Why Building A Cash Position For My Dividend Income Portfolio Makes Sense

by: Canadian Dividend Growth Investor

Every decade or so there's at least 1 mass market plunge for whatever reason. During that period, there will also be sector-specific downturns. Company-specific drops of 5 - 10% are also common during earnings report season. We're already 4 years away from the last recession, and I think it's prudent to build a cash position as a part of my portfolio. Other than a couple companies which I'm reinvesting dividends in, I'm going to accumulate the rest of my dividends. On top of that, I'll also be accumulating some of my paycheck savings. For now, I'm setting a goal of 5 - 10% cash position in relation to my portfolio value.

Some income investors like to be fully invested so that their income stream is ever increasing. For a large portfolio, I understand there's a higher opportunity cost for holding a substantial amount of cash and forgoing the dividends that could be received by using that cash to buy dividend paying stocks. But who can argue that cash wasn't king in the 2008 financial crisis when the market plunged 40%? Especially for someone with a "small" portfolio, having some excess cash on hand can create spectacular returns by buying shares of quality companies in a mass market drop.

For the Big Portfolio

For the guy with a big portfolio of say, $1M, with a yield of 3%, that's $30k of dividends per year. Or alternatively, $7500 per quarter. This guy can build a cash position quickly because large amounts of dividends are coming in periodically. Thus, in a market downturn, it's much easier for this guy to buy cheap shares.

For the Small Portfolio

Comparatively, for the guy with a small portfolio of say, $10k, with a yield of 3%, results in only $300 of dividends per year. Imagine those dividends are paid quarterly. So, every quarter, $75 is received. Additional funds will need to be contributed, in order to make a meaningful purchase. In short, for the small guy, it takes a longer time to build a cash position. So, that's why it serves well for the him to have that cash position ready.

Most Value out of Value Investing in Mass Market Drop

Back in 2008 - 2009, I could have bought a position in a quality Canadian bank with a yield north of 7%. Now, I can only grab one for 4% yield, not that that's a bad yield to start with. If I had bought and kept shares of Bank of Nova Scotia (NYSE:BNS) back in 2009, say at $25, that would have been a starting yield of 7.8%, and a current yield on cost of 9.9%. But because I bought my shares after the financial crisis happened, I'm only sitting at a yield on cost of 4.6%.

In addition, buying Bank of Nova Scotia at that price, would have increased that portion of my portfolio by more than 130%. Other blue chips also made big gains. They include: Coca-cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Colgate-Palmolive (NYSE:CL), Kimberly-Clark (NYSE:KMB), McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG), and Chevron (NYSE:CVX).

I picked a price of each company near the 2009 lows and rounded it. I also rounded the current prices and gains. The important thing is to look at the big picture.

Ticker 2009 Lows Current Price Gain(%)
KO $22 $37 68%
JNJ $50 $86 72%
CL $30 $59 96%
KMB $45 $93 106%
MCD $55 $94 70%
PG $50 $75 50%
CVX $62 $117 88%

Currently, I'm almost fully invested. I don't generate enough dividends from my portfolio to make regular purchases. As a result, I need to have cash in the case a downturn happens, so that I could scoop up shares of excellent companies at cheap valuations and high yields when the time comes that most are selling. Value investing works best when most are selling. Right now, it's obviously not that time.

In a Mass Market Drop, All Prices Go Down

Some would argue that in any market, there's value to be found. I don't disagree with that. For example, I believe International Business Machines (NYSE:IBM) and QUALCOMM (NASDAQ:QCOM) are undervalued. But in a recent example, I bought shares of Digital Realty (NYSE:DLR) near fair value, and when the REIT sector pulled back triggered by the rising interest rate, it pulled DLR along with it anyway. I'm still under in the teen percentages. Thankfully, I was able to prevent emotional selling by rationalizing that the company simply went from fair to undervalued, and that its fundamentals are still intact. Thus, in the case of a mass market drop, it wouldn't matter how well a company is doing, most people are still going to sell in a panic.

Buy in Mass Market Drops, and you need Cash for that

Taking advantage of a mass market drop can do wonders for a dividend income portfolio. With most of my money invested, it's prudent for me to build a cash position now, even though it won't do much on the side until the market drop happens. I don't know when, but history tells. And it will come.

Disclosure: I am long BNS, CVX, DLR, IBM, KO, MCD, QCOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I'm long BNS on the Toronto Stock Exchange.