I am working on questions of portfolio construction in light of what I have come to accept as the attributes of dividend-growth stocks. The basic issue becomes, how does one meld dividend-growth stocks with the asset allocation principles that have been derived from the teachings of Modern Portfolio Theory? That leads to questions like these:
- Should one's entire investable retirement assets be placed into a dividend-growth portfolio? (Probably not.)
- If not, what percentage of retirement assets "should" be devoted to dividend-growth stocks? Does that differ by age, and if so, how?
- What does “diversification” mean when you are talking about dividend-growth stocks?
- Do the risk-reducing characteristics of dividend-growth stocks allow you to have a higher allocation to "stocks" than is commonly prescribed?
For me, this is the next frontier in thinking about dividend-growth investing: What is its place in overall portfolio construction? I think I have a few answers, but I am positive that I don’t have all of them. So I am just going to propose some ideas, and perhaps readers can provide points of view with comments. I picture this becoming a series of articles that explore the basic question: What is the role of dividend-growth stocks in a portfolio?
Two important caveats before we get started:
- The outcome cannot be a one-size-fits-all pie chart of asset allocations. Everyone’s needs, goals, ages, risk tolerances, and psychologies are different. So the search here is for basic principles to think with (as Chuck Carnevale might say). The ultimate application of those principles must be done individually. Everyone's pie chart looks different.
- The “portfolio” being allocated is the one that includes all of your investment assets. I usually use “portfolio” to mean, say, a Dividend Growth Portfolio. But here, that just becomes one slice in the pie chart, just a single aspect of the broader picture.
Hypothesis #1: Dividend-Growth Stocks Are a Separate Asset Class
I might as well start with a proposition that will make traditionalists cringe. I believe that dividend-growth stocks comprise a separate asset class.
Traditionally, stocks are sliced and diced in many different ways. The Morningstar Style Box (MSB) has become an industry standard, so common that a category like “large cap value stocks” goes unquestioned as an asset class, and investors are advised to have a certain portion of their assets in that class.
But where did that come from? The MSB is a proprietary nine-square grid that provides a graphical representation of the "investment style" of stocks and funds. It classifies them according to market capitalization on the vertical axis (small, mid-size, and large) and by growth/value characteristics on the horizontal axis (growth, core, and value). Morningstar says, “By providing an easy-to-understand visual representation of stock…characteristics, the Morningstar Style Box allows for informed comparisons and portfolio construction.”
In the MSB, “core” means a stock for which neither value or growth characteristics dominate. “Growth” stocks tend to be low-yield, extremely growth-oriented stocks, while “value” stocks tend to be high-yield, low-growth stocks. Morningstar uses a specific objective scoring system to determine where to categorize each stock. On average, each of the three styles accounts for approximately one third of the total shares in circulation.
Morningstar categorizes funds and ETFs as well as stocks. It does it based on the stocks it holds. Here is the style box for SDY
, the SPDR S&P Dividend ETF. This fund tracks the S&P High Yield Dividend Aristocrats Index, which selects companies from the S&P 1500 Composite Index that have consistently increased dividends for 25 years and weights them by dividend yield. I don’t present this as an ideal dividend-growth portfolio, but rather to show how a dividend-oriented portfolio cuts across the traditional style-box asset classes.
[Source: Morningstar SDY Quote page, accessed 4/29/11] The red dot, called the “centroid,” represents the weighted average of domestic stock holdings, while the shaded area represents 75% of the fund’s holdings.
As you can see, SDY’s 60 holdings cut across 8 of the 9 “styles” of the entire MSB, including all cap sizes and all but the “small growth” cell (in the lower right corner). There is no single cell, and no catchy phrase like “large-cap growth,” that captures the nature of SDY’s portfolio. The only thing that these stocks have in common is that they pay dividends and haven’t cut them for at least 25 years. That aside, they are all over the place in terms of sector, industry, cap size, and “style.”
So my hypothesis is that, if a single cell of the MSB qualifies as an asset class, then an oval shaped area that cuts across several traditional cells—but which contains stocks that share important behavioral characteristics—also qualifies. The key is not that it is scattered across the traditional MSB. The key is that the members of the class can be defined objectively and tend to perform in predictable ways within similar margins of variance that have been allowed for currently accepted asset classes.
Let’s look at it another way. Pretend that instead of the 9-cell MSB having become industry standard, a 20-cell box had been created by a competing company called Evening Star. The box has just two columns: “Pays dividends” and “Doesn’t pay dividends.” It has 10 rows, corresponding to the 10 sectors that are commonly recognized. It’s known as the Evening Star Style Box (ESSB). Let’s also pretend that the ESSB has been around for 20-30 years, and that everyone has become accustomed to categorizing stocks in this way.
Stocks that now reside in a single cell of the traditional MSB would be scattered about in the ESSB. Wouldn’t it be legitimate for someone to note, “Hey, check out these 477 stocks scattered around. They all share certain characteristics: Same cap size, all ‘growth’ stocks. They should represent an investment class too.” And I think that person would be at least arguably correct.
That’s all I am saying about dividend-growth stocks.
I had originally intended to cover dividend-growth stocks’ role in asset allocation in one article, but the subject is far too vast, because it forces you to consider other aspects of asset allocation. How a single asset class fits in is just one piece of a much larger puzzle. Here are a few of the other topics that need to be considered:
- What are the most—and least—worthwhile aspects of Modern Portfolio Theory and the asset-allocation principles that have been derived from it? Indeed, is there any usefulness to any of it?
- Tactical versus strategic asset allocation—and what do those terms mean?
- Active versus passive (or “lazy man”) portfolio management
- What role do “noninvested” assets (such as pensions, Social Security, or your house) play?
- Activities within an asset class (such as trading or not)
- Changing allocations over time (as you age or pass through life transitions such as getting your kids off the payroll, marriage and divorce, semi-retirement, retirement, having grand-kids, and the like)