Are Dividend Investors Stock Pickers?

My approach is to try and identify the best dividend stocks for the long term, and then dollar cost average my way into the position. I have had my fair share of dividend cutters however, which have resulted in reductions in dividend income. General Electric (GE) and American Capital (ACAS) are two examples where I suffered losses and declines in dividend income. I realize that no matter how good or bad of a stock picker I am, things could change and thus even the best plan could fail accordingly.

In order to minimize the risk of decreases in my dividend income, I have established several controls. Today I will discuss my views on diversification.

I like to keep a diversified portfolio of at least 30 dividend stocks. These stocks should be representative of several industries, in order to avoid weakness particular to specific sectors such as financials for example. The dividend aristocrats’ index is a good place to start looking for income investments because it is more industry diversified. By keeping at least 30 stocks my portfolio will be more likely than not to show returns similar to what the market would return. Just because I am a dividend investor does not mean that I don’t want to have any capital gains however. Quite on the contrary, dividend yields between 2% and 4% are sustainable if coupled with dividend growth potential. Thus I would expect prices to increase in order to maintain the current yield low and prevent most investors from realizing that yield on cost would be higher in the future.

Anyone who believes that a concentrated portfolio of 10- 15 stocks is the way to beat the market and has some success with it is probably playing with chance. Such a portfolio might return more than the averages initially, but sooner or later odds are that returns would get closer to index returns. Another problem with concentrated portfolios is the variability in total returns, relative to a portfolio of over 30 stocks. If all your stocks yielded 4% and you have one dividend eliminator and no increases, your dividend income would fall by 6.67% for the concentrated portfolio and 3.33% for the more diversified one. Thus, you would need portfolio dividend growth of 7.1% just to return to the same income level as before the dividend cut, leaving little room for keeping up with inflation. With a more diversified portfolio on the other hand you only need a 3.40% increase.

The problem with a more diversified portfolio is keeping track of more stocks. If one could easily learn everything about 10 – 15 stocks, then learning about 30+ stocks would probably take twice as much time. The solution is that most quality dividend stocks are characterized by strong competitive advantages, which are prevalent for many years if not decades. While keeping abreast of all developments is important, most of these developments would not have a material impact on the company in the long term. Examples include quarterly earnings and most news about companies. Thus, once you learn about particular companies, you could then spend more time learning about other stocks.

Another problem with a more diversified portfolio is that sometimes it is difficult to find thirty quality dividend stocks which are all trading at attractive valuations. Over the past two years this has not been a problem however, because of the bear market we have been experiencing. In retrospect however, building a quality dividend portfolio does take time. Thus, by starting small and initiating a position in as many attractively valued stocks as possible by dollar cost averaging your way into the position over time and looking for beaten down stocks, one could build a diversified portfolio consisting of over 30 stocks easily. I currently own 38 dividend stocks, and I am planning on expanding this number over time. In future articles I would be specifically addressing my portfolio.

Some of the greatest dividend stocks out there which are perfect building blocks for a dividend portfolio include:

Abbott (ABT) manufactures and sells health care products worldwide. The company operates through four segments: Pharmaceutical Products, Diagnostic Products, Nutritional Products and Vascular Products. Abbott Laboratories has increased dividends for 38 years in a row. The stock yields 3.40%. The yield on cost on stock purchased at the end of 1989 is 37%. (analysis)

Clorox (CLX) engages in the production, marketing, and sales of consumer products in the United States and internationally. The company operates through four segments: Cleaning, Lifestyle, Household, and International. Clorox has paid uninterrupted dividends on its common stock since it was spun out of Procter and Gamble (PG) in 1968 and increased payments to common shareholders every year for 32 years. The stock yields 3.10%.The yield on cost on stock purchased at the end of 1989 is 19%. (analysis)

Chevron Corporation (CVX) operates as an integrated energy company worldwide. The company is a dividend achiever, which has consistently boosted dividends for 22 consecutive years. The stock yields 3.50%. The yield on cost on stock purchased at the end of 1989 is 17%.(analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates through three segments: Consumer, Pharmaceutical, Medical Devices and Diagnostics. Johnson & Johnson has consistently increased dividends for 46 years in a row. The stock yields 3.40%. The yield on cost on stock purchased at the end of 1989 is 29.10%. (analysis)

PepsiCo (PEP) manufactures, markets, and sells various snacks, carbonated and non-carbonated beverages, and foods worldwide. PepsiCo has been raising dividends for 38 consecutive years. The stock yields 2.80%. The yield on cost on stock purchased at the end of 1989 is 16.90%.(analysis)

These high yields on cost are not incidental. Most of the original Dividend Aristocrats from 1989 are generating substantial yields on cost even after they stopped raising distributions consistently.

Full Disclosure: Long ABT, CLX, CVX, JNJ, PEP

Relevant Articles:

- Dividend Portfolios – concentrate or diversify?
- Dividend Aristocrats List for 2010
- Capital gains for dividend investors
- Not all dividend stocks are overvalued