Wednesday, February 12, 2014

Optimal Cash Allocation for Dividend Investors

Many income investors I have gotten to interact with, seem to be struggling on the topic of what their optimal cash allocation should be. I am going to try and discuss this from my own experience of someone in the accumulation stage of the game.

High allocations to cash can be helpful in situations where markets are dropping. Purchasing attractively priced shares after a 10% - 20% drop in prices is much easier when you have a certain allocation of cash. However, if you have high allocations to cash, and prices keep rising, you have a high opportunity cost of this resource. The past five years have been brutal for those who have been waiting in cash, waiting for a huge correction, which never came. At the same time, the purchasing power of this cash is constantly decreasing, which is normal for cash.

In the current low interest rate environment, having a lot in cash would probably not generate much in income. In addition, investors would be losing out on potential for dividend compounding if they are not fully invested.  If one finds Coca-Cola (KO) overvalued at 19 times earnings, or already has a full position in McDonald’s (MCD), they might decide to focus on a Philip Morris International (PM), Altria (MO) or Kinder Morgan (KMI) instead. One can always find attractively valued dividend stocks out there, as long as they keep looking.

In reality, investing cash as soon as it becomes available in companies which are cheap at the moment could be the most optimal strategy for investors. I find that hoarding too much cash in an effort to wait out until prices correct by a certain predetermined amount such as 10% - 20%, is similar to market timing. Based on numerous studies that have been conducted on investor behavior and performance, it is very safe to assume that for over 90% of investors out there, market timing is a losing proposition.

In general, it does not really make that big of a difference twenty years after the investment, if one purchased at the high for the year or the low, as long as they made the transaction. For example, in 1988, shares of Coca-Cola (KO) traded between a low of $2.20/share and a high of $2.80/share. Investors who didn't want to buy at 2.80/share because the price was “too high”, missed out on the rising stream of dividends that is still going on. While the results from investing at $2.20 and $2.80 are going to be different, the most important thing is to have purchased an asset like Coca-Cola and hold on for as long as it made sense. And Coca-Cola was certainly a good value in 1988, selling for somewhere between 12.20 and 15.80 times earnings and yields between 2.60% - 3.40%. One investor that took advantage of this hidden value was the Oracle of Omaha himself, whose holding company is earning an yield on cost of over 30% on their investment in the world's largest soft-drink maker.

Also in 1988 Bank of America (BAC) traded between $4.50/share and $7/share. Investors who purchased the stock at either the high or the low were much better off than those who held on to their cash and waited for a correction. Of course, if investors didn’t sell after the first dividend cut in 2008 however, they would not have had much to show for their investment. But selling your dividend stocks is not the topic of this article.

In my dividend portfolio, my cash allocation is somewhere between positive 1- 2% and a negative 1- 2%. I usually let dividends accumulate and then reinvest them in the best values at the moment. In addition, I typically try to add cash to my portfolio monthly. I accumulate the cash and then try to make purchases with the proceeds.

I get lists of attractively priced stocks by running my monthly screen on the lists of dividend champions and dividend achievers. As a result of my cash contributions every month, plus the addition of cash dividends from my accounts, I manage to purchase shares in anywhere between one and three companies. Sometimes however, a company that I have analyzed and liked, would get into value territory. My cash infusion might be a few weeks away, yet knowing that this opportunity might be short lived I might take action. One such example occurred in 2010, when Yum! Brands (YUM) announced a dividend increase that effectively put the stock at the 2.50% entry yield I require. I immediately jumped in, and bought a small position on margin. A few days later, my cash deposit and the dividends I received in the meantime increased my cash position above zero.

If stock prices were to fall precipitously from here, many companies which have been previously overpriced, would become cheaper. As a result, investors would be able to scoop up great businesses at depressed prices. Those who are still in the accumulation stage and deploy their cash every month will be able to take advantage of the opportunity and buy quality shares at a discount. More experienced investors might also decide to use margin and make investments, a few days or weeks prior to any planned cash deposits into their brokerage accounts. Investors who held some cash however, would likely be able to deploy a large portion of it in attractively valued stocks, provided that they do not freeze under fire, and provided that they do not wait for even lower prices that may or may not materialize. These are the investors who should carefully consider however the opportunity cost of holding that cash for extended periods of time waiting for a market decline, versus deploying that cash immediately.

Full Disclosure: Long MCD, KO, PM, MO, KMI, YUM,

Relevant Articles:

Should I buy dividend stocks now, or accumulate cash waiting for lower prices?
Warren Buffett’s Dividend Stock Strategy
Dividend Stocks For Long Term Wealth Accumulation
How to accumulate your nest egg
The Only Reason for Automatic Dividend Reinvestment

6 comments:

  1. I assume you're talking about cash outside of regular cash held in reserve for emergency situations, etc.?
    I also struggle with the amount of cash to hold in my investment accounts. Generally, my cash balance is fairly low - I like to put it to work as soon as I can rather than wait for the "perfect" opportunity to deploy capital. I do agree that there are almost always attractively priced dividend stocks to be found, if you are willing to go hunting!

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  2. Love reading your articles. Being less than 15 months from retirement, I have a significant cash position to protect my wife and me from a market correction. Your advice is great for younger investors, with a couple of possible exceptions. One of these are tobacco stocks. I am biased, however, since my younger brother died at age 54 from cigarettes, but I wouldn't invest money there. Second, I think you are missing some great opportunities by having your yield set too high for your age. Starbucks and Nike and examples of stocks with huge growth potential over the next 20 years that are increasing their dividends, but they have yields under your threshold. Anyway, thanks for sharing your thoughts, it is much appreciated. Keith

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  3. DGI,
    This is a difficult subject and is situational. It seems correct to me to maintain emergency funds, that they not be intended for investment, and that funds over that predetermined amount be available to invest. Here, the emergency fund was established long before the first security was purchased. The size of your emergency fund generally is tied to the amount you earn and need annually, a percentage thereof, as you know. This cash position also provides a great deal of stability in bad times. So I draw a distinction between waiting in cash and a emergency fund. If I have money available to invest, I find the best bargain I can and don't hold that cash for long, but the emergency fund is separate.

    All the best and thanks for the posting,
    A

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  4. Thank you everyone for reading the Dividend Growth Investor website.

    Matt and A,

    This article outlines what I think about cash allocation in the portfolio. The emergency fund should be something separate.

    Also, I would love to own some US gvt fixed income/government bonds one day ( 20% - 25%), but I do not see those as good values today, so I would have to wait and see.


    Keith,

    Sorry about the loss of your brother.

    I am not sure about low yielders like NKE and SBUX, which will likely do very well. They seem overstretched and I also can't get myself to purchase a company above 20 times earnings. I sometimes override my rules on yield and streak, depending on circumstances. But I honestly have not looked in much detail over NKE and SBUX financials. Maybe I should.

    Best Regards,

    DGI




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  5. DGI,
    I agree that bonds, generally, are too high. Especially the government and investment grade corporates. Some decent values in High Yield, but you gotta be careful and be comfortable with the risk profile. You are right to be cautious.

    A



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  6. I don't typically aim for any certain percentage of cash because I'd rather put the money to work since there's always something that's of decent value. Around $10k is the most I like to build up to because the opportunity cost is just too high and who knows what the markets will do next.

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