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The interest in the stocks of companies paying higher than average dividends has been in a rapid upswing over the past couple of years as it has become readily apparent that short-term interest rates are not rising any time soon. Ben Bernanke has all but promised us years of low short-term rates. With money market funds paying less than 0.1% on average, many investors are turning to high-dividend paying stocks to supplement their income.

Once the decision has been made as to which stocks will make up an investor’s high-dividend portfolio, there is still the question of how these stocks will be weighted. Some investors and financial advisors will use the tired and increasingly out of favor method of weighting by market capitalization. There is also the idea of equally weighting each stock, which has become more popular in recent years. But I suggest that there is a better method for weighting high-dividend 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 my company uses 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:

Company

Dividend Yield

5-Year Growth Rate of Dividend (Annualized)

Debt to Equity

1- Debt to Equity

Johnson & Johnson (NYSE:JNJ)

3.50%

12.00%

21.00%

79.00%

Chevron (NYSE:CVX)

3.10%

5.10%

10.00%

90.00%

ADP (NASDAQ:ADP)

3.00%

17.40%

0.00%

100.00%

Harleysville Group (NASDAQ:HGIC)

3.90%

13.60%

14.00%

86.00%

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 weighting of 1/3 each. The spreadsheet Weighting High-Dividend Yield Stocks shows how I arrived at my figures.

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.

The table below shows my final results for the four companies I am analyzing. Because of its 0% debt to equity ratio and strong five year dividend growth rate, ADP is weighted the heaviest at 29%. Chevron has the lowest weight of 20% due to its relatively lackluster five year dividend growth rate.

Company Weight Avg Div Yield Avg Debt to Equity Avg 5-Year Div
Growth Rate
Johnson & Johnson 24%
Chevron 20%
ADP 29%
Harleysville Group 27%
Totals 100% 3.50% 10.87% 12.61%

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 losers in the portfolio.

Source: A Disciplined Approach to Weighting High-Dividend Yield Stocks