Seeking Alpha
Long only, value, dividend growth investing
Profile| Send Message|
( followers)

Summary

  • The amount of capital you have in a company is more important than the number of shares you have in a company.
  • The more the capital you have in a dividend stock, the higher the amount of dividends you receive.
  • Therefore, it’s better to think in terms of how much capital you are using to buy your shares, instead of how many shares you are buying.
  • The above make sense only given that you buy shares at proper valuations, as it goes without saying the lower price you pay, the higher income you get.
  • Thinking in terms of how much capital you have allocated to each holding also helps with risk management by thinking of stock allocation and income allocation.

Recently, I had a chat with my friend about stocks. I told him I bought Gilead Sciences (NASDAQ:GILD) recently. His response to my surprise was, "It's so expensive! It costs $10,000!" Further conversation led to my understanding that he was thinking in terms of buying 100 shares at the present price of ~$100 per share. It turns out he only buys 100 shares or 1000 shares each time he makes a purchase.

My friend also thought that it's easier for a stock to go from $3 to $6 (100% gain), than another stock to go from $100 to $200 (again, 100% gain). But really, the stock price will go up or down in the long term based on how the business performs AND based on how much you paid for the shares. If you bought the shares way overpriced, even if the company does well, it'll still take time for the earnings to catch up to the price, as shown in the Wal-Mart (NYSE:WMT) example (see the third graph).

On a related note, some excellent comments about allocation were brought up in my last article, How do I stick to the slow, but sure Process of Dividend Growth Investing?, in which I displayed a simple portfolio of 10 dividend growth companies, with 10 shares of each. I want to expand on the idea of allocation in this article.

First, here again is the simple portfolio example with allocations in today's price.

~ Table 1: 10 Shares in Each Company ~

HoldingPrice1YieldInvested CapitalStock AllocationAnnual IncomeIncome Allocation
Coca-Cola (NYSE:KO)$41.122.97%$424.105.64%$12.205.52%
McDonald's (NYSE:MCD)$95.453.43%$955.3012.70%$32.4014.66%
Wal-Mart (NYSE:WMT)$75.732.54%$765.5010.18%$19.208.69%
Bank of Nova Scotia (NYSE:BNS)2$73.503.48%$7489.94%$25.6011.58%
Microsoft (NASDAQ:MSFT)$45.152.48%$462.206.14%$11.205.07%
International Business Machines (NYSE:IBM)$190.412.31%$1,922.3025.55%$4419.91%
Cisco Systems (NASDAQ:CSCO)$24.653.08%$258.903.44%$7.603.44%
General Electric (NYSE:GE)$26.153.37%$274.303.65%$8.803.98%
Chevron (NYSE:CVX)$127.113.37%$1,289.3017.14%$42.8019.37%
Kinder Morgan (NYSE:KMI)$40.814.21%$422.505.62%$17.207.78%
  Total:$7,522.40 $221 

1. Friday, August 22 Closing Price
2. on Toronto Stock Exchange

Each Trade Shouldn't Cost Too Much

Since it costs me $10 per trade, I included that cost in the "Book Value" column. Cost-wise then, it only makes sense for me to buy 10 shares of IBM, CVX, and maybe MCD if I must buy slots of 10 shares each time. That is, 0.5% trading cost to buy 10 shares of IBM, 0.8% cost to buy 10 shares of CVX, and 1% trading cost to buy 10 shares of MCD. More important than the cost is buying quality stocks that you're comfortable with at the right valuation (price).

Stock Allocation

Personally, I don't like allocating too much of my portfolio to any single company. In the example portfolios (Table 1 & 2), 25% of the portfolio is in IBM, while 17% is in Chevron. Percentage-wise, that seems excessive. One can imagine how scary that could be if the portfolio were much bigger (say ~$700,000, instead of ~$7,000). The idea is that if something goes wrong with a company that you're heavily into, then a big part of your portfolio is in danger. On the other hand, if you find certain undervalued opportunities, you might want to buy more of that company, up to the allocation percentage that you're comfortable with. For me, that's about 5% of my portfolio. If it is truly an undervalued opportunity, and it reverts back to fair value, it'll only grow into a higher allocation percentage. When a holding does grow into a certain percentage, like over 10%, I'll probably have to trim to keep sleeping well at night.

~ Table 2: 1000 Shares in Each Company ~

HoldingPrice1YieldInvested CapitalStock AllocationAnnual IncomeIncome Allocation
KO$41.122.97%$41,1305.56%$1,2205.52%
MCD$95.453.43%$94,46012.78%$3,24014.66%
WMT$75.732.54%$75,74010.25%$1,9208.69%
BNS2$73.503.48%$73,5109.94%$2,56011.58%
MSFT$45.152.48%$45,1606.11%$1,1205.07%
IBM$190.412.31%$190,42025.76%$4,40019.91%
CSCO$24.653.08%$24,6603.34%$7603.44%
GE$26.153.37%$26,1603.54%$8803.98%
CVX$127.113.37%$127,12017.20%$4,28019.37%
KMI$40.814.21%$40,8205.52%$1,7207.78%
  Total:$739,180 $22,100 

1. Friday, August 22 Closing Price
2. on Toronto Stock Exchange

Income Allocation

For a dividend growth investor, another type of allocation to watch for is the income allocation. In the above portfolio, 19% of the income comes from both IBM and Chevron, and 14% comes from McDonald's. With a small portfolio, it doesn't really matter since we're talking in terms of less than $50 of income coming from one company a year. However, as the portfolio reaches a certain size, say ~$700,000, then with the same allocation in percentages as before, $4,400 of income per year will come from IBM instead of $44. And it would be very damaging to the income of the portfolio owner if IBM reduced or cut its dividend.

Introducing the Equal-Weight Portfolio

With a 10-stock portfolio, it's simple to divide the portfolio such that 10% is allocated in each company initially. To make it simple, let's say we start a portfolio with ~$10,000. Then, about $1000 is allocated to each company.

~ Table 3: Equal-Weight Portfolio ~

HoldingPrice1# SharesInvested CapitalStock AllocationAnnual IncomeIncome Allocation
KO$41.1225$1,0389.95%$30.509.48%
MCD$95.4511$1,048.9510.05%$35.6411.08%
WMT$75.7314$1,070.2210.26%$26.888.35%
BNS2$73.5014$1,0399.96%$35.8411.14%
MSFT$45.1522$1,003.309.62%$24.647.66%
IBM$190.416$1,152.4611.05%$26.408.21%
CSCO$24.6541$1,020.659.78%$31.169.68%
GE$26.1538$1.003.709.62%$33.4410.39%
CVX$127.118$1,026.889.84%$34.2410.64%
KMI$40.8125$1,030.259.87%$4313.36%
  Total:$10,433.41 $321.74

1. Friday, August 22 Closing Price
2. on Toronto Stock Exchange

We now have a portfolio of companies with different number of shares but similar amount of capital allocated. The income allocation is also much more balanced. Comparing between this equal-weight portfolio and the previous portfolio, I would be much less emotional about price movements for any of the companies for this portfolio than the former (Table 2).

But I Already Started a Portfolio...

If you already started a portfolio, and you didn't think about allocation before you started, don't sweat it. In fact, you might like to hold more of some companies (up to a certain allocation percentage) over others because you expect the former group to perform better than the latter.

Furthermore, you'll probably be continuing to build your portfolio. Every additional purchase you make will affect both the stock allocation and income allocation. So, if you're adding a new holding to your portfolio, you'll be reducing both the stock allocation and income allocation of your existing holdings.

In Conclusion

It is true that the more shares you buy, the more dividends you receive, BUT you still get that same dividend yield based on the capital that you put in to buy those shares. So, I think it's more telling to think in terms of how much capital you have in a company rather than how many shares of a company you hold.

If you like what you've just read, consider clicking the bolded "Follow" link at the top of the page above the article title to receive an email notification when I publish a new article.

Source: Dividend Growth Investing: It's Not The Number Of Shares, But The Invested Capital That Matters

Additional disclosure: The author is long BNS on the Toronto Stock Exchange.