662
National Health 10000 54.90 182 2.94 $535
National Retail 10000 30.63 326 1.62 $528
Main Street 10000 29.12 343 1.86 $638
BCE 10000 40.96 244 2.2824 $557
General Electric 10000 23.14 432 0.76 $328
Waste Management 10000 40.44 247 1.46 $361
Vodafone 10000 32.35 309 1.5807 $488
Prospects TOTAL 90000 $4596
TOTAL 600000 $22386
Click to enlarge

Equal-weighting proponents say their method "protects" their portfolio by preventing one or two bad apples from spoiling the whole bunch.

Well, I'd rather protect my portfolio by allocating more money to the companies in which I have the most confidence -- both as businesses and dividend-growers. I am willing to buy some higher-yielding, arguably less "blue-chippy" stocks, but I'd rather not have oversized percentages of my dividends come from them. So I'll buy considerably more McDonald's than Main Street Capital, thank you.

The above 30-20-10 breakdown approximates what I'm trying to do with my portfolio, but I prefer ranges to absolutes. In other words, when I'm fully invested, my DGI Superstars might range from 25k-35k and my Role Players from 15k-20k. That way, I don't feel I have to buy $20,000 worth of low-yielders such as Aflac and Deere to have "full positions." It also paves the way for the Kinder Morgans and Altrias to earn promotions to Superstar status eventually.

One important thing I must keep reminding myself: It's not about the dollars for each position, it's about the dividends and their growth over time. Which brings us to an interesting third option.

WEIGHTED BY QUALITY TIER & DIVIDENDS PAID

Company Cost Price Shares Div/Sh Div Pd
Walgreen 36245 48.07 754 1.26 $950
Procter & Gamble 30692 77.70 395 2.406 $950
Coca-Cola 32377 38.18 848 1.12 $950
Philip Morris 23280 83.44 279 3.40 $949
Chevron 28662 120.43 238 4.00 $952
ExxonMobil 32859 87.16 377 2.52 $950
Johnson & Johnson 31108 86.41 360 2.64 $950
McDonald's 29063 94.36 308 3.08 $949
General Mills 30825 49.32 625 1.52 $950
DGI Superstars TOTAL 275111 $8550
Kinder Morgan Mgt 10619 79.84 133 5.28 $702
Royal Dutch Shell 12530 64.59 194 3.60 $699
ConocoPhillips 16840 66.30 254 2.76 $701
Altria 12366 33.88 365 1.92 $701
Southern Company 14359 41.62 345 2.03 $700
Realty Income 12680 39.50 321 2.178 $699
Kimberly-Clark 20192 93.48 216 3.24 $700
Wal-Mart 27149 72.98 372 1.88 $699
Aflac 28895 57.79 500 1.40 $700
Wisconsin Electric 18796 41.04 458 1.53 $701
Deere 28689 83.64 343 2.04 $700
Target 25767 63.31 407 1.72 $700
Role Players TOTAL 237084 $8402
Health Care REIT 10015 61.44 163 3.06 $499
Omega Healthcare 7554 28.40 266 1.88 $500
National Health 9333 54.90 170 2.94 $500
National Retail 9465 30.63 309 1.62 $501
Main Street 7833 29.12 269 1.86 $500
BCE 8970 40.96 219 2.2824 $500
General Electric 15226 23.14 658 0.76 $500
Waste Management 13830 40.44 342 1.46 $499
Vodafone 10223 32.35 316 1.5807 $500
Prospects TOTAL 92449 $4499
TOTAL 596442 $21451
Click to enlarge

In the third portfolio, I strive to produce $950 in annual dividends from each top-tier company, $700 from each member of the second group and $500 from each third-stringer. As is the case in the other options presented, those would just be the starting figures. We'd expect these dividends to grow significantly over time, requiring occasional portfolio rebalancing.

I like this concept because I'm all about dividend growth and about maximizing investments in top-tier companies. However, there are enough quirks to make me uncomfortable with this plan. Do I really want to spend $36,245 to create $950 in Walgreen divvies and $27,145 just to reach the $700 mark for Wal-Mart? Again, going to ranges -- say, $800-$1100 for the Superstars and $600-$800 for Role Players -- would create more flexibility.

Still, even as I always, always, always keep an eye on dividends and their growth, my plan for now is to stick with variable dollar weightings by tier. Using ranges instead of absolutes, it is a fairly simple way to put more faith in my best ideas while being open-minded about other possibilities.

Disclosure: I am long WAG, PG, KO, PM, CVX, XOM, JNJ, MCD, GIS, KMR, RDS.A, COP, MO, SO, O, KMB, WMT, AFL, WEC, DE, TGT, HCN, OHI, NHI, NNN, MAIN, BCE, GE, WM, VOD, MMM, KMI. 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.