In the beginning of 2017, I set out to create a total return portfolio for my long-term savings. At that time, I had learned through self-study about value investing, high-yield dividend investing, and dividend growth investing. Seeking Alpha was a wonderful inspiration, as was Get Rich with Dividends by Marc Lichtenfeld and the wisdom of Warren Buffett.
What Seeking Alpha authors helped me realize is that dividend investing can be about much more than income. It is a powerful mechanism for compounding wealth. As Lichtenfeld emphasizes, a dividend reinvestment plan (NYSEARCA:DRIP) earns a higher return when there are dips in the stock price because dividends are reinvested at a cheaper price. An attractive element of DRIPs is the ability to add more shares in small amounts without paying transaction fees.
Transaction-free investing services were just starting to take hold at the time. They have their drawbacks, but they have their advantages too. They may not offer retirement accounts, but as a teacher, I am not in a high income bracket, so the impact of investing in a taxable account is very small. DRIPs may not be available, but they are not terribly important when one can by shares transaction-free, other than potentially missing out on some microshare ownership. Depending on what investing strategy you use, it can be cheaper to use a taxable transaction-free trading account than a tax-protected account with fees, especially if you are in a lower income tax bracket.
The transaction-free structure became an important part of my dividend portfolio strategy. The opportunity cost of a DRIP is what else I could do with my dividends. With transaction-free trading, I would not have to reinvest each dividend in the stock that paid it if I felt I could invest it at a better value elsewhere. This became the thesis of the Transaction-free Dividend Portfolio. At any time throughout running the portfolio, I would invest my dividends and/or new contributions in the dividend-paying stocks that I felt had the highest potential for total return through margin of safety, dividend yield, and dividend growth.
An added advantage to this strategy is that over time the portfolio would naturally diversify. Nevertheless, through the experience of investing in this portfolio strategy, I would learn a hard lesson about diversification.
The Strategy in Action
My approach to portfolio choices focused on finding dividend-paying stocks with the biggest discounts to intrinsic value. I screened for stocks with dividend yields of at least 3% and/or dividend growth for at least 5 years. These were not hard rules, but they were usually the starting guidelines. I used several different methods to determine quantitative intrinsic values, including earnings-based models, discounted cash-flow models, and a dividend discount model. I also considered various qualitative factors that would contribute to capital gains, dividend growth, and dividend sustainability.
The Top Five Holdings
The first company to attract my attention in early 2017 was Apollo Commercial Real Estate Finance (ARI). Seeking Alpha author Brad Thomas had written several pieces on this commercial mortgage REIT, which was yielding nearly 11% at the time and appeared to be able to sustain that by managing portfolio risk. It also appeared to have room to grow its share price, which it has done by 9.9% since then. My total return with dividends thus far has been 34.3%. I made a large 1-time investment that remains 15% of my portfolio, and have been reinvesting the large dividends in other dividend-paying stocks.
My next 2 investments, Cisco (CSCO) and Target (TGT), were companies that had consistently been growing their dividends and were both yielding almost 4%. Both companies were in periods of strategic transition, which made short-term investors nervous, and I felt that this was driving down their share prices much lower than their intrinsic values. It appears that my thesis was correct for both companies. As their transition plans gained traction, the share prices have grown considerably, and both companies have increased their dividends twice since I purchased them.
Qualcomm (QCOM) was my next big investment. Lawsuits have made investors nervous about the stock, but I had faith in the management's capital allocation skills, its approach to returning value to shareholders, and the power of 5G technology to make it a strong long-term performer. The stock price has been volatile as I held on through good and bad news regarding court cases and a failed hostile takeover attempt by Broadcom (AVGO). I recently took advantage of trade war concerns to add to my holding. Qualcomm's management does not get enough credit for how well it returns value to shareholders. When its stock-price is low, it buys back more shares; when its stock-price is high, it raises the dividend at a higher rate instead. I trust the management to keep using these strategies to my advantage, so I don't worry a bit about how the stock price reacts in the short-term to other internal and external factors.
Most recently, I have been building an investment in AT&T (T). This decision surprised even myself. I was not the biggest fan of the company for a long time, in particular its interest in leveraged buyouts. However, the company is generating plenty of cash flow, enough to maintain the dividend and pay down debt. I was not initially convinced that the Time Warner merger would be all that beneficial, but in this age where content is so valuable, I am beginning to see it. Now the company has sold its stake in Hulu and is looking to offer its own streaming service. While streaming may seem like a crowded market, many consumers are already paying for the HBO subscription that this service would include, and I imagine customers will see value in the ability to bundle the service with various other AT&T services like their cell phone, television, and internet.
When I had my eye on big investing ideas like the 5 above, I made large contributions to my portfolio to fund large allocations. Essentially, the other 30% of my portfolio is built on small purchases made with dividends from the stocks I was already holding. These were chosen because they appeared to be undervalued at the times I bought them and offer more dividend income and diversification.
These smaller holdings have included Bank of Nova Scotia (BNS), CVS Health (CVS), Gladstone Land Corporation (LAND), and some other stocks, REITs, and funds. These have added income and diversification to the portfolio, but not much in the way of capital gains.
*The yield today is the forward yield on the average price paid for shares of the holding.
|Holding||Allocation||Total Return||Yield at Purchase||Yield Today*|
|Cisco Systems (CSCO)||17.6%||95.4%||3.9%||4.7%|
|Apollo Commercial Real Estate Finance (ARI)||14.7%||34.4%||10.9%||10.9%|
|Bank of Nova Scotia (BNS)||4.2%||–1.7%||3.8%||4.4%|
|Gladstone Land Corporation (LAND)||3.9%||–3.2%||4.1%||4.1%|
|Blackrock MuniYield Quality Fund III (MYI)||3.1%||6.2%||6.9%||5.2%|
|CNO Financial Group (CNO)||2.6%||–8.2%||2.4%||2.5%|
|iShares International Select Dividend Fund (IDV)||2.5%||–1.0%||4.2%||4.4%|
|Braemer Hotels & Resorts (BHR)||2.4%||10.8%||6.6%||6.6%|
|Nuveen Preferred & Income Securities Fund (JPS)||2.2%||7.3%||7.2%||7.9%|
|Invesco S&P High Income Infrastructure Fund (GHII)||2.1%||3.9%||5.1%||5.1%|
|Golar LNG Partners (GMLP)||1.8%||–25.7%||21.5%||7.5%|
|Chatham Lodging Trust (CLDT)||1.5%||13.2%||7.0%||7.0%|
The diversification of this portfolio was not intrinsic to its design. It mostly occurred naturally with the purchase of each stock, although diversification was a factor in some of the smaller allocations. The fund is 95% equities, 5% bonds/fixed income, and less than 1% cash. Transaction-free trading does not currently allow direct bond investment, and I have not felt that a large bond allocation–especially indirectly through funds–would meet my total return goals. I keep my long-term cash allocation in a high-yield savings account.
Within the 95% of the fund that is in equities, much of it is concentrated in the top 5 stock holdings. So it is heavily weighted toward the technology and real estate sectors. Smaller stock holdings and some ETFs and closed-end funds, have helped add exposure to other sectors.
33% of equities are giant-cap, 37% large-cap, 20% mid-cap, 10% small-cap, and less than 1% micro-cap. Like the sector allocation, this was mostly incidental, but I have paid some attention to it and am pleased with how it looks.
92% of equities are invested in the U.S., 5% Canada, and 3% other, so it is not very internationally diversified. This is due to a combination of factors. My transaction-free app is limited to companies traded on the NYSE and NASDAQ exchanges. Like many investors, I also find companies in my own country more likely to fit into my circle of competence. While I would like more international diversification, I do not want to make large allocations to stocks I do not understand or to ETFs and CEFs, so I will be patient about international diversification until it works within my other priorities. Bank of Nova Scotia and a small allocation in the iShares International Select Dividend Fund (IDV) are filling that role for now, and I am keeping an eye out for ADRs that meet my investment criteria.
My small bond allocation includes a preferred stock and corporate bond closed-end fund and a municipal bond closed-end fund. 93% of their holdings are investment-grade. Earlier on, I was more bullish on high-yield bonds, but I have gradually allocated away from them as I have felt that the high-yield market in both corporate and municipal bonds was becoming increasingly risky.
In my teaching career, I have learned that often warning people about the mistakes you have made doesn't always work. Sometimes people need to learn by making the mistakes themselves. In my own learning I am no exception.
I have been warned plenty of times about the danger of diversification becoming "di-worse-ification." The 5 best ideas I had in 2017 were huge performers for me. Smaller allocations I made in lukewarm ideas have mostly been a drag on returns. In fact, my 6 best ideas, which were my 6 largest allocations, have offered a combined return of 27.6%, while the other 18 holdings I invested in have had a combined return of –0.5%. It might have been better to have a more concentrated portfolio and hold cash for longer if I did not feel that there was a strong case for investing it in a particular security. I should have been more patient about diversification.
I also found that as my portfolio grew, it became more difficult to keep tabs on every security I hold, especially when I entered graduate school in February of 2018 and became extremely busy. For both these reasons, I have been working within the past few months to simplify the portfolio a bit. I sold 4 securities that–while profitable–required too much work to understand. This allowed me to add shares to holdings that I like and understand and that continue to be undervalued. I look forward to keeping a more concentrated portfolio for the near future, at least for my remaining busy year of graduate school.
|Holding||Total Return||Reason for Change|
|Omega Health Care Investors (OHI)||31.5%||Sold to reduce risk exposure.|
|8point3 Energy (CAFD)||5.6%||Acquired.|
|Nuveen Real Asset Income and Growth Fund (JRI)||5.3%||Sold to simplify the portfolio.|
|Brookfield Real Assets Income Fund (RA)||8.3%||Sold to reduce risk exposure.|
|Delaware Enhanced Global Dividend and Income Fund (DEX)||0.8%||Sold to simplify the portfolio.|
|Nuveen AMT-Free Quality Municipal Income Fund (NEA)||0.6%||Sold for better opportunity.|
|Gladstone Investment Corporation (GAIN)||40.6%||Sold to simplify the portfolio.|
|Credit Suisse Asset Management Income Fund (CIK)||–0.3%||Sold for better opportunity.|
|Buys||ARI, BHR, BNS, CAFD, CIK, CLDT, CSCO, DEX, GAIN, GMLP, JPS, JRI, NEA, OHI, QCOM, RA, TGT||CNO, GHII, IDV, LAND, MYI||BHR, CVS, GAIN, JPS, LAND, QCOM, T|
|Sells||NEA||CAFD, CIK, RA||DEX, JRI, OHI|
Returns, Risk, and Conclusions
The returns I have had on this portfolio have been wonderful, but I of course have benefited from a bull market. Without taxes and fees, the annualized total return if I had invested in the S&P 500 over the period I held this portfolio would be 8.3%. It has been a good time to invest in stocks. The pre-tax annualized total return of my Transaction-free Dividend Portfolio is 10.8%, outperforming the S&P 500 by about 30%.
I did not publish post-tax returns because those could be different from one investor to another. If you make twice my salary–like many of my non-educator friends do–you would pay a higher tax rate for holding this identical portfolio. You might be better off using a different strategy in an IRA.
The numbers given here to show my returns are based on the stock prices of my 16 holdings at the close of the market on June 7, 2019. Those could easily change in a short period of time, as they have been doing quite frequently in the recently volatile market.
Having exposure to a more concentrated portfolio than the broad market means more risk from factors affecting individual securities. For example, the S&P 500 might barely budge from a bad earnings report from Target, but my portfolio could easily drop 2% from that news. I do not mind this risk, since I have taken the time to get to know my stocks and am confident in their long-term outlook.
I am currently not overly concerned about CVS being down 17% because I believe in the long-term potential of company's transition plan. I haven't lost too much sleep about GMLP being down 47% because I anticipate growth in the LNG carrier industry over the next few years, despite–and perhaps even because of–low natural gas prices. I will happily continue to collect income from these stocks while I wait for their prices to come back up, just as I did when Qualcomm and Target were down 9-10%. In early 2018, my shares of Omega Health Care Investors (OHI) were down 18%. I waited it out, collected dividends, and sold them in 2019 for a total return of 31.5%.
Maybe I am crazy, but I do not fear stock price volatility. If you do, then a concentrated value stock portfolio is probably not for you. You might consider buying some index funds and avoiding checking in on them too often. I see margin of safety and high-yield dividend income as protections against capital losses, and I see short-term price dips as opportunities to reinvest dividends at less expense. I love that transaction-free trading has given me the opportunity to do this in a flexible way. My biggest takeaway from 2.5 years of dividend investing is that investing in my circle of competence and understanding the stocks I own helps me both beat the market and sleep well at night, and sacrificing that for the sake of diversification is not the right choice for me.
Disclosure: I am/we are long ARI, BHR, BNS, CLDT, CNO, CSCO, CVS, GHII, GMLP, IDV, JPS, LAND, MYI, QCOM, T, TGT. 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.