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SDS (Seductive Dividend Stocks)
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Sorry I hide my true identity but I'm a physicist/engineer, native contrarian and idea generator. I am an eclectic dividend investor with motto "In God We Trust, All Others Pay Cash" applied to companies I invest in. I like to read /and read a lot - did you look on my SA photo 8-)? / including... More
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  • Diversification For Dividend Growth Investors (Dec 23,2011) 2 comments
    Sep 16, 2012 3:05 AM

    Dividend omission is the biggest enemy of income investor. There are two types of dividend omissions (and cuts) - predictable (for companies with pure financial situation , e.g. after few years of negative earnings) and non-predictable (e.g., for companies in good shape) that can be viewed as Black Swan events.

    Many dividend growth investors (DGi) have quite concentrated portfolio from 5-12 stocks. Probably this is OK if you are perfect in stock selection and can closely follow market, so you can react within few minutes (in our days of high-frequency trading probably this period squeezed to few milliseconds) on company announcement about dividend omission.
    Based on normal distribution of stock prices (this is not so good approximation of reality) economist usually suggest diversification with 25-35 stocks, i.e. invest in each company 3%-4% of money. While average DGR ~ 6.5% and average inflation ~ 3.5%, average real income growth rate ~3%, so dividend omission in 1 of 33 equally weighted companies in a DGi portfolio is quite significant event. Unfortunately average dividend cut probability (~4%) that can be a Black Swan event is higher than estimated average real income growth rate (~ 3%).

    Because of market uncertainty a DGi can be sure only in one number - his (her) yield on cost (YOC). Dividend history, DGR, number of cuts, etc. are all from history. If DG investor plan to sell some stocks (BTW, /s/he must do it in regular IRA at certain age) - market neutral portfolio (stocks with anti-correlated prices) is a good approach but again all correlations (or beta) are from history. With historical average probability of dividend omission ~ 3% (assuming that stock price also drops to zero) it is better to keep each position below this 3% and have yield above this 3%+inflation rate. So you face 1 omission if you hold 34 average dividend stocks per year. If you hold 11 stocks you face 1 dividend omission in 3 years.

    Because dividends cuts are strongly correlated within a single country (at least USA, UK, Japan) and cuts are often 50%-90% DGi should held about 2X-3X more stocks than "regular" investor. On another hand, because standard deviations of DGR for stocks is significantly smaller than stock prices standard deviations. Textbooks recommend that good equity portfolio should consists of 20-50 stocks (20 was recommended while ago when price correlations of stocks were relatively small, 50 is common current recommendation). Textbooks recommend that good bond portfolio should consists few bond funds because authors of textbooks consider that small investor cannot assemble good bond portfolio him/her-self. One quite good book I read (sorry do not recall the title) recommends that good bond portfolio should consists about 500 different bonds. Because DG stocks have non-zero DGR in contrast to bonds with DGR=0, I think that DGi should have smaller portfolio that a bond investor.

    Also from history of US stocks probability of dividend omissions and cuts for DG stocks is lower than for other dividend stocks, so numbers are slightly better. Nevertheless, I think DGi should have wide equally weighted portfolio from 100+ stocks.

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  • SDS (Seductive Dividend Sto...
    , contributor
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    Author’s reply » It becomes evident that some DG investors are too naive from conversation to recent good article http://bit.ly/1d9gA3T. So I re-post lightly truncated discussion.

     

    SDS : "At average probability ~ 4% (http://bit.ly/A3tOrH) a DGi with 25 stocks should expect in average 1 cut per year and another DGi with 100 stocks should expect 4 cuts per year in average (of course I ignore quality of companies). "

     

    PTI: "Very true, but with the lower number of stock the more likely that an outlier number of companies cutting their dividend will hurt you. With a portfolio of ten stocks there is a legitimate possibility that 3 (30%) of them could cut their dividend. With a portfolio of 100 stocks, it is extremely unlikely that 30 of them would, even though the percent is the same. I believe the "law of large numbers" (am I using this term correctly?) explains this possibility. The larger the number of samples (ie, stocks) the more likely you are to be close to the true average."

     

    SDS: FORMALLY YOU LOSS DOES NOT DEPEND ON NUMBER OF STOCKS IN YOUR PORTFOLIO.
    Let simplify situation and assume 4 % gross failure probability. Gross failure here means that a company unpredictable closes the doors and investor looses all money (kind of Black Swan event). If you have 50 equally weighted stocks (i.e., 2% of your whole money was invested in each firm) you face 2 gross failures per year and you loose 4% of invested capital. If you have 100 equally weighted stocks (i.e., 1% of your whole money was invested in each firm) you face 4 gross failures per year and you again loose 4% of invested capital. So, naïve diversification doesn’t help.
    In reality dividend cut and even dividend suspension happens without (at least sometime before) quit of business of the firm which reduces dividends. Observations show that stock prices drop 15-40% before cut announcement and 5-40% immediately after dividend cut announcement. In average total stock price reduction is about 60% (these numbers came from relatively small set of events, so statistics is pure). Again at 4% annual probability of dividends failure average loss for investor does not depend on number of stocks in the portfolio. Of course I assume that all firms are equally expose to any failure, that failures occur randomly (see also http://bit.ly/J0r2m2), and that dividend investor sells at cut (not always wise – see http://bit.ly/rrrjkX).
    It seems interesting that default is also about 4% for investor grade bonds and bond investors recover in average 40% of principal (i.e. loose the same 60% as dividend “buy and blindly hold” investors). Although I think this is coincidence it might be worth to use bond diversification principles to dividend investing.
    The tricks of diversification are
    a) to choose only companies with lowest failure probability (but I guess Mr. Market prices them accordingly);
    b) to play coherency factors (http://bit.ly/102frew) and here small investors might have some advance with micro and nano-caps which are not investable for Wall Street;
    c) to adjust invested capital to failure probability.
    Well a) and c) mean ability to forecast dividend cuts and we know that forecasts in finance are very bad (usually only 50% are correct which means that any coin is a good “forecaster”). Due to good (in my eyes) dividend culture David Fish reaches fantastic ability (~ 90%) to time dividend increases for DG stocks (see his numerous SA articles). I do not know any other financial forecast with even 80% correct rate for quite huge number of stocks (~ 500 in CCC list).
    1 Jan 2014, 06:42 AM Reply Like
  • SDS (Seductive Dividend Sto...
    , contributor
    Comments (4321) | Send Message
     
    Author’s reply » Butterfly Seeker argues that statement "default is also about 4% for investor grade bonds and bond investors recover in average 40% of principal" is "extremely wrong and misleading statistic" and pointed to
    http://stanford.io/1a6...
    and
    http://bit.ly/Kjfhc2
    in comments to http://seekingalpha.co... .

     

    I made mistake, somehow 4% printed in my memory for bonds. I know bonds very badly and do not invest in any bond.

     

    SDS
    2 Jan 2014, 12:04 AM Reply Like
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