Diversification And Dividend Growth Investing

Summary

• How many stocks do you hold in your dividend growth portfolio?
• How many is too many?  Or, not enough?
• To me, the end justifies the means with regard to a reliably increasing passive income stream.  Yet, I prefer to spread my risk around high-quality names.

In a recent article I talked about the benefits of a dividend growth investing strategy, and especially, focusing on generating a reliable stream of passive income rather than focusing solely on total returns. If you’re interested in that article and the discussion ongoing in the comment section, here’s the link. Today, I wanted to follow that piece up with a piece about diversification within a dividend growth portfolio and how it might differ from traditional diversification ideas.

Before I get doing, I want to say that these are just my views on DGI diversification. Honestly, I’m not sure if there is a consensus regarding the proper way to build and manage a DGI portfolio within the DGI community. The end sort of justifies the means with regard to one’s passive income stream.

I don’t know if there is a right or wrong way to go about accumulating dividend growth stocks, but in this piece I’m going to talk about my strategy for doing so and why I believe it’s the best. As always, I look forward to your opinions in the comment stream as well. I think diversification is an aspect of dividend growth investing that gets relatively little coverage, so I’m sure that we can all learn a thing or two from one another in this regard.

If you follow my work here at Seeking Alpha, you probably know that I own what many consider to be an over-diversified equity portfolio, consisting of 60 individual holdings. In the grand scheme of the contributor portfolios that are posted here at Seeking Alpha, I think that my position count is on the higher side of things. However, there are certainly investors who hold more stocks, bonds, funds, etc.

Some of the critics of my decision to own so many equities talk about the necessity of concentration to beat the broader market. In general, this makes sense. Higher concentration could make it easier to beat the broader markets due to the alpha generated by just a couple of ideas.

I’ve heard comments along these lines: Why settle for your second, third, fourth, etc, best ideas? Just go with your best ideas and invest heavily.

There’s a fairly simple answer to that: risk assessment/aversion.

While I do have favorite companies in different sectors/industries, I don’t like the idea of loading up on just a few companies. I’d much rather spread my wealth around, buying baskets of high-quality names within the sectors/industries that I’m bullish on. For instance, I really like the media/entertainment space long term. I’ve written extensively about why Disney (DIS) is my favorite company in that space, but I also own Comcast (CMCSA), Alphabet (GOOGL) (GOOG), Amazon (AMZN), and AT&T (T) in that space. I like digital payments, but instead of picking and choosing between Visa (V) and Mastercard (MA), I simply choose both. I own Coca-Cola (KO), PepsiCo (PEP), and Starbucks (SBUX) in the non-alcoholic beverage space. In the alcoholic beverage space, I own Constellation Brands (STZ), Diageo (DEO), and Altria (MO). This list of baskets can go on and on.

When I talk about investing I oftentimes use the baseball comparison and say that I’m content to swing for singles rather than for the fences. Sure, by investing in 2-3 companies in each space that I like I’m conceding the ability to own the absolute winner, but then again, I’m also not likely to make a terrible decision that could really hurt my long-term financial outlook. When thinking about diversification, I think it’s important to think about trends and secular growth stories and building high-quality baskets within these areas rather than placing single stock bets. I’m always happy to be safe, rather than sorry.

I’ve had people make comments about the fact that my portfolio of large-cap blue chips basically mimics the S&P 500 (the index which I compare it to regarding total returns) and ask how could I expect to outperform it?

Well, there’s also a fairly short and simple answer to that: value.

I’ve managed to outperform the S&P 500 since I began investing in 2012 with a portfolio that consists largely of S&P 500 names, because I don’t buy them blindly. The problem that I have with indexing is that when you buy a large basket of stocks, you get the good and the bad. You get the stocks that are posting solid performances and those that are shrinking. You get stocks that are expensive and those that are cheap. Instead of buying the bunch, I simply focus on buying high-quality names when they’re cheap. It’s not the company selection that differentiates my portfolio from the broader averages, it’s the valuation that I’m willing to pay.

Over the long term, the market seems to find equilibrium. This is what people mean when they say, mean reversion. The valuation of equities fluctuates, in large part because of human psychology, which is rarely rational. Or, at least, I should say, rare irrational in the moment.

Humans (and therefore, the market itself) seem to be able to make logical decisions when they have ample time to rationalize their scenarios. However, in the short term, it’s fear and greed that oftentimes rule the moment and as a value-oriented portfolio manager, I try to take advantage of this inefficiency and turn it into profits.

There are dividend growth investors out there that do not care much about the value of their holdings. Their focus is 100% on income, which isn’t necessarily a bad thing so long as their decisions are allowing them to meet their financial goals (after all, it’s not alpha that is important, but rather, financial freedom). However, I am not one of them.

Why? Because I’m fairly young and my nest egg isn’t quite large enough to generate the income that I would require to retire comfortably. I need the compounding process to continue to take place and grow my wealth (as well as my income) so that I can reach that threshold one day.

Yet, my nest egg also isn’t inconsequential, so I’m not in a situation where I need to take large risks to reach that threshold either. I require fairly conservative growth to reach financial freedom, so I maintain a balance of growth aspirations alongside capital preservation (once again, getting back to the 'better safe than sorry' mindset).

This is why value is so important to me. Focusing on the margin of safety that value investing provides, I’m able to give myself exposure to risk assets while reducing the level of risk. Obviously, there is no such thing as avoiding risk altogether in the equity space, but buying high-quality stocks at a discount to fair value is about as good as it gets in this regard.

This focus on value and discounts is why I own so many different stocks. Usually, high-quality names don’t trade at discounts for long. When the market overreacts to news, it’s quick to adjust (revert back to the mean) on these names because they’re so widely followed and owned. This means that investors do have to be fairly nimble when taking advantage of the various discounts in the high-quality space throughout the year. It also means that investors will likely have to make large purchases to fill out positions before the sales diminish.

I don’t like to make large purchases all at once. Another capital preservation method that I use is spreading out my risk along the time horizon. What I mean is, I typically like to fill out positions in 3 evenly weighted purchases. Even though I believe myself to be fairly conservative with my price targets and I don’t buy the first lot of three until the shares are discounted properly, I also acknowledge that I don’t have a crystal ball and that the process of coming to a fair value/determining margin of safety can be more art than science (and therefore, I could easily be wrong).

I like to fill out positions in multiple purchases as a hedge against my own potential folly. Sure, this can be sort of counter-productive with regard to maximizing returns (we’re getting back to the high conviction, high concentration methods that others use here). But, I’d rather be safe than sorry; humans are a flawed species and I think recognizing this and protecting myself from myself is a good idea.

But, because I prefer to buy stocks over a longer period of time, rather than jumping in all at once, I oftentimes don’t have the chance to make two or three purchases of a discounted name before it reverts back towards fair value (or higher, even). This is why the majority of the positions that I own are actually underweight.

Luckily for me, I’ve proven to be fairly adept at calling bottoms (or at least, being close). Oftentimes I buy my first lot of shares and never have the option to average my cost basis down. But, that’s alright because it means that the shares that I did buy have moved up in the price, making me money while I continue to collect the yield that I originally found to be attractive.

I don’t mind holding on to so many stocks because high-quality names are less volatile than the rest of the market and don’t require as much regular maintenance. Every morning when the market opens (and throughout the day) I check my portfolio and I only really do deep dives into single stock due diligence if I see a move that is 2-3% (or more). Moves like this typically mean that there was some sort of major news regarding those shares.

During earnings season, owning 60 stocks or so does mean that I have a lot of reading to do. However, oftentimes I have a pretty good grasp of the numbers I expect to see and all I have to do is browse the reports to check up on them. If expectations are being met, I don’t always read the entire conference call and go through the earnings presentations.

I hear some people say that managing a portfolio of 10-20 stocks is too much work, yet when the majority of your holdings are behemoth names like Coca-Cola there isn’t really a whole lot of dramatic change going on in the first place.

I know that Jim Cramer says that investors should spend about an hour a week doing work on their stocks. This might be the right number for investors who own names in certain sectors or industries, but I think it’s overkill for the majority of dividend growth aristocrats. Maybe I’m being too blasé here, but I’m rarely taken by surprise with negative news regarding my holdings. I spend a lot of time doing work on stock throughout the week, but the majority of that work is on new names that I’m adding to my watch lists and/or specific trades that I’m considering in the short term.

I don’t have exact weighting targets for my holdings because I don’t really think that’s all that important. I do have limits on the upper end (I don’t want to be overly exposed to any one given company), but I don’t mind having a bunch of holdings that make up 1% or less of my overall portfolio so long as they’re contributing to my reliably increasing income stream. I’ve sort of found that over the long term, if I focus on high-quality value where I can find it, my sector/industry exposure balances itself out. Different areas of the market come and go as darlings and dogs. By taking what the market gives me, I’m able to continually grow my passive income stream while picking up a diverse set of assets over time.

One thing to consider when owning a lot of companies is the trading costs associated with buying smaller lots. Fees can eat into returns over the long term and personally, I always make sure that the trading cost (money associated with the buy combined with the theoretical sale cost) is less than 1% of my overall position size. This means that the costs associated with trading will never have a large impact on my returns (and they will be less than the costs would have been if I was paying a professional ~1.5% to manage my money).

Thankfully, in this day and age it’s fairly easy to find discount brokerages or to receive free trades from some of the large, well-known brokerage platforms. Usually, these deals are tied to the amount of money that you house with them, so they might not be available to everyone. But, I’d definitely say that you should look around and not be afraid to move your money from brokerage to brokerage when deals are available. I’ve made $1000s of dollars in the past from the cash incentive deals offered by brokers for transferring money to their platform. Yes, the paperwork can be daunting sometimes, but to me, it’s well for an extra $600 here or $900 there (especially when you’re lowering the costs of maintaining your portfolio with cheaper trades in the process).

In conclusion, I think the general theme of this piece is that if you’re focused on capital preservation and conservatively accumulating high-quality assets, it’s likely that you will find a wide variety of stocks to own. And, since the focus on a DGI portfolio is on the passive income stream rather than the total returns (oftentimes, at least), that’s totally okay. Spreading the wealth around within the high-quality dividend growth space protects an investor from single stock risk while still allowing them to achieve their dividend growth goals. I think risk aversion and DGI investing go hand in hand. Some might find this to be boring, yet I find it comforting. I’m well on my way to financial freedom owning these “boring” high-quality names.

If you enjoyed this piece, please stay tuned for the upcoming Seeking Alpha market place service that I'm currently working on: The Dividend Growth Investor Club. I'm hoping that this will be a place where income-oriented individuals can come together and discuss their ideas as we all pursue financial freedom. I'll be posting a variety of exclusive content, including single stock research, sector DGI watch lists chock-full of relevant fundamental data, and sample portfolios with different target dividend yield and growth thresholds for Club members. The service should be launching in the coming weeks.

Analyst’s Disclosure: I am/we are long DIS, AMZN, KO, PEP, SBUX, GOOGL, DIS, CMCSA, T, DEO, STZ, MO, V, MA. 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.