Wednesday, June 17, 2009

Dividend Portfolios – concentrate or diversify?

My post on replacing dividend stocks sold triggered some heated debates by some readers. Some investors believe that by concentrating on their best ideas they could generate the best returns. After all, it is much easier to be up to date on any developments on ten to fifteen companies, rather than focusing on at least 30 individual stocks.
In retrospect, it is easy to identify the best performing stocks over the past two or three decades and develop screening criteria that would have triggered a buy signal. The question is whether this success could be replicated over the next two to three decades. I am highly skeptical of methods that show great promise on paper, because the market is an ever-evolving creature, which tends to fool even the best investors. Even the almighty Warren Buffett has evolved his strategies over the years, from a pure Graham follower, to an avid business owner and stakeholder in some of America’s most successful corporations such as Johnson & Johnson (JNJ), Coca Cola (KO) and Procter and Gamble (PG). Without adapting his methodology to the external environment and his portfolio size, Berkshire Hathaway (BRK.A) would have never made it to what it is today.

Back to sticking to the best investments, I disagree that ten to fifteen companies would provide an adequate diversification for ones portfolio. There are about ten sectors that comprise the S&P 500 alone, which sure leaves you holding just a single stock from each sector if you wanted to concentrate only on your best ideas. Chances are that a concentrated portfolio would not be diversified internationally or diversified into small and mid cap dividend stocks. Over time even the best ideas could take a longer time to live up to their full potential especially if the market ignores a group of stocks such as large caps, while favoring international and mid cap domestic stocks. It is difficult to forecast which would be the best performing sectors or stocks over the next few years

A portfolio consisting of 10 to 15 shares would likely experience a higher volatility and thus a higher amount of risk in comparison to a portfolio consisting of at least 30 dividend stocks from a diversified list of sectors. Thus, on a risk adjusted basis the more concentrated portfolio would likely underperform a more diversified portfolio consisting of more than 30 individual stocks.

Even if you owned a quality dividend stock from each sector in the S&P 500, your dividend income could suffer greatly if your stock cuts or eliminates its dividends. If you owned Bank of America (BAC) stock and had a 10% allocation to this once high yielding and high dividend growth stock, chances are that your dividend income would have dropped off much faster in comparison to having a 3% allocation to the stock. You also might have not properly diversified your sector risk as well, as you might have picked the worst performer in the sector, even though the other leaders do better.
For example, Coca Cola (KO) has had a horrible ten-year total return in comparison to Pepsi Co (PEP). While the so-called cola wars have swept the globe over the past several decades, predicting which company would be the winner in each decade would have been highly unlikely. Thus, sticking with both competitors in the cola wars could be the best idea for investors.

Now there is another side to this equation and it is that identifying more than 40 quality dividend stocks could be a rather difficult task to handle. My goal has been to diversify as much as possible by holding up to 100 individual securities. This would make my dividend income stream properly diversified and not dependent on a dividend cut by any individual stock. In reality however, requiring a minimum number of companies to own could lead to lowering your entry criteria, which could prove as disastrous for long term performance as concentrating in the best ten stock ideas that you might have.

One thing to add here is that per the paretto principle, I would expect about 80% of my long-term performance to come from 20% of the issues I select. In a 40 stock portfolio that means that about 8-10 companies that I own today would be responsible for most of my gains over time. Since I own mostly dividend growth stocks such as the dividend aristocrats and the dividend achievers I think that this is a fairly accurate statement. In a previous study I found that the percentage of companies that remain in the S&P Dividend Aristocrats index after 10 years is about 30%. In addition to that the average company stayed 6.5 years in the S&P Dividend Aristocrats index from the time of its addition. In addition to that out of 26 initial components of the elite dividend index in 1989, only 7 are still parts of it 20 years later. The companies are: Dover Corp (DOV), Emerson Electric (EMR), Johnson & Johnson (JNJ), Coca Cola (KO), Lowe’s (LOW), 3M (MMM) and Procter & Gamble (PG).

Of course it would have been next to impossible to predict which ones were to remain the index back in 1989. It would be almost impossible to predict which ones would remain in the index 20 years from now as well, due to the limitations of using only past data to reach a conclusion. Thus, by diversifying your risk by spreading your bets to several stocks from as many market sectors as possible, investors would have a higher chance of finding the best dividend stocks, which would generate the most returns for them for the future.

The article was included in the Carnival of Personal Finance #210 – Punch Out Edition

Full Disclosure: Long EMR, KO, PEP, JNJ, PG and MMM

Relevant Articles:

- Replacing dividend stocks sold
- Warren Buffett – The Ultimate Dividend Investor
- Diversifying into small and mid cap dividend stocks
- International Dividend Achievers for diversification

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