Dividends Matter a Lot, But Not More Than Proper Diversification

Includes: DVY, STO, VALE
by: Roger Nusbaum

There were a couple of interesting comments on the blog earlier this week about what I've called dividend zealots, DZ for short. The way some of the articles and comments by the DZs read it would seem buying companies with long histories of increasing their dividends is an infallible investment strategy. Owning nothing but dividend growers is far from the worst strategy one can implement and while it should be obvious that plenty of people do have success with this, there are people who have success with all other types of strategies. Whatever you think is the worst possible way to invest/trade, I promise you someone is having success with it.

It should also be obvious that any strategy can fail for whatever reason. Constructing a portfolio of stocks that have some lengthy track record for dividend increases still requires picking stocks each of which has their own risks and rewards and the balance of these risks and rewards can change at any time. Dividends can get cut after all. While I am not certain, I would think there would have been at least a couple of financials that would have passed various dividend screens meeting some preferred criteria and if any did pass these screens 2008 still hurt them.

My take on dividends is that they are very important most of the time. In my opinion getting an extra 1-2% portfolio yield above the SPX in a year like 2008 means next to nothing when the market drops 38%, similarly they take on less importance in a year like 2009 where the market goes up 25%. Beyond those occasional huge years, extra yield matters a lot but not more than proper diversification. In my CNBC appearance this past week they flashed a stat that over the last 80 years, 55% of equity returns have come from dividends (that was a new one to me), the one I am more familiar with is 42% of returns coming from dividends since 1950 (I think it is 1950, but you get the idea).

I think of dividends at the portfolio level. The higher the yield versus the SPX the better, up to a point. More important to me than the yield is proper diversification. Being properly diversified gives a better chance of reducing portfolio volatility than being extremely lopsided in stocks that would seem to have many of the same attributes. With a little time spent I'm sure a portfolio could be assembled with 20 stocks that yield five or more percent and work out most of the time but every so often something would come along and decimate the portfolio. Yes the portfolio would probably recover, but a healthy dividend yielding portfolio is not immune to large drawdowns.

For quite a few years now the SPX has yielded pretty close to 2% either way. We've been pretty close to a 3% yield either way and getting there is not that difficult in terms of remaining properly diversified (the way I think of it anyway). Four or five years ago I wrote an article for Real Money where I tried to assemble a portfolio that was diversified in the way I think a portfolio should be diversified that would yield 4% but I came up a few basis points short.

In terms of why not to be too narrowly focused on, in this case, dividends I'll use Vale (NYSE:VALE) as an example. I'm not sure of the exact date of purchase (and I can't call my assistant at this hour and ask her) but I know we had it to start 2005. Eyeballing a Yahoo chart (Google Finance doesn't go back this far with VALE) VALE is up about 375% since the start of 2005 versus a gain of about about 7% for the SPX on a price basis. We still own VALE.

VALE pays dividends, they are not usually very high but they most certainly are lumpy as is the case with many foreign stocks. Many foreign companies have what could be thought of as a dividend policy where they pay some percentage of earnings, so if earnings go up the dividend goes up and if they go down the dividend goes down. There obviously can be other factors but you get the idea.

VALE is no hidden gem. At one point I disclosed that one of the reasons we bought it is because it kept getting mentioned in the Barron's Roundtable, it has also been one of the largest holdings in iShares Brazil (NYSEARCA:EWZ) for a long time. If the whole demand for commodities made any sense to you in the middle of the last decade then you probably at least looked at this company. Ruling it out for lack of consistent dividend growth would have been to misunderstand what was happening globally and how one of the largest miners in the world might benefit.

A less dramatic example would be Statoil (NYSE:STO) which we have owned since late 2004 (we've sold a little twice and bought a little more once). It is up a little over 60% on a price basis in that time and has paid a dividend every spring that has usually been in the 4-5% range (the dividend info at Google Finance is wrong). That the dividend might have grown every year was never the priority, it has actually gone up and down since we've owned it. It offers access that I believe I understand, a product whose demand is going up, a country I know I want to own and the dividend is pretty good. That is a decent thesis behind a stock pick.

I've used these two stocks as examples before because they both capture a forest for the trees idea that I think many DZs miss.