Wednesday, June 25, 2014

Does diversification lead to lower quality of investments in dividend portfolios?

Diversification matters, because it protects investors from the proverbial bad apple that can take a serious bite out of your dividend income at the worst possible time. Dividend investors should construct an income producing portfolio consisting of at least 30 individual stocks, which are representative of as many sectors that make sense, in order to be somewhat diversified.

One of the main concerns that some investors have against diversification involves time spent keeping up with companies and the quality of new investments purchased.

The problem is that not every company is a quality one, and by expanding their list of holdings from 20 to 40, some investors are concerned that the quality of the portfolio would be deteriorating. This could be particularly true, if investors were simply adding additional positions in companies the sake of adding new positions simply to meet the number of positions requirement. Investors should never sacrifice quality of the companies they buy stock in, simply for the purposes of diversification. Owning shares of a company that makes horse-carriages just so you have exposure to the sector would have been a bad idea ever since the automobile became mainstream in the early 20th century. Investors should choose only these quality stocks that make sense and which are attractively valued.

The number of positions in a portfolio will depend on the external environment and the availability of quality firms at attractive valuations. It is much easier to start a dividend portfolio when stocks are undervalued, than when stocks are hitting new all-time-highs every day. However, in my investing I have found that there are usually at least 20 quality dividend companies with sustainable competitive advantages which I find attractively valued. I still monitor companies with solid competitive advantages that I have added to a wish list for a potential inclusion to my portfolio, in order to be ready when the right time comes. For example, in early February, I bought shares in McCormick (MKC) and Diageo (DEO) on the dip, thus taking advantage of a brief sell-off that had temporarily taken those shares into value territory.

The initial amount of time spent to research new positions can easily consume 10 – 30 hours per week. However, keeping up with new material developments affecting the company should not take more than a few hours per week. This makes a diversified portfolio of 30 - 40 individual securities manageable to maintain and monitor.

There are ten major sectors as identified by Standard and Poor’s. For my portfolio, I try to gain exposure to as many of these sectors as possible by purchasing the top three or four companies that pay rising dividends. This provides for an easy pool of at least 30 – 40 companies to own at some point in a diversified dividend portfolio, without lowering the quality of an income portfolio. By selecting the top three or four players in a given industry, when one incidentally ends up cutting dividends or going under, the other major players in the field will win business or might be available for purchasing on dips. As a result, the overall risk to the portfolio is not going to be that high, unless the whole sector is imploding. Of course, it doesn't make sense to merely add companies for the purposes of diversification. If a company is not perceived as a good quality by the investor, and it cannot be purchased for a good value today, then it should not be acquired, even if that means no exposure to the sector altogether. In some sectors such as energy, it is easier to select the top players, since most companies in this group of stocks tend to pay a stable and rising dividend. In other sectors such as Technology, it is more difficult to find a company that has raised distributions for over 20 years in a row for example. The availability of good stock candidates for inclusion in a dividend portfolio is going to vary over time. For example, back in 2008 - 2009, I found utilities like Con Edison (ED) or Dominion Resources (D) to be decent picks.  Currently, I am having a hard time justifying a purchase in any utility company in the US.

In my personal experience, having a diversified portfolio, representative of many sectors, and involving multiple companies per sector has definitely shielded me during difficult times.

For example, back in 2010, my energy holdings included Exxon Mobil (XOM), Chevron (CVX), British Petroleum (BP), Kinder Morgan (KMR) and Enbirdge Energy Management (EEQ). When British Petroleum (BP) cut dividends in 2010, I immediately sold the stock. With the cash proceeds I purchased a stock which was in the energy sector and was also based outside of the US. The company I purchased was Royal Dutch (RDS/B). I could have easily purchased any of the other major oil players, and had similar results. Whenever I sell a stock, I try to replace it with the stock of a company in the same industry when possible. However, this is not always a viable alternative.

Another example was during the 2008 – 2009 period, when many financials cut dividends. I ended up selling State Street (STT), General Electric (GE) and American Capital (ACAS). However, other financials such as Aflac (AFL) or M&T Bank (MTB) did not cut dividends, which is why I hung on to them. I even ended up adding to Aflac at some crazy low prices. Unfortunately, the financial sector did not offer many financial companies that fit my models, which is why I ended up reinvesting most of the funds generated from the sales in stock from other sectors.

To summarize, it is important for ordinary investors to spread their risk out, in order to protect their nest egg. This could be easily done by creating a diversified dividend portfolio that includes at least 30 - 40 equally weighted positions, that are built slowly over time, and purchased at attractive valuations. One should not add companies merely for the sake of adding companies of course. However, based on my experience since 2007 - 2008, a decent number of quality dividend paying stocks is always available at attractive valuations to the enterprising dividend investor. Therefore, it is quite possible to build a diversified portfolio of quality companies, and live off dividends, without being exposed too much to sector risk. As I frequently say, the goal of dividend growth investor is to get rich, and stay rich. I believe that one needs to get rich just once in their lifetime, and then reap the rewards for the rest of their life.

Full Disclosure: Long XOM, CVX,  KMR, EEQ, BP, AFL, MTB,

Relevant Articles:

Diversified Dividend Portfolios – Don’t forget about quality
Dividend Portfolios – concentrate or diversify?
- Replacing Dividend Stocks Sold
How long does it take to manage a dividend portfolio?
Myths about Warren Buffett

11 comments:

  1. Hi DGI,
    Always love your blog and have learnt so much from you over the years. Thanks, Jon from the UK.

    ReplyDelete
  2. What are the ten major sectors? Have you written about that?

    ReplyDelete
    Replies
    1. Hi James,

      Please refer to comment by KeithX

      DGI

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  3. The question is HOW much diversification leads to lower quality investment in a diversified portfolio? I totally agree with you that diversification is crucial and 30-40 (give or take 10) is in the sweet zone. However, many investor are over diversified. There is NO reason to own hundreds of stocks. You cannot own hundreds of stocks (as many mutual funds do) and not be sacrificing quality! I have written an article "Disadvantages of Diversification in Investing" for anyone interested :http://arborinvestmentplanner.com/disadvantages-of-diversification-in-investing/

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    Replies
    1. Hi Ken,

      Thanks for commenting. I actually do not put a limit on total stocks I should own. I think it is limiting, and can lead to poor decisions by investors. If I own 50 stocks today, and all are above my buy territory, I would not add new money there. If fundamentals are fine, I would not sell. So if I have money to put to work, I would put them in new companies, even if that increases my number of stocks to 60.

      The subject of quality is very subjective. The truth is, when I buy a company, I think it is quality today, but one could never know what would happen in 30 years. In my own investing, the best ideas I have had have surprisingly been after ideas number 30 or 40. I experiment a lot in my investing however, and I also hold on to spin-offs for example. I mean if I owned 40 stocks, and those were altria in 2006, Abbott in 2006 and COP in 2006, now I would have stakes in 3 more companies ( KRFT, MDLZ, PM) and (also ABBV) and PSX and PSXP. If my limit was 40 stocks, I would have had to sell those spin-off shares, which would have actually detracted from portfolio quality.

      In addition, in order to get to those 30 -40 companies, don't you think you need to have a higher population of companies to watch, understand, and analyze, and only then purchase if they fit an entry criteria? In my situation that is much more than 100 companies I track. Everyone's situation is different, so just because I could follow 100 companies, that doesn't mean everyone else should do it.

      Actually, there are many investors who owned hundreds of stocks, and still did really well. Peter Lynch is one such investor, and so were Ben Graham and Walter Schloss. Even Buffett has had stakes in much more than 30 - 40 businesses and companies since the 1970s. I believe that the concentration myth is coming from investors who have not really thought out deeply about their shortcomings,what are traits of successful investors etc.


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  4. S&P sectors:
    Information Technology
    Financials
    Health Care
    Consumer Discretionary
    Energy
    Industrials
    Consumer Staples
    Materials
    Utilities
    Telecommunication Services

    Another great article, DGI.

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  5. It's always important to diversify a stock portfolio among different companies in different sectors. There can be such a thing as over-diversification as overall total reruns can be diluted when holding too many companies. What's the magic number for a portfolio? Who knows. There is no one size fits all answer to that question but it seems that most portfolios fall into the 30 - 40 individual stock range. With your examples, you have been able to pick various companies in different sectors at a time when great value was present. This is one of the best ways to build a dividend growth portfolio. Thanks for sharing.

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  6. HI DGI,
    As someone starting out I have just a handful of stocks. However each month my screening process usually pops up repeat companies in sectors I already own. Should I just hold off or look at what is available in a sector I don't own yet (even though not as good of a value?)
    Thanks
    DFG

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  7. Hi there DGI,
    I wouldn't so much as say that diversification lowers your portfolio quality, but rather it stabilizes it through evening out your returns. As one sector does better, another might just do 'ok', while a third does poorly. Had you been more heavily allocated into the two areas that did 'better and 'ok' you'd have been doing very well. Conversely if you were allocated into the 'ok' and 'poorly' sectors you have been worse off. By utilizing diversification you are effectively hedging your results for more stable and expected returns. Although diversification gives no solid guarantee of a return unless you were to buy Options.

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