I spent the better part of a three-decade long engineering career breaking things. My colleagues and I routinely used high, low, and varying levels of temperature, vibration, and electrical stress to fry, freeze, and fracture the electronics used in aircraft and elevator controls and then eliminated the root cause of the problems discovered before the product was released to the field for customer use. The testing method was called Highly Accelerated Life Test, HALT for short. I'm actually writing a book on this subject and it should be published early next year.
Our philosophy was that it is better to know how a product fails instead of how it works properly. After all, there are really only a handful of things that can go wrong, but many things tend to go right. It's also much easier to understand and correct a problem in development so it never actually occurs under normal use.
The same approach can be used to analyze a dividend growth (or any) portfolio. Looking at just a few things that might go wrong (before it goes wrong) is preferable to fixing things later.
HALT on a dividend growth portfolio would consist of subjecting the portfolio to a series of "what-ifs," or a form of stress testing.
For example, if Company XYZ stops increasing the dividend, how will that affect the total income stream? Or if Company XYZ plus Company ABC stops increasing the dividend, what happens? And what if Company 123 eliminates the dividend in the same year that ABC and XYX freeze the payouts?
I'll use my own portfolio as an example. The table below contains the list of the dividend stocks that I currently own, the portion of total dividends each stock pays, the portion of overall income each stock contributes (I also own two bond funds that throw off income), and a short list of intangibles and concerns.
|Ticker||Portion of Dividend Income (%)||Portion of Total Income (%)||Intangibles|
As you can see, three stocks: Apple, Inc. (NASDAQ:AAPL), United Technologies Corp. (NYSE:UTX), and Chevron Corp (NYSE:CVX), and an exchange traded fund, ALPS Alerian MLP ETF (NYSEARCA:AMLP) comprise over half of the dividend and more than a third of overall income. If anything were to happen to the payments from those four investments my total income stream could be adversely affected.
AMLP, an index fund of individual MLPs, mostly oil and natural gas pipeline, processing, and storage companies, is tied to the energy industry. The ongoing rout in oil prices over the last year and half has migrated over to the midstream after decimating the upstream producers, such as Chevron. A mitigating factor is that the strongest companies in the MLP industry and AMLP index might not be as affected as much as the firms that are more prone to lower prices and those that more highly leveraged.
Concerns about a slowdown in building construction in China could impact United Technologies.
I wasn't counting on a growing dividend from Apple. It became an "accidental high yielder" (stealing a phrase from a fellow SA contributor) after it resumed paying its dividend some time after I bought the stock.
Fix and repeat
It's all well and good to identify potential bad apples (no pun intended) in your portfolio. The rubber hits the road when you take steps to prevent any contagion from affecting the real reason that you own dividend paying stocks in the first place: income.
A potential threat from a slowdown in iPhone sales probably won't affect the Apple dividend any time soon. Putting aside Apple for now leaves AMLP, UTX, and CVX as the primary threats to the income-producing dividend portfolio.
As in the HALT process, corrective action, or a fix to prevent the potential failure from affecting the entire system needs to be performed on the dividend portfolio.
Many possibilities exist. Ensuring that cuts in the dividend stream won't impact the overall income generation process is one. My rule of thumb is that the total income achieved is 25% greater than the total income needed. This can cushion the blow if say AMLP or CVX suddenly stop increasing, or heaven forbid cut, the dividend. I foresee turmoil in energy as more of a risk than a potential UTX China slowdown problem.
Using a "worst case" scenario of losing half of the AMLP and CVX dividend streams, I find that I'm still in good shape. The overall income would drop by about 10%, well within the 25% cushion.
Therefore, I'm inclined to not take any drastic action regarding AMLP or CVX, especially considering that I have paper losses on both stocks due to the oil crisis. Tax lost harvesting is not an option for me at this point. However, it is imperative that I monitor the situation continuously going forward.
As I did during my working career applying HALT to electronic products, I use the same techniques in stress-testing my dividend growth portfolio. Finding the weak links is prudent in today's market environment, especially for energy-related issues such as AMLP and CVX.
Disclosure: I am/we are long CB, UTX, AFL, AAPL, CVX, AMLP, T, VZ, WMT, VOD, KO, MCD, JNJ, PG.
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.