Weighting your dividend payers should be done by variables other than market cap.
We can use multiple parameters for weighting holdings, such as dividend yield and growth.
Having a disciplined weighting scheme can help investors retain the best companies.
About every quarter I update my weights for my dividend paying stocks in my retirement portfolio. Let me first summarize the idea behind my weighting scheme. I do not normally believe in weighting by market capitalization, nor do I generally believe in equally weighting stocks. There are better ways to figure out how to distribute the money in your portfolios. I suggest a weighting mechanism for dividend paying stocks that rewards a company with a higher weight as it makes good decisions that are in the interests of shareholders.
There are several variables I use when weighting high-dividend stocks in client portfolios. I will use three of these variables as an example here. They are the dividend yield, the five-year annualized growth rate of the dividend, and the company's debt to equity ratio. Let's look at four of my favorite high-dividend paying stocks, which are Johnson & Johnson (NYSE:JNJ), Wal-Mart (NYSE:WMT), ADP (NASDAQ:ADP), and Merck (NYSE:MRK). Note that Coca-Cola has been removed from this list because its debt to equity ratio went above 100%. It has been replaced by Merck.
5 Year Growth Rate
Johnson & Johnson
Note that because a higher debt to equity ratio is undesirable, we don't actually want to weight by that number. Therefore I've included the variable 1-Debt to Equity, which is what we will use for weighting purposes. This variable can be looked at as the percent of equity that is not financed by debt.
It is relatively straightforward to implement a simple weighting scheme using these variables. The scheme can be made more complex by weighting the weights. In other words, we could assign a higher weight to the five-year growth rate in dividends compared to the other two variables. We could give it a 50% weighting, while the other two variables receive 25% each. However, for the example here I will give each variable a 331/3% weight. This means we are assuming each parameter carries the same importance. But if we think that dividend yield is the most important factor we could assign it a weight of 50%, or even greater, and reduced the others accordingly. The weightings spreadsheet can be seen on our planning tools page at the bottom of the page. Users are free to open the spreadsheet and input their own stocks and data.
This spreadsheet is a good starting point for those who wish to have a disciplined approach to weighting their portfolio. But it is just a starting point. There are many changes that could be made, including which variables to use, how many variables to use, and the weight of each variable in the weighting process. The highlighted cells in the spreadsheet can be changed to see how the individual weightings in the portfolio would change. Readers can also use our dividend break-even calculators at the link above to help them with their decisions.
The table below shows my final results for the four companies I am analyzing. Given the inputs and our weighting scheme, we see the results. Because of its relatively high dividend yield and low debt load, Johnson & Johnson tops the weights this quarter at 33%. Note that the last three columns are not populated for each holding because these calculations are the average of the four holdings.
Johnson & Johnson
Below we see the weightings from December of last year:
Johnson & Johnson
Merck (Not on the list on 9/2013)
As the number of companies held in a high-dividend portfolio increases, it becomes even more important to have a methodical, disciplined approach to weighting each holding. Weighting by characteristics that tell us something about each company's future prospects and abilities to keep growing dividends makes even more sense if one thinks about deciding whether or not a company should be eliminated from the portfolio altogether. If I have 20 stocks in my portfolio I can have several others in reserve or "on the bench". If the proposed weighting of one of the companies in reserve surpasses the lowest-weighted company in the actual portfolio, it may be time to make a switch to the company in reserve.
It is also important to have a disciplined approach to weighting when it comes to rebalancing. Whether rebalancing monthly, semi-annually, or annually, one should have a defined methodology rather than a subjective, by the seat-of-the-pants approach that could lead to having too much weight in underperforming companies and too little weight in companies that are actually improving the outlook for future dividend increases. It also helps investors do the one thing that can be so difficult: Sell the worst holdings out of the portfolio.
Disclosure: I am long JNJ, MRK, ADP, WMT. 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.