Dividend Growth Stocks Vs. The XLP, Part 2

Includes: CL, COST, KO, MO, PG, PM, TGT, WMT, XLP
by: Eli Inkrot

<< Return to Part 1

In the first part of this article I outlined the prospect of comparing the Select Sector Consumer Staples SPDR (NYSEARCA:XLP) to the approach of individually selecting specific dividend growth stocks. I choose the XLP as it has within it many of the favorite dividend growth stocks. Companies like Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO) and Colgate-Palmolive (NYSE:CL) (see Part 1 for a list of XLP's top 10 holdings, their individual weighting and dividend characteristics).

In Part 1, we outlined that while diversification is fundamentally important it can be difficult to accomplish in the short term. Limited capital allocation and psychological frictions often get in the way of equally spreading one's investments. Neither the 11% chunk of the S&P 500 that is the XLP nor a handful of dividend growth stocks will truly provide a reasonable basis for diversification. On the current yield and dividend growth front, we surmised that an individual collection of dividend growth stocks would likely take precedent over the XLP. While the dividend growth prospects of the two are likely to be comparable, one can achieve a much higher initial yield. Beyond portfolio allocation and dividend prospects, it is also important to consider the applicable fees and flexibility of each strategy.


With fees attacking everything from changing a plane ticket to your bank account, it would be wise to take heed. The overall sentiment of the ETF is that it provides a low cost alternative to diversify one's portfolio. Mutual funds had a similar tactic, although I would challenge the low cost part. Transaction costs are essential in evaluating scarce capital allocation decisions. Let's consider the example that you wanted to individually buy the 42 companies in the XLP ETF.

With a 1-year time horizon and $7 trades, this equates to about $588 round trip; if you were to buy all of the shares on January 1st and sell on December 31st. For illustrative purposes let's say you invested $10,000. This represents a cost of 5.88% and thus would negate a large portion, if not all, of your potential gains. Conversely, one could simply buy the ETF holding all 42 companies and pay the round trip fee of $14, plus expenses. As the XLP tracks an index, the turnover is quite low (3.64%), the management is inactive and the resultant expense ratio is also low at 0.18%. For that same $10,000, one would pay just $32 to be invested in those 42 companies, with a total expense of 0.32%.

Given a longer time horizon the gap between individual stocks and the ETF narrows and eventually fades, as one who holds individual stocks is not subject to annual expenses. However, in our illustrative example this would take about 32 years. Given a more realistic circumstance, say buying 10 of your favorite dividend growth stocks, it would take about 7 years for the individual stock fee's to drift lower than the ETF fees. I use the word drift purposefully, as once the fees for the individual stocks become less than the ETF they will forever be less. Still, 7 years is well within delayed gratification range, which is something that most people struggle with even on a day-to-day basis.

Conversely, if you have $327,000 lying around you could buy and sell the 42 individual stocks in 1 year and beat the relative fees of the XLP ETF. This is simply a function of fixed fees versus the variable expense ratio. In 2 years this number halves to about $163,000. In 10 years this number is much more manageable $33,000. Still, I believe that it is much more likely that you are faced with scarce capital allocation decisions such that the first example is much more applicable. Perhaps insofar that $1,000 is a more likely starting point. To beat most mutual funds fees is not so much a challenge as it is an inevitability. To beat an ETF's fees is much more of game, which rests on the cornerstones of any successful investing strategy: wealth and time. Ironically, these are precisely the same factors that allow one to take more risk.

In the very long run I would argue that the individual dividend portfolio would likely be able to trump the fees of an individual ETF. However, I recognize the necessity of scarce capital along with the applicable conveniences that an ETF provides. As a long-term "buy and holder" I personally would advocate individual stocks as the winner in the fee category. But instead the point is awarded to the ETF as it takes care of a variety of behavioral finance issues that some might be inclined to follow. For example, jumping in and out of securities based on their latest intuition. Beating ETF fees are a function of wealth, time and math; of which many unfortunately do not have the patience.

Selective Holdings

With the score tied 1 to 1 between the individual portfolio of dividend growth stocks and the XLP ETF, let's move on to the definitive factor: selective holdings.

As described previously, one is not simply limited to picking a group of dividend stocks or this specific ETF. There are an unimaginable amount of opportunities that one might put their cash towards. However, given a limited capital decision, only a few opportunities are available at a given time. Both an individual group of dividend growth stocks and the XLP ETF appear to be attractive against the alternatives. Attractive in that one is investing in a collection of tangible assets that provide the basis for everyday life. With alternatives being in the form of cash, low-yielding deposits, ball-game tickets or a night out on the town. It is the hope that the investment in wide-moat companies will not only maintain one's purchasing power but also increase it over time. After-all why not buy a hamburger today if the deferred investment provides more money in the future, but only to the extent that you are still buying just that same hamburger tomorrow.

Let's look at selective holdings within the example of the XLP ETF. While you might love 80% of the companies within the XLP it is possible, if not probable, that you would not like some of the other companies. Which in turn begs the question, 'if you happen to dislike a couple of company's why would you ever commit even a dime of scarce capital to an unwanted endeavor'? Let's say you don't like Phillip Morris (NYSE:PM) and Altria (NYSE:MO) for your moral stance on cigarettes and think that the super long term prospects of tobacco are declining. If you owned the XLP you would have no way of making this distinction. Furthermore if you were correct, and tobacco did eventually fall, you would have no way of separating yourself from the PM and MO holdings without selling the entire ETF. This becomes increasingly problematic if the majority of the holdings are living up to your standards. Additionally, you have no basis for picking up companies that you think might be undervalued compared to the alternatives.

On the other hand, the method of selecting individual dividend growth stocks not only allows for such selectivity, but it outright relies on it. It is true that one is apt to make mistakes much more easily along the way following this strategy. However, if one has the discipline and time it could prove to be a worthwhile endeavor. One would own exactly what they want to own and would know exactly why they are holding each security.

Beyond disliking a company, it is possible that you simply don't agree with the ETF's holdings. A forefront example comes to mind in the case of Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST). Within the low cost providers, I would mark Target (NYSE:TGT) as my go to dividend growth stock. That's not to say that WMT doesn't carry weight, as it has been more than generous in returning shareholder value. I simply like Target better at the moment for its cleaner stores, expansion into Canada, move to include groceries, quantifiable $5 Billion share buy-back plan and its commendable goal of reaching $3 a share in dividends based on $8 a share in earnings by 2017. Yet, TGT isn't even in the XLP. Instead it's tucked away in the Consumer Discretionary ETF.

The bottom line is that an individual dividend growth portfolio takes on risk in the same manner that the financial psychology of an individual provides risk. That is, if one is able to make use of both wealth and time, then the applicable decision is merely a factor of math. Given that one needs to be diversified, neither a handful of 10 dividend growth stocks nor the XLP ETF will provide it for you. However, we are subject to scarce capital such that there is an unfortunate bias towards capital fund grouping. In this way, the easy thing to do is use a "set it and forget it" ETF or mutual fund. But it is important to consider the amount and practicality of that decision. With regard to current yield and dividend growth prospects, it is likely that one's yield on cost would be taken care of in either decision. However, the individual selection of dividend growth stocks does provide an alley for a much more substantial initial yield.

Fees can act as such an inhibitor that is it paramount to consider their lasting effects. It is eventually true that fixed costs will fall below variable costs, given enough time and money. For the very long term investor individual stocks, especially those that require below average monitoring, offer a valuable incentive to hold the long-term mindset against the short-term friendly ETF. However, if you find yourself with limited capital and a short-term attitude it is a matter of math that an ETF will provide a lower expense.

Finally, the nature of selective holdings is such that one cannot ignore the future prospects. If you happen to like the future of all 42 companies, then great the XLP is a low cost alternative. But in the more likely case that you would prefer to own a variety of alternatives outside of the particular ETF realm, individual selection is likely more to your style. I would agree that for those unwilling to do your homework, individual stocks simply won't work. However, the homework doesn't have to be intimating. For a collection of long-term dividend growth stocks one is simply looking for wide and tangible moat companies, whose futures appear to be sustainable such that earnings grow and payouts increase by a pace that far outpaces inflation. What Mr. Market decides to do from there is secondary.

Disclosure: I am long KO, PEP, PG.