Monday, March 23, 2015

The Perfect Dividend Portfolio

A few years ago, when I was starting my website, I featured research from Jeremy Siegel on the performance of the original companies in the S&P 500 index between 1957 and 2003. You can find the link in my article titled The Ultimate Passive Investment Strategy. Prof Siegel describes how an investment in the original 500 companies in the S&P 500 would have fared over that 46 year period. My favorite part was about the Total Descendants Portfolio, which assumed a total passive approach, where an investor reinvests dividends, holds on to shares of spin-offs, doesn’t do any rebalancing.

The lessons are very eye opening:

1) Having a totally passive approach has worked great for long-term investors

This is because spin-offs were held, transaction costs and taxes were minimized. It was quite interesting to learn how a totally passive investment ended up outperforming the S&P 500 over that 46 year period.

It is also interesting that only 30 companies failed outright, while 92 were merged and 74 were taken private.

2) The best performers were consumer staples and pharmaceutical companies.

The reason behind this strong performance is because many consumer staples and pharma companies have moats, reinforced by strong brands used regularly by consumers, customer loyalty and pricing power. The combination of competitive advantages, pricing power, brand loyalty which have resulted in above average returns for investors

3) Valuation is important

The most interesting thing is that investors in the so called slow growth companies for which investors have low expectations tend to outperform glamorous companies in new and exciting industries. This is because their valuation is usually low, and because investors in hot industries tend to bid up the valuations in pursuit of growth to the point of low expected returns. If you overpay for future growth, you might not earn a satisfactory return on investment even if your expectations are eventually met.

4) S&P 500 of today is not a passive index

Over the past six – seven years that I have been focusing on dividend growth stocks, I am hearing more and more people talking about index funds like some sort of a magic panacea for all investors. The truth is that S&P 500 is an actively managed portfolio, with frequent turnover, where new companies are frequently added when their valuations are often pretty steep. In addition, index funds have to sell due to adjustments due to buybacks, spin-offs, float adjustments, and other reorganizations. When a new company is added, investors bid up the price before it is added to the index as well, which also causes worse performance. Furthermore, the rules of the index get changes too often and investors who are passive by nature do not probably take the time to learn about them. Needless to say, if you are a terrible investor who makes poor choices, you will not be saved by index investing because it is the lack of education and emotional strength to hold on when things are tough. Plus, if the investor has to select this international index or that other index they heard about on the internet, they are essentially still picking stocks. Only this time the process of picking securities has a fancy named as it is called asset allocation. I have done better than the S&P 500 index since 2007. Of course, if I were a true indexer, I would have also had to own international indexes, which have not done too well. So I have done much better than most indexers out there.  And my goal is not even to beat some index either.

However, if I were a busy professional with a family, and no free time or desire to learn about investments, I would invest only in index funds in my 401k/IRA. That describes most individuals out there (roughly 80% - 90%). Therefore, chances are these people are not reading my site. This situation also doesn't describe most of the people reading this site either.

5) Some Industries are built to last

Many investors are afraid of missing the next hot industry. As a result they chase those new industries, because they believe that they would make their big break in investing this way. They seem to forget that just because an industry makes people’s lives better, that doesn’t guarantee profits for investors. As a result, everyone piles in, pays high prices, but doesn’t make high returns. At the end of the day, the slow growth, boring stocks keep producing consistent results to their long-term investors. The important thing, as we mentioned before, is to avoid overpaying.

6) Some companies are built to last

After reading the research again, and also reading about the Corporate Leaders Fund, I am convinced that investing in blue chip dividend stocks for the long term is the best strategy for my portfolio. It is true that investing in 500 stocks today, and doing nothing, could result in a much different portfolio due to mergers and acquisitions, spin-offs, a few failures. However, from the 500 companies from 1957, there were not that many complete failures. This could change in the future, but nevertheless confirms my belief that doing nothing with a portfolio could actually produce the best results in the long-term. For example, one of my biggest mistakes has been selling a company and thinking that I can do better with something else. In 9 out of 10 such circumstances, I would have been better off I had been busy working instead and not fiddle with the portfolio. A portfolio is like a bar of soap - the more you fiddle with it, the smaller it gets.

7) The most important lesson is to be a long-term investor

The best lesson is that success in investing lies down to choosing an investment at an attractive valuation, building a diversified portfolio of those investments, holding through thick and thin, and only reinvesting dividends selectively. The S&P 500 index which constantly added new companies, was very active and failed to do better than a totally passive index. Investors who believe they can outguess the direction of companies and choose to frequently churn portfolios end up doing pretty bad in the future. That’s why it is important to sit on my portfolio for the long term, and do almost nothing. Time in the market is more important than timing the market. Time in the market is important, because it allows your capital to compound quietly. It is important to keep your winners, and not succumb to rebalancing or too much in other activity. It is quite possible that a few of your companies will end up going more than 1000%, which is why selling early because no one went broke booking a small profit is a foolish mistake to make.

Relevant Articles:

Buying Quality Companies at a Reasonable Price is Important
The ultimate passive investment strategy
Should dividend investors invest in index funds?
Dividend Investing Knowledge Accumulates Like Compound Interest
How to never run out of money in retirement

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