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What Is Parity?

When I write about "What Next To Buy, And Why?", I usually discuss something that I call "parity." (OK, let's be fair: I always talk about parity.) What I mean by parity in this context is the target Percent Allocation that I would like all of the stocks in my IRA to have in terms of the value of that stock vis-à-vis the total value of the portfolio (less any currently available cash). At present I have 34 positions in my IRA, which means that my target parity number is 1 divided by 34, or 2.94%.

What I am then looking for when I survey my current positions is whether or not each stock is at or above this parity target percentage, or below it. If it is below it, then what I have tried to do in the past is to get it up as close to parity as I can by buying more shares with any funds that become available (usually collected dividends, but sometimes (not often enough) contributions to my IRA).

If a stock is well above parity, and has also shown a gain in value that is at least as high as it is over the Percent Allocation parity target (in dollars), then it is a candidate for "taking profits," whereby I might sell some of the shares of that position, up to the number of shares that it is over parity, and re-invest those funds in something that has a higher yield, usually resulting in a new position ending up in my IRA.

The reason parity in terms of Percent Allocation is important to me is that I'm trying to minimize the risk that any one position might pose to the overall value of my portfolio if something untoward should happen to that company (or its industry) that would cause the value of its stock to plummet. My ambition is to have 50 positions in my IRA, so that my Percent Allocation parity target is an even 2.00%.

Below is a list of the stocks I currently hold in my IRA, ordered by their ticker symbol, with their percent allocation, as well as how far they are either above or below parity, also expressed as a percentage:

As Of:

Alloc to

2/12/2014

%

Parity

Company

Ticker

Alloc

Diff

AFLAC, Inc.

(NYSE:AFL)

3.31%

0.37%

American Capital Agency

(NASDAQ:AGNC)

2.55%

-0.39%

BHP Billiton plc

(NYSE:BBL)

2.82%

-0.12%

ConocoPhillips

(NYSE:COP)

3.21%

0.27%

Crescent Point Energy Corp

(NYSE:CPG)

2.84%

-0.10%

Digital Realty Trust, Inc.

(NYSE:DLR)

2.60%

-0.34%

Freehold Royalties, Ltd.

(OTCPK:FRHLF)

2.65%

-0.29%

General Dynamics Corp

(NYSE:GD)

3.28%

0.34%

Hasbro, Inc.

(NASDAQ:HAS)

2.92%

-0.02%

Harris Corporation

(NYSE:HRS)

3.02%

0.08%

Johnson & Johnson

(NYSE:JNJ)

2.92%

-0.02%

Kimberly Clark Corp

(NYSE:KMB)

3.04%

0.10%

The Coca-Cola Company

(NYSE:KO)

2.84%

-0.10%

Lockheed Martin Corporation

(NYSE:LMT)

3.91%

0.97%

Lorillard, Inc.

(NYSE:LO)

3.34%

0.40%

Main Street Capital Corp

(NYSE:MAIN)

3.39%

0.45%

Altria Group, Inc.

(NYSE:MO)

2.46%

-0.49%

Microsoft Corporation

(NASDAQ:MSFT)

3.16%

0.22%

National Grid, plc

(NYSE:NGG)

3.06%

0.11%

Annaly Capital Mgmt

(NYSE:NLY)

2.56%

-0.39%

National Presto Industries

(NYSE:NPK)

2.76%

-0.18%

New York Community Bancorp, Inc.

(NYSE:NYCB)

3.53%

0.59%

Omega Healthcare Investors, Inc.

(NYSE:OHI)

2.41%

-0.53%

Philip Morris International

(NYSE:PM)

2.70%

-0.24%

Prospect Capital Corporation

(NASDAQ:PSEC)

2.97%

0.03%

Resource Capital Corp

(NYSE:RSO)

2.87%

-0.07%

SeaDrill, Ltd.

(NYSE:SDRL)

3.01%

0.07%

AT&T

(NYSE:T)

2.43%

-0.51%

Textainer Group Holdings Ltd.

(NYSE:TGH)

2.50%

-0.44%

Two Harbors Investment Corporation

(NYSE:TWO)

2.39%

-0.56%

Universal Insurance Holdings, Inc.

(NYSE:UVE)

2.80%

-0.14%

Vodafone Group, plc

(NASDAQ:VOD)

2.96%

0.02%

Walgreen Company

(NYSE:WAG)

3.45%

0.51%

Wisconsin Energy Corporation

(NYSE:WEC)

3.32%

0.38%

The Goal

I am a Dividend Growth Investing [DGI] type of investor, although I am somewhat unorthodox in that I hold a number of stocks that a DGI "purist" might not consider having in their portfolio, such as mREITs and BDCs. While the value of my portfolio is important to me, and I do, of course, want it to go up, I am primarily interested in creating a future revenue stream from the dividends and distributions that the stocks in my portfolio generate so that I can use that income in retirement to replace the paycheck that I will be giving up when I decide to finally hang up my spurs and kick back on the porch.

One problem that I am faced with is that, for a variety of reasons, I'm quite a bit behind in terms of saving for that eventual retirement, and I therefore need to accelerate the growth of my IRA, and the income that it generates, as quickly and safely as I can.

I plan on retiring by the time I am 67 at the latest, assuming I live that long. That target date is 15 years in the future. If I can retire earlier, I will, but in the meantime I need to assume that it's going to take me until I'm 67 to get my retirement portfolio to the point where it generates a reliable income that will help me meet my cash needs in retirement; a level of income that, along with Social Security and my "pension" from my current employer, will allow me to live comfortably and not have to resort to eating cat food on Saltines and living under a bridge.

That's the background of the goal of my plan to be able to retire comfortably, and thus not have to have some sort of part-time job in retirement in order to meet my cash demands (or worse).

The Question

In a recent article about how I use My Mad Method [MyMM] to determine what next to buy, and why, a reader asked a question that I have seen floated about several times on a variety of different DGI-oriented articles, including some of my own. The question basically asks whether parity of the income that each position in my portfolio generates should take precedence over the parity of the value of each position.

This is actually a valid question, and one that I've pondered for a while. The nut of the argument is, if my income stream from dividends is the most important priority for how my portfolio performs, then shouldn't there be balance among the positions in my portfolio in terms of how much revenue each position generates so that if a high source of income makes a drastic cut in its dividend, it won't affect my income too severely?

The Sorting

Since this question popped up again recently, I decided to take a look at the dividends that each of my stock positions generates, or rather, what I anticipate each will generate in the current calendar year. One thing I have always tracked on my MyMM spreadsheet is the projected annual dividends of each of my positions. This is a calculation that I plug in whenever I buy more shares of an existing position, or add a new position to the stable.

(However, one thing to keep in mind is that as the current year progresses, you won't get the full amount of the dividends in the current year that a new addition will provide in future full years, so you need to adjust your projected amount from new purchases in the current year based on how many dividend payments you're actually going to get throughout the remainder of this year.)

With this number available, I display it on my "dashboard" of all of my stocks, along with other summary and high level information about my portfolio. I then calculate the Percent of Projected Annual Dividends for each position against the sum of all projected dividends, and then rank all of my positions based on their projected dividends and display that Rank on the dashboard as a quick reference; using this "Projected Dividends Rank" is easier than trying to interpret individual percentages of the expected total amount of dividends for the year relative to each other.

In order to analyze the question of whether parity of dividend income should take as much or more of a priority than parity of the Percent Allocation of each position, I made a copy of this "dashboard" worksheet, and simply sorted the whole thing by this Projected Dividends Rank column, in descending order. The reason for sorting in descending order is that I was most interested in the stocks that were contributing the least to my total expected income this year, so I wanted them to be at the top of the sorted results.

Below is the colorful result of that sorting. What you will see is the starting MyMM Rank of each position, its Projected Dividends Rank (in descending order), its Gain/Loss Rank (the ranking of how much each position has gained or lost (as a percentage) based on the current value versus its cost basis), and then the Combined Rank, which simply takes the sum of the other three Ranks and ranks that value to give me an overall picture of how each position stands in comparison to all the others. (These Ranks have been given Conditional Formatting in Excel so that the lowest numbers are more green, with #1 being the greenest, and the highest numbers are more red, with #34 being the most red.) I've also included the Recent Yield of each position, the Percentage of Projected Annual Dividends (for the current year), the Percent Gain or Loss of each position during its lifetime in my portfolio, and the Percent Allocation of each, all for additional reference:

I've added some breaks (additional lines) to the list above in order to denote a number of "levels of interest" about the results of the sorting:

  • The first break, coming after UVE, simply separates the top ten worst performers in terms of their Projected Dividends Rank from the rest of the positions.
  • The next break (right after LMT) is the mid-point between the top and bottom halves of the entire portfolio in terms of the Projected Dividends Rank.
  • And the last break (right after LO) separates stocks that I expect to each earn less than 2.94% of the total income for the year (the parity target) from those that should earn 2.94% or more of that total.

I've also drawn a solid black line under JNJ, which is the cutoff point between those stocks that have at least a 3.00% Yield (those below the black line), and those that have a Yield less than 3.00% (above the black line; with the slight exception of MSFT, which just squeaked below a 3.00% Yield). I did this to keep the Top 10 lowest contributors to my income together, because as a group they paint an interesting picture.

The Conundrum

Take another look at the Top 10 lowest contributors to my annual projected income (let's call them the "Worst 10 Dividend Producers" [in my portfolio]), and you will see a lot of familiar, even household names.

So what's wrong with this picture? Is there anything wrong with this picture?

Most of these companies are either Dividend Champions or Dividend Contenders, with the notable exception of UVE, which is not even a Dividend Challenger or Near-Challenger. What's remarkable about this group of Worst 10 Dividend Producers (again, in my portfolio) is that almost all of them are also in the Top 10 in terms of having realized the best gains to their value over my cost basis for each of them.

The notable outlier in this group is, interestingly enough, The Coca-Cola Company, which I've now highlighted in yellow. Not only is KO in the Worst 10 Dividend Producers group, but it is also 24th in terms of Gain/Loss Rank, putting it in the "Worst 10 Gainers/Losers" group as well.

Since all of these Worst 10 Dividend Producers (except KO) are also in the Top 10 Gainers group, it's little wonder that their Yields are very close to or below 3.00%.

My initial thought was, perhaps what I need to do is buy more of these dividend stalwarts to help bring their contributions to the total annual income more in line with parity for projected dividends? But since they're almost all high gainers, their Percent Allocation numbers are also quite high, almost all above parity for that figure (again, except for KO, and also UVE, which I recently sold off about 36% of because it had appreciated so very much in value). Adding more to these positions would "violate" my stated condition that I don't want any one stock to be in a position to drag the portfolio's bottom line down if something significantly bad should happen to its share price.

And therein lies the conundrum: Could this be an indication that companies that are known throughout the investing community to be "must haves" in terms of a healthy DGI portfolio have achieved that status not because they produce the most dividend income (when held in relative Percent Allocation parity), but because in addition to having decades-long histories of consistently raising their dividends, they also appreciate in value faster and more steadily than those that have significantly higher Yields (many of which have suffered significant hits to their values in the time that I've held them)?

The fact that some of the best DGI stocks produce the worst in relative income seems counter-intuitive.

So the question becomes, should I take the dividends that I am generating from everything and invest them into more shares of these Worst 10 Dividend Producers so that they can contribute more to the total income than they already are, but which would at the same time throw their Percent Allocations well above parity?

Or, in the interest of my stated goal of generating the most income from my portfolio as possible, should I harvest profits from such Dividend Champions as AFL, WAG and (Contender) LMT so that I can add more shares to those positions that are higher yielders, thereby increasing the acceleration of the total amount of income that the portfolio produces annually?

The Debate

The reason for aiming for parity in terms of Percent Allocation is to protect the value of my portfolio from a drastic drop in price of any one stock, or even an industry or segment. By keeping the value of all of the positions in my portfolio close to the same parity target, I protect my bottom line, but I don't necessarily maximize the income that my portfolio can generate.

If I continue to shave off shares of stocks that are the Worst Dividend Producers but Best Gainers (but keep them at or above Percent Allocation parity), then I will eventually erode my holdings of what are for the most part companies that are considered dividend stalwarts. However, if I take those harvested profits and invest them in companies with higher yields, but which may not appreciate in value as steadily as those dividend stalwarts, then I will be increasing the income that my portfolio generates at an accelerating rate.

The problem becomes that while I could realize a short-term acceleration in the income that my portfolio can generate, I run the risk of relying too heavily on those companies with higher yields, but who do not have proven track records of increasing their dividends annually, and which in reality raise and lower their dividends based on changes to their own business situations.

When I reach retirement, I need the most income that my portfolio can generate, but I also want that income to grow at a steady, reliable rate that will (hopefully) beat the overall rate of inflation, and that is what the Dividend Champions, Contenders and Challengers [CCCs] are valued for.

The Proposal

As I mentioned above, my expected retirement won't come for another 15 years or so. Based on that, I think that for the time being I will accept a slightly higher risk of having the value of my portfolio erode in exchange for accelerating the amount of income that it currently produces, and using that accelerated income to continue to invest at as rapid a rate as I can. Then, as I continue to approach my target retirement age, I will start shifting from higher yielding non-CCC companies to more "traditional" Dividend Champions, Contenders and Challengers. This will require some careful monitoring of those companies that generate a disproportionately higher percentage of income so that when I do choose to sell them off I don't suffer losses that exceed the amount of income they have generated over the lifetime that I have held them; to do otherwise would be self-defeating. I also need to keep an eye out for opportunities to load up on shares of "safer" Dividend CCCs during dips in their prices in order to acquire them at the best possible value.

Therefore, I am proposing that I implement this strategy for my IRA in a three-stage process:

  • During the next 5 years (2014 thru end of 2019), continue to harvest profits from those companies that have appreciated enough in value that I have realized significant gains, and only sell off what is above what will keep them at parity in terms of their Percent Allocation; during this time, use those harvested profits to invest reasonably in higher yielding, higher risk stocks that are of appropriate value, such as REITs, mREITs and BDCs, as well as venturing into Preferred Stocks, keeping them at or close to Percent Allocation parity; and use this strategy to increase the number of holdings in my IRA to my target of 50 positions.
  • During years 6 thru 10 (2020 thru end of 2024), begin shifting the accelerated income that my IRA portfolio will then be generating into making purchases of more Dividend CCCs, even to the point of the CCCs exceeding whatever the Percent Allocation parity target is at that time.
  • During years 11 thru 15 (2025 thru whenever I retire in 2029), shift the focus of the makeup of the portfolio into one that heavily favors the Dividend CCCs, but still retains some relatively safe high yielding investments such as health care and other REITs, some select BDCs, and Preferred Stocks.

So don't be surprised if in future articles you see me harvesting profits from solid companies that have realized substantial gains and redeploying those funds into other vehicles that will generate more in annual dividend income than what I sell off.

Now, What To Do About KO?

One stock that sticks out like a sore thumb in the chart above is KO, which as I mentioned is in the Worst 10 Dividend Providers group and in the Worst 10 Gainers/Losers group. I know that conventional wisdom holds that KO is a tried-and-true Dividend Champion, and that holding KO for the long haul will reward the DGI investor. However, given its performance in my portfolio, and its substantially small contribution to the annual income of my IRA from dividends, I have to seriously consider whether the current amount of KO that I hold might not be put to better use somewhere else, in some company that will generate substantially more dividends and still be considered somewhat "safe."

If I do close my position in KO, some may call me a heretic, and some may even call me a lunatic. But in terms of my personal goals and where I am now compared to where I want to be in 15 years, I can't help shaking the feeling that maybe now isn't the right time for me to be holding KO.

Your comments and opinions are welcome, so please feel free to pipe up and opine in the Comments section below.

Source: The Parity Conundrum

Additional disclosure: Disclaimer: I am not a professional investment advisor or financial analyst; I’m just a guy who likes to crunch numbers and can make an Excel spreadsheet do pretty much whatever I want it to do, and I’m doing my best to manage my own portfolio. This article is in no way an endorsement of any of the stocks discussed in it, and as always, you need to do your own research and due diligence before you decide to trade any securities or other products.