The Dividend Growth Weighting Game

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Includes: AVA, BAX, BBL, BCE, COP, COST, CVX, DE, GE, GIS, JNJ, KHC, KMI, KO, LMT, MAIN, MCD, MMM, MO, NNN, O, OHI, PEP, PG, PM, SCG, SO, T, TGT, VZ, WBA, WEC, WELL, WMT, XOM
by: Mike Nadel

Summary

It seems neither logical nor beneficial to equally weight a Dividend Growth portfolio.

If one is counting on dividends for today and tomorrow, weighting by quality and financial strength seems prudent.

Here is a real portfolio weighted by quality of holdings.

Main Street Capital (NYSE:MAIN) very well might be the creme de la creme of business development companies. The only BDC I own is internally run by proven managers who maintain an impressive balance sheet. Thanks greatly to its generous dividend, I have been a satisfied shareholder for nearly two years.

Still, I know exactly what I have gotten myself into: a company that lends money to firms unable to secure financing from banks and other mainstream institutions. MAIN only has a four-year history of raising dividends, and it froze its payout for 30 months from October 2008 to March 2011. Oh, and mere whispers of a possible Fed interest hike in the spring of 2013 sent share price skidding about 20%. An investor doesn't get a stock with a 7.3% yield without assuming some risks.

So why would I want to depend upon such a clearly speculative holding to provide more income than my portfolio's core components?

Well, I wouldn't. And I don't.

I have been into Dividend Growth Investing for about three years now, and I don't believe equally weighting a portfolio makes sense.

Higher Quality Gets Greater Weight

By dollar value, Johnson & Johnson (NYSE:JNJ) is my largest position. The health care giant's history of dividend increases began the same year Bob Dylan released his first album. (Kids: Ask Mom and Dad what an album is. Then ask who Bob Dylan is. Then go back to ignoring Mom and Dad while you stare at your cellphone screen.)

So it seemed logical that I would want my JNJ stake to generate at least twice as much income as MAIN does for my portfolio. To make that happen, however, I had to invest significantly more money in Johnson & Johnson; right now, the paper value of my JNJ stake is roughly 5 1/2 times that of MAIN. And that's A-OK with me.

Within 8-10 years, my wife and I plan to start living off of our dividend income, Social Security payments and pensions. We need to be reasonably certain that the dividends will keep growing at an inflation-beating rate. JNJ has raised its payout through multiple wars, political upheavals, recessions and Cleveland sports heartbreaks. MAIN? The last time the economy got in trouble, its dividend was frozen for 2 1/2 years.

Thankfully, our portfolio includes far more established, high-quality, dividend-growing companies such as JNJ than it does speculative holdings like MAIN.

Adjusting My Mindset

Back in September 2013, I wrote an article, "Weighting Portfolios: Equally, Variably Or By Dividends Generated?" I concluded: "Still, even as I always, always, always keep an eye on dividends and their growth, my plan for now is to stick with variable dollar weightings by tier."

That was then; this is now. For the last year or so, I have built my portfolio specifically with the dividend stream in mind. I am counting on my 13 "DGI Superstars" (to borrow a term from the series of articles I wrote in the summer of '13) to provide at least 50% of my income.

My 14 "Role Players," strong companies I consider either core holdings or top satellite positions, combine to produce about a third of my dividends.

Finally, there are my "Prospects" -- companies I'm happy to own but which, for one reason or another, do not rate as highly as the others. In total, those eight generate about an eighth of my portfolio's income.

("Mathletes" among you might have figured out that the percentages do not add up to 100%. That's because my relatively small investment in the Dividend Growth 50 is not included in the calculations.)

The following three tables detail my portfolio holdings by percentage of annual dividend income (DIV%) and percentage of paper value (VAL%). A few pertinent notes follow each table.

COMPANY SYM DIV% VAL%
Kinder Morgan (NYSE:KMI) 5.4 4.5
Philip Morris International (NYSE:PM) 5.1 3.6
McDonald's (NYSE:MCD) 4.2 4.1
ExxonMobil (NYSE:XOM) 4.2 4.9
Procter & Gamble (NYSE:PG) 4.1 5.1
Chevron (NYSE:CVX) 4.1 3.7
Johnson & Johnson   4.1 5.3
AT&T (NYSE:T) 4.1 2.5
Wisconsin Energy (NYSE:WEC) 4.0 4.5
Coca-Cola (NYSE:KO) 4.0 4.9
General Mills (NYSE:GIS) 3.9 4.5
Realty Income (NYSE:O) 3.8 3.0
Altria (NYSE:MO) 3.8 3.0
       
DGI SUPERSTARS   50.8 53.6

Over the course of the last 16 months, Kinder Morgan, AT&T, Wisconsin Energy, Realty Income and Altria have moved up to this class.

Thanks to its robust 5.6% yield, AT&T kicks out 4.1% of my portfolio's income while being a mere 2.5% position by dollar value-- the biggest spread among my DGI Superstars.

KMI became my largest dividend producer the day my Kinder Morgan Management shares were converted to KMI via merger. At this time, KMI is the only company for which I have stopped reinvesting dividends; I don't want that position to become too outsized. For the same reason, I also am thinking about turning off the drip for PM.

COMPANY SYM DIV% VAL%
General Electric (NYSE:GE) 4.1 3.7
ConocoPhillips (NYSE:COP) 3.1 2.4
Verizon (NYSE:VZ) 2.9 2.2
Southern Company (NYSE:SO) 2.7 2.2
Target (NYSE:TGT) 2.6 3.4
Baxter International (NYSE:BAX) 2.6 3.2
3M (NYSE:MMM) 2.6 3.6
PepsiCo (NYSE:PEP) 2.2 2.8
Kraft Foods (KRFT) 2.2 2.2
Deere (NYSE:DE) 1.8 2.3
Walgreens Boots Alliance (NASDAQ:WBA) 1.5 3.0
Avista (NYSE:AVA) 1.4 1.3
SCANA (NYSE:SCG) 1.3 1.2
Lockheed Martin (NYSE:LMT) 0.6 0.7
       
ROLE PLAYERS   31.6 34.2

I have trouble classifying GE. It was one of the first companies I bought -- back in 2008, before I had ever heard of DGI. Due to its severe dividend cut in '09 and its 3 Safety score from Value Line, I had it in the lowest tier when I originally settled on this structure. But it is growing its dividend again and has reduced the scope of its troublesome finance arm, so I begrudgingly bumped it up to Role Player.

3M is a core holding and, I believe, one of the truly great American corporations. But I want each DGI Superstar to contribute at least 3.5% of my income, so it doesn't quite qualify for my highest tier. One day, when it isn't so overvalued, I hope to buy more.

Walgreens originally was a DGI Superstar but its overvaluation (and resulting low yield) led me to sell a fairly large chunk of it, dropping it down to Role Player. Of everything I own, WBA has the biggest disparity between the position's worth relative to my overall stock portfolio (3%) and the income it produces (1.5%). With a 1.8% yield, it takes a big investment in WBA to generate meaningful dividends.

I had been accumulating LMT through its DRiP but stopped doing so recently when it changed the rules. It is an outstanding company deserving of this tier in my portfolio, but it now will take me awhile to bring it up to the level of dividend production I desire. That's fine ... I'm a patient guy.

COMPANY SYM DIV% VAL%
BCE (NYSE:BCE) 2.7 1.9
Omega Healthcare (NYSE:OHI) 2.2 1.6
Main Street Capital   2.0 1.0
Wal-Mart (NYSE:WMT) 1.8 3.0
Health Care REIT (HCN) 1.8 1.6
National Retail Properties (NYSE:NNN) 1.1 1.0
BHP Billiton (NYSE:BBL) 0.9 0.5
Costco (NASDAQ:COST) <0.1 <0.1
       
PROSPECTS   12.5 10.6

With the Canadian telecom BCE, currency issues have resulted in me getting fewer U.S. dividend dollars each quarter -- not ideal for a DGI portfolio.

OHI is very close to having earned a promotion. Along with fellow REITs HCN and NNN, however, it lacks the BBB+ credit rating I prefer.

Wal-Mart is on probation due to last year's pathetic 2.1% dividend hike. I'm glad I didn't sell because it has experienced a nice price run-up, but I'm hoping it will announce a much more robust raise next month -- and reclaim its spot as a Role Player.

BBL is my first foray into the materials sector and is a speculation play because it carries only a 3 Safety score.

Low-yielding Costco is my favorite retailer but also is my smallest position by far. I need to add significantly to it over time for it to move up to the next level, but it is almost always overvalued.

Conclusion

I do value my Prospects. I especially like the way MAIN, BBL, OHI, BCE, HCN and NNN bump up my overall portfolio yield. Yet I have absolutely no interest in investing as much capital in my lowest-rated holdings as I do in my blue chips.

I mean, I'm still trying to justify that GE is producing a higher percentage of income for my portfolio than General Mills is. The former infamously slashed its payout during the recession; the latter has paid dividends without interruption or reduction since Cy Young was a star pitcher and not an award!

Bottom line: As I execute the DGI strategy, the quality of my holdings and the sustainability of my growing income stream are of utmost importance. So isn't it common sense to invest accordingly?

Disclosure: The author is long AVA, BAX, BBL, BCE, COP, COST, CVX, DE, GE, GIS, HCN, JNJ, KMI, KO, KRFT, LMT, MAIN, MCD, MMM, MO, NNN, O, OHI, PEP, PM, PG, SCG, SO, T, TGT, VZ, WBA, WEC, WMT, XOM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.