Wednesday, March 30, 2016

Focused Dividend Investing: Pros and Cons

I believe that diversification is the only free lunch in investing. However, different investors have different takes on the topic of diversification. Some claim that it makes sense to only invest in their best ideas. I will try to discuss the pros and cons on the focused approach. At the end, I will talk to you about my take on the situation.

Focused Investing Pros:

1) If you purchase a great company, which is a successful investment, it will help your portfolio a lot if you are overweight in it. For example, if you invested everything in Wal-Mart when it became a dividend achiever in 1984, you would have done much better than the average investor out there.

2) It helps the investor really focus on a select number of companies and learn everything there is to those companies. If you have a substantial amount of money in a few stocks, you will monitor them very closely, and you will be intimately more familiar with them.

3) It is easier to track 20 companies, than track 50 or more. In addition, the investors could learn more information per investment when they focus on about twenty companies, than when they focus on 50 companies.

4) If you have great ideas, you should put most money there. If you have a few great ideas over your lifetime, and you put a large portion of networth to them, the wealth building effect to your bottom line would be tremendous.

5) Some of the best investors such as Warren Buffett, Charlie Munger have made a majority of their money from just a small number of concentrated bets throughout their career. We have all heard about the time when Warren Buffett put 40% of his partnership in American Express (AXP) in 1964, and made millions of dollars.

Focused Investing Cons:

1) If the investor is still starting out, they might concentrate on the wrong type of companies, which could lead to massive losses. For example, if you just started investing in 2007, and you bought Bank of America (BAC), you would have lost a lot of money in the process.

2) It does not take a lot of time to research companies.Even if you think you know everything about a company, there are still unknown risks that could crush a portfolio – earthquake, new regulations, changes in consumer preferences, bad press etc. Therefore, you never know what your best ideas are ahead of time and it is impossible to know what will happen in the future. If you spread your bets however, the risk of loss from a single position would be minimized.

3) The investor might be wrong on their assessment of the company, and their portfolio could suffer a big blow from a concentrated position, from which they might never recover financially and psychologically.  If the investor in step 1 loses a substantial amount of money on a concentrated investment, chances are that they will remember this pain of money and loss of an ego for a long period of time. This pain might preclude them from investing in the stock market ever again. The opportunity cost of this might be the difference between retiring and working all your life.

4) You must be willing to sit through long, and excruciatingly painful periods of time, when you will be out of step with reality. Most investors I have met do not have the type of psychological training to hold onto their strategy when it is temporarily out of step with everything else. Example – tech stocks did great between 1998 – 2000, yet investors in Berkshire Hathaway and other old-economy companies did terrible. Yet, even if you bought those at the top, you did better in the long run. However, listening to your neighbors brag about earning 100% in one year on their tech funds, while you are temporarily losing money would be very tough psychologically.

5) In reality, you need to learn about at least 100 or so companies in order to get a portfolio of 10 or 15 companies. Since things do not change materially from year to year for most dividend growth stocks, I don’t see a problem with someone holding 50 companies. If you analyze one company per week, you have effectively monitored all of your positions. Of course, if you check Johnson & Johnson (JNJ) for “news” or “opinions” every single day, you are wasting your time, not doing serious research.

6) You are not Warren Buffett. Since a very early age, he has studied, operated and thought about business every single day of his life. He has spent 70 hours per week screening for companies, reading annual reports, reading other relevant materials like trade/industry publications, and tap dancing to work. If you spend 50 hours/week at your job, chances are that a focused approach might not be best, since you don’t have the time to really study everything about 10 companies. Thus diversification might be an easier solution. As a side note, I have learned to avoid looking for the next Warren Buffett. Most Warren Buffett wannabe's end up concentrating their investments and losing a lot of money when things go wrong. You may want to research the Valeant (VRX) saga for more details.

My take

The more I learn about investments, the more humble I become because I realize how much I don’t know. To me the cost of concentrating on an investment that doesn’t work out is simply not worth it.

I never know what my best ideas are ahead of time. Out of all the companies I have analyzed since 2008, and all the companies I have purchased for my dividend portfolio, I realized that the truly outstanding performers were those that I would not have placed in a top ten dividend portfolio.

I also experiment with different ideas from time to time. This is why I have 20 -30 positions that are less than 1% in my list of portfolio holdings. This is because I constantly challenge myself, as I keep learning more. For example, my studies of history indicate that the best performers of the past like McDonald's (MCD), Wal-Mart (WMT) or Procter & Gamble (PG), were never in the sweet spot in terms of dividend yield and dividend growth. This is what prompted me to buy Visa (V) in 2011 at $94. I also held some small positions in W.W. Grainger (GWW) and Sherwin-Williams(SHW), which did great, but I decided to sell and buy higher yielding companies in the sweet spot. My best ideas did well, but not exceptionally so. Thus I learned a lot by expanding my portfolio size.

I have also learned humility. In early 2014, my best idea was Phillip Morris International (PM). Since 2008, everyone believed that it would do better than Altria (MO). In fact, the opposite turned out to be true. However, things have slowed down a little.

I have learned it is good to hold the leaders in a given sector or industry, rather than place all my bets on one company.

I own both PepsiCo (PEP) and Coca-Cola (KO), and even Dr. Pepper Snapple (DPS). Each one has a sort of unique risk and rewards to it, which make it great in my portfolio.

I hold a variety of companies in portfolio, which will do well under various scenarios. If I am wrong on future dividend growth, I will earn some dividends on my high yielders like Verizon. I am exposed to rapid growers like Visa (V) or Casey's (CASY). I also have a lot of companies in the middle ground, which are doing fine.

I built my positions over time. To build a portfolio with $30,000 worth of stocks, I need a little less than 30 months if I save $1000/month. The quantity and availability of good ideas changes over time. If I thought Altria (MO) to be a steal at $15 in 2009, I might still like it at $60/share, but I might not be willing to put money to work there. Therefore, I would have to find another idea. Sure, I could sell Altria (MO) today and buy something like Phillip Morris International (PM), which is cheaper and has better prospects. But I don’t want to pay taxes to sell Altria and buy PMI, which will neutralize the effects of the transaction.  I don’t want to compound risks. Everyone assumes PMI has better prospects than Altria. But the reality is Altria has to deal only with US Fed and State government. PMI has to deal with a lot more governments, which is similar to spreading resources too thin. Perhaps, this is why it has done worse than Altria since 2008. The main point is to be diversified, since the future could turn out much more differently than your expectations. Anyone that tells you how the future could be predicted is either lying to you or lying to themselves. The lesson is to be conservative with your portfolio, in order to increase your odds of survival no matter what.

Thank you for reading! Is your portfolio diversified, or concentrated?

Full Disclosure: Long MO, PM, V, CASY, PEP, KO, DPS, GWW, MCD, PG, WMT

Relevant Articles:

Concentrated versus Diversified Dividend Investing
Dividend Portfolios – concentrate or diversify?
How to properly weight dividend portfolio holdings
Is your dividend income riskier than expected?
The importance of multiple income streams

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