by Dividend Growth Investor | September 19, 2012 1:00 am
Most dividend investors spend a large portion of their time looking for the perfect dividend stocks, analyzing fundamentals and deciding whether companies have the sustainable economic advantages to continue raising distributions in the long run.
Identifying the best dividend stocks and worrying about entry price is just a part of successful dividend investing. Investors should also focus on diversification, in order to ensure that they do not have a major part of their income coming from just a handful of income stocks.
Investors who own a portfolio of income stocks, where a large portion of distributions comes from a handful of stocks could suffer if these securities or the sector they are in experience some turbulence. Financial stocks were some of dividend investor’s favorites before the crisis of 2007 to 2009.
Investors who derived a large chunk of their income from financial stocks saw their dividend income decrease sharply, even if they had allocation to other companies which raised distributions during this dark period for income investors. As a result, dividend investors should focus on sound portfolio or money management, in order to avoid drastic dividend reductions from just a handful of income stocks they own.
There are several ways that dividend investors use money management in their portfolio building processes. Two methods include weighing your positions by yield or attempting to equal weight your positions. Both methods have advantages as well as shortcomings. There are other methods for weighing individual positions in a dividend portfolio, but the two previously mentioned ones are the most common ones in my discussions with dividend investors.
With equal weighted portfolios, investors have adequate diversification in the their portfolio as well as their distribution incomes. As a result, if one or two positions cut dividends in a given year, the overall impact on annual dividend income would not be detrimental.
Some investors also weight their portfolios based on yield. As a result, companies with high dividends get a higher proportion of the portfolio, which leads to higher current yields. Many companies have higher yields when their stock prices are depressed. Other companies of such sectors as utilities, REITs and MLPs have traditionally paid higher than average dividend yields.
The risk of weighting portfolios based on yield is that investors would end up being concentrated in just a handful of high yielding sectors, which could make a portfolio riskier than expected. In addition, an over-representation of higher yielding stocks could offer a big blow to total dividend income if these income stocks have unsustainable distributions and end up cutting or eliminating entirely their fat distributions.
During the financial crisis, investors who had a higher allocation to high yielding Financials and REITs that cut dividends, suffered huge blows to their dividend incomes. The goal of successful dividend investing is to keep receiving a stable dividend income, and not having to go back to work.
I typically attempt to weigh my positions equally, as long as the underlying valuations make sense. I own more than 40 individual issues in my dividend portfolio, which have been accumulated over a very long period of time. As a result, less than half of the positions I own are underrepresented.
This is because I would sometimes purchase shares in a company that temporarily become undervalued. After that the shares would increase in value, making the stock overvalued. As a result I would not increase my position for many years, yet I would keep the stock as long as the dividend is maintained or increased.
For example, my position in Family Dollar (NYSE:FDO) was purchased a few years ago when the stock was trading at much lower valuations than today and was offering a much higher yield. Because I find the stock to be relatively overvalued I have not really added to it in years. This means that it’s relative proportion in my income portfolio has been decreasing over time, especially since I add money to work every month.
I would however attempt to keep companies that are attractively valued currently at close to equal dollar values. For example, let’s look at a situation where I owned $5,000 worth of Phillip Morris (NYSE:PM), and I had a $3000 position in PepsiCo (NYSE:PEP).
Let’s assume that I found PepsiCo to be attractively valued. I would try to add to my PepsiCo position until I own $5000 worth of PepsiCo stock. Currently, the top 30 stocks in my portfolio by weight account for 86% of my total portfolio value. I find 24 of them to be attractive enough to attract new funds from me this year.
Currently, I find both Phillip Morris and PepsiCo to be attractively valued. In addition I also find United Technologies (NYSE:UTX) and Kimberly-Clark (NYSE:KMB) to be priced within my buy range, and I have added to my positions in both stocks over the past month.
Unfortunately, my portfolio is already overweight in both PepsiCo and Phillip Morris which is why I would not be able to add money there for a period ranging from six to twelve months.
United Technologies provides technology products and services to the building systems and aerospace industries worldwide. This dividend achiever has raised distributions for 19 years in a row. Over the past decade, United Technologies has managed to boost distributions by 15.30% per year. The company trades at 17.30 times earnings, yields 2.70% and has a sustainable distribution coverage. Check my analysis of the stock.
Kimberly-Clark together with its subsidiaries, engages in manufacturing and marketing health care products worldwide. This dividend aristocrat has raised distributions for 40 years in a row. Over the past decade, Kimberly-Clark has managed to boost distributions by 9.70% per year. The company trades at 18.20 times earnings, yields 3.60% and has a sustainable distribution coverage. Check my analysis of the stock.
Full Disclosure: Long PEP, PM, FDO
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