I've received a couple of messages over the past month (I've been away) from readers asking me whether a dividend growth investing strategy should be an "exclusive" strategy in the sense that an investor should put all his money into stocks that pay rising dividends over time. Of course, the answer to this question is the same as the answer to almost every portfolio allocation question: It depends.
Different investors have different investing goals and circles of competencies. Someone who has very little knowledge of individual stocks is probably best off going the index fund route. A man in his late 40s who has spent his career working in the natural gas industry might have a particular talent for finding undervalued companies in the natural gas sector which do not pay dividends. And an investor in his late 50s desiring to create a stock portfolio to generate enough income for living expenses might desire to focus the majority of his investing within the dividend growth realm.
While it is up to each investor to determine the investing strategy that he is most comfortable with, I can certainly tell you the type of portfolio allocation that I'm going to try to achieve. But before I get started with that, I do want to point out one thing that I think is particularly important to my position in the dividend growth investing debate.
Sometimes I'll get questions like, "Do you plan on putting 100% of your investable assets into dividend growth stocks?" And when I answer that question with a no, some people respond to me with an attitude of "Aha! Gotcha now, you hypocrite!" You'd swear by the tone of some of these comments that catching a dividend growth investor with a share of Google (NASDAQ:GOOG) in his portfolio is the same thing as catching him cheating on his wife. I think that asking dividend growth investors to have complete fidelity to dividend growth stocks with the entirety of their portfolio creates a needless (and misguided) expectation.
Most of us invest because we want to delay gratification today in the hope of having more purchasing power tomorrow or a chunk of self-generating income indefinitely. It is up to us to determine how to get to whatever our own finish line may be, and I think that it is ridiculous for investors to put themselves in straightjackets so they can adhere exclusively to one particular strategy.
Let's say that I plan on creating a portfolio that consists of 70% dividend growth stocks, 10% non-dividend paying growth stocks, 10% index funds, 5% REITs, and 5% actively managed mutual funds. That's most likely not an allocation that you're going to find prepackaged on any financial planner's website, yet it might fit my personality best. In this regard, I try my best to fight this "straightjacket" approach to investing that tries to force us to compartmentalize our investing into some generic, vanilla formula that an online calculator spits out.
Without any ado, here's the portfolio percentage allocation that I'm going to try and construct over time with my personal portfolio:
50% Dividend-Growth Stocks. These are the companies that I expect to do the heavy lifting, and once I purchase them, I have no inclination of ever selling them unless I think the firm's competitive position diminishes significantly -- say, the company starts to look like Kodak (EK) in the mirror -- or appears to be so overvalued that a reasonable return going forward seems highly unlikely (think back to when Johnson & Johnson (NYSE:JNJ) was trading at 40x earnings at the start of the decade).
Mentally, I'll refer to this part of my portfolio as the "Permanent Capital" portion, because I don't expect these companies to create a permanent capital loss (in a sense, these are the companies I turn to when I want to "inventory" the profits and income from other areas of my life). These are companies like 3M (NYSE:MMM), Johnson & Johnson , Kimberly-Clark (NYSE:KMB), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG), Clorox (NYSE:CLX), Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL), and Exxon Mobil (NYSE:XOM). My expectations for these companies are 7-11% earnings and dividend growth, as well as a starting dividend in the roughly 3-4% range.
Special Situation Dividend Growth Stocks. This is the portion of my portfolio where I look to establish "turbo-charged" dividend growth over a 5-15 year period. If you get a chance to look at any of the great articles written by David Crosetti or David Van Knapp, you'll see that they both had the adroit acumen to purchase shares of McDonald's (NYSE:MCD) before its great run up in price. And if you look at the 5 or 10 year dividend growth rate for McDonald's, you'll see that McDonald's has grown its dividend by 30% annually over the past five years and 26% annually over the past ten. While I don't think that I'll be able to spot a company that will give me 20% or more dividend growth for a decade, I do want to put 25% of my portfolio into large-cap companies that I expect to deliver 10% or more. Often, these companies will most likely have a quality that would disqualify them from inclusion on the "permanent" list above.
The first type of companies that would find a spot on this list would be those that had to slash their dividends due to a one-time event, yet I expect the company to be able to generate substantial dividend growth over the medium to long term. Looking at the financial crisis, I see that companies like General Electric (NYSE:GE), Wells Fargo (NYSE:WFC), and US Bancorp (NYSE:USB) had to slash their dividends heavily, yet the strength of each firm's long-term earnings power did not suffer quite as much as the dividend cut might indicate. If I believe that a company has ameliorated the problems that caused the dividend cut in the first place, I'm going to try to get in and enjoy 9-15% annual dividend growth over the medium term.
A second category of companies that I would look to for this part of my portfolio would be firms that are raising their dividends significantly, yet are starting from a low buy-in point, like 2%. These are companies like Wal-Mart (NYSE:WMT) and Beckton Dickinson (NYSE:BDX). Wal-Mart has raised its dividend by 18% annually over the past 5 years, and Beckton Dickinson has raised its dividend by 14% annually over the past five. My hope with this companies is that I would be able to compensate for the lower initial dividend yield by achieving 10-13% annual dividend growth over the ensuing decade.
And the last category of companies that would fall into this subset would be technology companies that are still transition to the dividend growth phase, like Intel (NASDAQ:INTC), IBM (NYSE:IBM), and Microsoft (NASDAQ:MSFT) and have the potential for 10-12% annual dividend increases over the medium term. These companies tend to have weaker moats and a less established dividend history than the "Core 50% Dividend Growth Portfolio," yet they offer diversification into the tech sector and the promise of 10%+ dividend growth over the next 5-10 years.
And the last 25% of my portfolio I plan on reserving for the mishmash of everything else. I wouldn't mind picking up a company like Realty Income (NYSE:O), which has paid a dividend every month for the past 500 months (unfortunately, the stock is a bit pricey these days), and a real estate index fund may not be totally out of the question. I'd planning on putting 5% of the portfolio into a small cap index (this is because I have no talent at picking individual small cap companies, yet I want to own them somehow since I have seen the Ibottson Associates data which notes that small cap stocks have outperformed their large-cap counterparts since 1926).
I'd also like to put 5% into an emerging markets index fund for similar reasons as the small cap. And to round things off, I'd like to own three to five mutual funds (yes, I just said the "MF word") that are run by management teams that I have great respect for. These will most likely be the Sequoia Fund, the Tweedy Browne Global Value fund, the Vanguard Wellington Fund, and the Scout International Fund.
This is my rough roadmap for what I'm trying to achieve with my portfolio. It's not going to happen overnight. If Realty Income falls to $30 in two years (and the earnings power is not threatened), I might establish a large position that makes Realty Income 30% of my portfolio, and its concentration would go down over time as I funneled money into different investments.
Likewise, Coca-Cola could drop to $55 next year, and that could take up all of my discretionary income if it remains that undervalued. Like Benjamin Graham once said, "The market is there to serve you, not instruct you." While these are my rough goals of where I want to end up, I'm going to focus most of my attention on buying what I consider to be the greatest amount of future profits at the lowest risk-adjusted price, and if that happens to drift me away from my stated portfolio goals, then so be it. My primary focus is to generate an x amount of dollars by a certain age.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.