Dividend Growth Investing: The Role Of Diversification

Stock portfolio diversification is a contentious topic among investors. On the one hand, there are those who argue that a portfolio should be concentrated on a small, highly selective group of stocks (less than 10 stocks, perhaps as few as 4 or 5). These few stocks are considered to be the investor's best ideas and can be monitored closely and frequently. On the other hand, there are those who argue that a portfolio should include a fairly large number of stocks (about 20 or 30, perhaps 50 or more). These stocks may provide broad diversification across and within sectors while reducing the portfolio's volatility. I think each approach is justifiable and can lead to investing success, although it may depend on how one defines success. Regardless of the approach an investor chooses to follow, I think it is critical to evaluate the role of diversification in meeting the investor's goals.

What Is Your Investing Goal?

Every investor should have a goal and an investing strategy that is tailored to achieving that goal. As a dividend growth investor, my primary goal is to build a sustainable and rising stream of income from dividends. The plan is for this dividend income stream to eventually replace my job income and allow me to be financially secure in retirement. My secondary goal is to achieve a satisfactory total return on my investments, which I anticipate will happen naturally while I pursue my primary goal. To create my dividend income stream, I have been investing for the long term in established companies that have paid increasing dividends for many consecutive years, generally aiming to buy their stocks at attractive valuations. Some well-known examples of dividend growth stocks in my portfolio include Abbott Laboratories (ABT), Chevron (CVX), Coca-Cola (KO), Johnson & Johnson (JNJ), and Procter & Gamble (PG). Each of these companies has raised its dividend for at least 25 consecutive years; in fact, all of them have already announced dividend increases in 2012.

What Role Does Diversification Play In Achieving That Goal?

A key word in the definition of my investing goal is sustainable: I want my dividend income stream to be sustainable over a long time period. It would be undesirable for my dividend income to increase in some years but decrease in others, especially once I am retired and dependent on that income. Diversification plays an important role in my dividend growth investing strategy primarily because it helps to sustain my dividend income stream in the face of adverse and possibly unpredictable events. That is, should any one of the companies in my portfolio freeze, cut, or suspend its dividend in the future, the effect on my total dividend income can be attenuated through diversification. A simple numerical example may help to illustrate this point. Consider the following two hypothetical portfolios:

• Portfolio A consists of 5 dividend growth stocks that are weighted equally by dividend income, such that each stock provides 20% of total dividend income.
• Portfolio B consists of 25 dividend growth stocks that are weighted equally by dividend income, such that each stock provides 4% of total dividend income.

Imagine that one of the companies in each portfolio suspends its dividend for some reason. This change in dividend policy for just one stock produces substantially different effects on total dividend income, reducing it by 20% for Portfolio A but only by 4% for Portfolio B. If I were retired and living off my dividends, then a 20% drop in income would likely be a serious blow, whereas a 4% drop would probably be less troublesome (though still undesirable). This example highlights the protective quality of diversification, which amounts to spreading out the risk of a loss of dividend income among many stocks rather than just a select few.

How Much Diversification?

Even if one accepts the argument that diversification can help a dividend growth investor create a sustainable dividend income stream, there is the question of how much diversification is necessary. I am not going to offer a specific recommendation for two reasons:

1. I think the degree of diversification should be tailored to the unique circumstances of each individual investor. Some dividend growth investors may be comfortable with 20 stocks each providing 5% of their dividend income. Other investors may desire greater diversification and have portfolios of 50 or 100 stocks, pushing the dividend weight of each stock to 2% or lower. My own portfolio currently consists of 22 stocks, although they are not equally weighted by dividend income. However, I am still building my portfolio and I anticipate eventually having more stocks than I do now, with lower variability among dividend weights.
2. Diversification should only be done when suitable opportunities are available to buy high-quality companies. Regardless of whether a portfolio already has 5 or 25 stocks, it would be foolish to invest in an additional company solely for the purpose of diversification. The company should be analyzed to determine whether it represents a high-quality investment by itself. If it does, and its stock can be purchased at an attractive valuation, then the diversification that it brings to the portfolio can be viewed as a side effect, not a cause, of the purchase. However, if a good opportunity to buy a high-quality company is not available, then it would not be wise to invest, otherwise one might be subject to the criticism discussed next.

The "Diworseification" Criticism

A common criticism of diversification is that it involves adding companies of progressively lower quality to a portfolio (because one would presumably try to buy the best companies first), resulting in a portfolio that is weaker than a more concentrated one. This interpretation is often mistakenly attributed to Peter Lynch, who used the term diworseification in his book One Up On Wall Street (see pages 146-150) to describe a company that needlessly diversifies itself by acquiring or expanding into businesses that bear little or no relation to its primary business, often resulting in negative effects on the company's overall performance. Nevertheless, the term has been co-opted to describe a portfolio made worse via diversification. My counterargument to this criticism is twofold:

1. The criticism is based on the assumption that the portfolio included only the 'best' companies in the first place, which need not be true. (I thank David Fish for making this point in a comment on a previous article.) Perhaps the stock of one of the best companies was not bought in the past because it was overvalued, but now it is attractively valued and its addition would strengthen the portfolio.
2. There is the assumption that the investor can accurately identify the best companies, which is unlikely to be true all the time. I suspect some investors tend to be overconfident, thinking too highly of either their analytical abilities or a company's future prospects. What they judge to be the best company might turn out to be wrong. Diversification by investing in the top two or three companies in an industry - which might be easier to identify than the single best company - can help protect an investor from overconfidence.

The 'Too Many Stocks To Monitor' Criticism

Serious dividend growth investors do not "buy and forget." Instead, they "buy and monitor" their stocks, in part to ensure that their dividend income stream remains intact. I will acknowledge that the average investor cannot extensively monitor every company in a portfolio of more than about 10 stocks. For example, Jim Cramer recommends to his viewers that they should do one hour of homework each week on every stock in their portfolios. (I doubt most of his viewers follow this advice.) However, I do not think that degree of monitoring is necessary for many dividend growth stocks. Companies that have long dividend growth streaks tend to be mature, well-established, and have relatively stable operating performance. It is unlikely that something major is going to happen in the span of a few days or a week that will drastically alter the company's future. For that reason, I do not think monitoring has to be as extensive or as frequent as some people suggest.

For example, consider McDonald's (MCD), which is another one of the dividend growth stocks in my portfolio. I doubt that anything is going to happen tomorrow, this week, or this month that will change my investment thesis regarding the company. It will continue to sell hamburgers, fries, shakes (a personal favorite of mine), and other menu items on a daily basis, operating in much the same way as it has in recent times. I pay attention to the company's monthly sales figures, quarterly and annual reports, and any other major announcements (such as their CEO transition this summer), but that is fairly basic monitoring that does not take much of my time (maybe one hour per month; longer for detailed reports). This is generally also the case for the other companies in my portfolio. Thus, diversification need not result in an excessive monitoring burden. One might accuse me of being overconfident by taking this perspective, but I think of it as being realistic about the time course of changes in the business world.

Conclusion

When it comes to diversification, investors should first know their investing goals and then determine the role that diversification can play in achieving those goals. I think the judicious selection of high-quality companies at good valuations can produce a strong yet diversified portfolio consistent with meeting an investor's goals. As a dividend growth investor, I think diversification can help me achieve my goal of building a sustainable and rising dividend income stream.

Disclosure: I am long ABT, CVX, JNJ, KO, MCD, PG.