A Dividend-Growth Portfolio Isn't A Strategy, It's A Class Of Assets

by: The Hedged Economist

Summary

The logic of the dividend-growth portfolio.

The limits of a dividend-growth portfolio.

The proper role of dividend-growth as one of many assets.

It’s a valuable asset that needs to be protected.

ORGANIZATION OF THIS SERIES OF POSTINGS ON PORTFOLIO STRATEGY

The purpose of this and the next few postings will be to put the dividend-growth portfolio that has been discussed in many of my other postings in perspective. A year-end summary of the dividend growth portfolio was presented in a previous posting, “Year-End Portfolio Summary: Keepers Carry The Portfolio.” (Year-End Portfolio Summary: Keepers Carry The Portfolio This posting discusses what the dividend-growth portfolio can do and, by implication, what it cannot do. It will be followed by a posting that discusses a second asset: cash. The need for cash beyond living expenses is implied by the deficiency of a dividend-growth portfolio as a standalone investment strategy.

Understanding the role of those two assets, a dividend-growth portfolio and cash, is all that is needed to understand a viable investment strategy that is appropriate for many long-run investors. However, there are other assets that are often considered alternatives to individual stocks and cash holdings. They are discussed in a third and fourth posting. In discussing those near-substitute assets, the emphasis will be on why they are not perfect substitutes. Further, the discussions will also address some of the limitations of those near-substitutes as separate asset classes.

After discussing the four categories of conventional assets, a fifth of posting will discuss the strategy implied by the focus on a dividend-growth portfolio and cash. These five postings might be considered Section 1 of a discussion of a total asset allocation. However, the implications for the appropriate strategy result in a strategy that exposes that investor to a number of important risks. Those risks can be hedged, and, as has been mentioned in connection with other postings, my preferred hedging strategy is to establish another long position that provides the hedge.

After covering the most conventional types of assets and the strategy they imply, there will be a series of postings on less conventional forms of investment that can be viewed as alternative investments. They can provide important hedges. While alternative assets aren't necessarily large portions of the portfolio, they are extremely important because often they are hedging a risk that can potentially create disastrous consequences.

At the end of November, Invesco posted an article entitled “Is Now The Time To Invest In Alternatives?” (Is Now The Time To Invest In Alternatives?) on SeekingAlpha. This series of postings is written in the belief that the question is totally inappropriate. Purchasing alternative investments is not a timing issue. Rather, holding a dividend-growth portfolio as the core of one's investments dictates that certain alternative investments be considered. In many cases, the risks the alternative investments hedge are not risks that one can time. They are the unpredictable and un-forecastable risks that are sometimes referred to as black swans. While the article cited above answers its own question, this series will not recommend specific levels of investment in alternatives. Rather, it will focus on the considerations that an investor should take into account when deciding what level of his or her investments to dedicate to each alternative investment.

The postings will discuss the rationale for holding each type of asset. A final posting will show the overall portions of the total assets in different forms. It will show the quantitative weights given to each different type of asset. It is not a conventional portfolio structure. Further, the weights are allowed to drift over fairly wide ranges. Thus, while the last posting might seem like the most interesting, in many respects it is the least important. The discussion of the rationale for each type of asset should provide an investor with the perspective needed to establish the appropriate weight within that investor’s portfolio.

By organizing the discussion into multiple postings, anyone who wants to can skip the postings related to assets that are of no interest. The decision to present information in a series of shorter postings was a direct response to a suggestion made in connection with a previous posting. A full discussion of a portfolio strategy can be quite lengthy, especially if it discusses the rationale for each asset class. Consequently, readers may prefer to skip certain portions of the discussion since it will undoubtedly cover topics of limited interest. Hopefully, the organization used for these postings will allow the reader to avoid wasting valuable time. After all, time is the most immutable resource available to the investor. On the other hand, when all of the postings on this topic are taken together, they present a complete approach to producing decent returns with minimal risk.

INTRODUCTION

The most important step for an investor is to set the objective for the investment. That's true regardless of what asset is being considered in what time frame. It's particularly important for an investor focusing on a long-run portfolio. The objective should be defined in general terms and in terms of things that the investor controls. The detail is not about rates of return, portfolio characteristics, etc. Rather, the detail should concern the investor’s behavior. After all, the investor can control his or her behavior, but he or she has no control over how the return on assets will behave.

The behaviors an investor has to address are things such as: How frequently does one plan to invest? Does the investor plan to buy-and-hold or trade frequently? How much time is the investor willing to put into planning the portfolio? How much time is the investor planning to put into individual investment decisions? Does the investor plan to use leverage, and, if so, when and how will he or she use that leverage? How will the investor respond to the potential fluctuations in the value of the investments? Will the investor be concerned about the value of each individual asset and want to trade accordingly, or is the investor willing to focus just on the total portfolio value? What time frame will the investor use for evaluating the investments? For example, is the investor monitoring current income and/or value, or is the investor going to focus on value and/or income-generating potential at some future date?

Only after the investor has defined what he or she is going to do is it possible to frame realistic goals. It is then possible to focus on what assets to use to accomplish those goals. Also, once one has determined what one plans to do, it is possible to decide what one wants to accomplish. (It would seem rather silly not to link what one plans to do to what one plans to accomplish, but a lot of people do it). In my case, once I decided what I planned to do, it was possible to set the following goals for my investments:

  1. Generate a reliable income stream that will grow over time
  2. Display less volatility than the market in general
  3. Provide returns that do not lag the overall market over a full market cycle
  4. Contain core stock holdings in a diversified portfolio of assets
  5. Require very few changes over a long period of time

It’s worth noting that the goal, “Require very few changes over a long period of time,” directly reflects the intended behavior. It also should be noted that the goal, “Contain core stock holdings in a diversified portfolio of assets,” clearly acknowledges that the dividend-growth portfolio is just one asset in a broader financial management strategy.

Everything that follows has to be understood in terms of those portfolio goals. The goals then determine portfolio structure.

DIVIDEND-GROWTH STOCKS

Many of my most recent postings have focused on the management of the dividend-growth portfolio. The dividend-growth portfolio as discussed in previous postings is composed of publicly-traded equity positions. That definition, publicly traded equity positions, is a viable definition of an asset class. In previous postings, there were references to other assets, but it was clear in each posting that the dividend-growth portfolio has become the major and the central component of the total portfolio. That is a reflection of the answers to questions concerning my personal plans for what I do. It was not a conscious decision to pursue dividend-growth investing. Rather, it is based upon planned behavior. However, it also reflects the options available (e.g., the absence of constraints imposed by things like 401((K)) plans and government regulations) and the environment (i.e., economic and market conditions) in which the plan is being implemented.

There is a reason for focusing on the dividend-growth portfolio and why the dividend-growth portfolio is central. BARON’S (Barron's - Financial Investment News - Stock Investing News - Investment News) on the front page of the Market Week section on October 9 had an interesting quote. "Capital gains are nice, but dividends provide more than 50% of a stock’s long-term return." One could quibble with the 50% figure since it would be possible to pick a different historical range to define long-term. In addition to varying depending upon the historical period picked, the portion also varies depending upon what types of stocks are included in the sample (e.g., just C-corps or both pass-through and C-corps, all size classes or just the S&P 500, just the industrials or also transportation and utilities, etc.). Nevertheless, market studies that analyze returns for various periods within that historical set have generally found dividends to be responsible for a significant portion of returns on stocks.

If dividends account for about half of the return on stocks, it would be foolish not to focus on them. Further, stocks tend to outperform other assets over a long period of time. So, it would seem to make sense to focus on what is responsible for half of the return of the asset that tends to outperform over the long-run.

In addition, dividends are a convenient focus because they are much easier to forecast than the price of the stock. They are easier to forecast because they are less volatile than prices. The price of the stock can rise or fall based upon greed and fear, but the dividend requires a business that makes a profit beyond that required just to sustain itself. It also requires an inclination on the part of the management to distribute those profits to the owners. Further, earnings and cash flow and any other data related to an equity position can be manipulated, but the dividend is there beyond question. An investor knows it's real.

The table below illustrates the difference in variability of the value of stocks versus the dividends the stocks generate. It's only for illustration since the proof would be a comparison of the variances of the two time series. This casual comparison, however, illustrates the point that dividends are less volatile than stock prices. It's also a much simpler way to illustrate the point than going through the process of showing how to compare volatility in two series, one of which is continuous, and one of which is quarterly.

Values

Dividends

S&P 500

Indexes

Percent

For The

Total

Percent

1/1

Level

Change

Year

Increase

YOY

YOY

2017

2275.12

18.6%

2016

1918.18

-5.4%

2016

46.47

3.2%

2015

2028.18

11.3%

2015

45.04

9.2%

2014

1822.36

23.1%

2014

41.24

11.9%

2013

1480.4

13.8%

2013

36.86

10.3%

2012

1300.58

1.4%

2012

33.41

16.2%

2011

1282.62

14.2%

2011

28.75

12.9%

2010

1123.58

29.8%

2010

25.46

0.0%

2009

865.58

-37.2%

2009

25.47

-23.2%

2008

1378.76

-3.2%

2008

33.15

2.3%

2007

1424.16

2007

32.42

Note: calculating the total dividends for a giving year for the S&P 500 will yield different results depending upon whether one uses dividend announcement dates or actual payment dates. The calculation can also be influenced by how non-cash dividends are valued. However, no matter how those issues are treated, the conclusions are the same because the level of dividend payments doesn't change significantly depending upon how those issues are addressed.

Consequently, a dividend-growth portfolio is a very logical way to pursue the objective of producing a growing income stream. Put bluntly, it is extremely easy and almost automatic if one has started by defining the appropriate behavior as an investor. It is not quite as simple as just stating that “the behavior will be investing,” but is very close to that. Further, if one adds less volatility than the market, and overall performance similar to the market through the cycle, it does not complicate the required behavior tremendously.

Granted, one could always pick the wrong stocks or the right stocks at the wrong time, but, assuming one can learn from one's mistakes, the only consequences of that would be that the time horizon or the savings required would be greater. If the investor sticks with the investment objective and approach, the objective will be reached. The greater risk is to be constantly searching for an objective and an approach, or, even worse, the investor could find that he or she is letting the market’s current performance constantly change how the investor behaves and what the investor wants to accomplish.

In addition, data on individual investor accounts generally show that portfolio returns are inversely correlated with the amount of turnover. That's true for the vast majority of accounts, but not all accounts. Some investors are very good traders, but to embark on that approach requires a determination to overcome certain natural tendencies that weigh against one's probability of success. A buy-and-hold approach generally outperforms. It requires fewer correct judgments: just the buy decision has to be right, rather than requiring both a well-timed sale and a correct buy decision. Buy-and-hold also involves fewer transaction fees.

A dividend-growth portfolio can be constructed so that, under normal circumstances, some stocks will be outperforming while others aren't. Under different market and economic conditions, the relative performance of the stocks in the portfolio should shift so that at all times there will be certain stocks in certain industries that are growing their dividend faster. The stocks that are growing their dividends faster will usually be appreciating in value faster.

In other words, by picking a variety of industries that perform differently over time, a fair amount of diversification can be achieved within the dividend-growth portfolio. For that reason, it's very convenient to include REITs and other pass-through entities as a form of equity. They provide a diversification benefit within the equity portfolio. To exclude them makes no more sense than excluding transportation or utility stocks. It's generally recognized that industry is not a reasonable criteria for deciding what to identify as an equity. Similarly, corporate form, whether a C corporation or not, is not an acceptable criteria for identifying what constitutes equity. By contrast, whether the stock of the company trades on a public exchange (and is subject to exchange regulations), is a reasonable criteria for identifying an asset class. Foreign stocks that can be bought on US markets through ADRs are another method of diversification within the dividend-growth portfolio.

At the investor’s choice, the portfolio can be designed to provide adequate dividends to support the investor. However, a decision on proceeding in that fashion is not a prerequisite for benefiting from investing in a dividend-growth portfolio. Many critics of the dividend-growth approach argue that the goal of generating dividends large enough to live on is an unnecessary complicating factor. They overlook the fact that by pursuing the objective of generating enough dividends to live on, the investor has actually simplified their decision process. Because they have access to the dividends, they have eliminated the need to decide when and which assets to sell. Further, the critics ignore They overlook the fact that the fact that pursuing the goal is a totally independent decision from the decision to emphasize a dividend-growth portfolio. In the process, they often overlook the fact that the dividend-growth portfolio is probably the approach that does the most to make that goal a feasible option.

Investments in dividend-growth stocks are a convenient way to focus on producing a growing income stream. However, they do nothing to protect that income stream. The assets are there working toward that objective, but they are totally exposed to many risks associated with any investment. Forced liquidation is one of the major risks any investor faces. After all, life is uncertain, and, at any point, emergencies or contingencies may arise that require access to the value represented by the assets in a dividend-growth portfolio. Forced liquidation associated with a market decline or market crash can have a particularly adverse effect on the investor. It's a risk that definitely should be hedged. Cash and cash substitutes are a particularly convenient way to hedge the risk of untimely forced liquidation. They will be the subject of the next posting.

However, forced liquidation is not the only risk that has to be hedged when the principal assets are in a dividend-growth portfolio. Inflation, especially rapidly accelerating inflation, can have a severe adverse effect on the real returns from a dividend-growth portfolio. One final risk that is often overlooked is the potential for a loss of liquidity. Modern investors are prone to assume that it will always be possible to liquidate equity positions, but historically markets have been known to close in the US, and many foreign markets have literally disappeared. In each case, the investor’s objective should be to hedge the risk at a minimum cost. A variety of conventional and alternative investments discussed in subsequent postings can be used to hedge various risks associated with the dividend-growth portfolio.

Disclosure: I am/we are long STOCKS IN THE PORTFOLIO REFERENCED.

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.

Additional disclosure: The purpose of the postings in this series is to illustrate the thinking behind the construction of a portfolio that meets the objectives discussed in this posting. There are no specific recommendations regarding buying or selling individual assets other than to the extent that it make sense based upon the logic discussed in the postings.However, I own assets in every category discussed in these postings.