Wednesday, July 22, 2015

Sector Allocations for Dividend Growth Investors

I am a fan of diversification as a tool to reduce risk. I diversify by buying at least 30 – 40 securities, representative of as many sectors as possible. As I mentioned in an article from last year on diversification, there are 10 11 sectors:

There are ten major sectors as identified by Standard and Poor’s. Those include:

Information Technology
Financials (used to include REITs, now they are their own sector)
Health Care
Consumer Discretionary
Consumer Staples
Telecommunication Services
Real Estate Investment Trusts (REITs)

I pick individual securities, based on valuation, quality, and expectations for future earnings growth.

However, I do not select companies simply because they are in a certain sector. I simply focus on companies that exhibit certain qualitative characteristics, which would allow them to boost dividends for years to come. If I can buy these securities at attractive prices, then I buy the security with the cash I have on hand. Sector allocation is merely an afterthought, which is not really that big of a factor in decision making.

Consumer staple stocks account for over a third of my portfolio value. I have relatively low weightings in Information Technology, Materials, Utilities and Telecommunications Services.

Consumer Staples
Health Care
Consumer Discretionary
Real Estate Investment Trusts
Information Technology
Telecommunication Services
Grand Total

There is a danger to overcommitting to a certain sector however. This is the lesson that investors in many financial dividend growth stocks learned the hard way during the 2007 – 2009 financial crisis. If you were overexposed to financials during that period, your income suffered from a wave of dividend cuts and eliminations. I was lucky that I avoided the banks like Bank of America (BAC), though I did lose some income thanks to General Electric (GE).

Speaking of quality, I have not found many quality dividend growth stocks in the telecommunications or utility sectors. There are some with long records of dividends increases of course, but when I analyze them, I simply cannot get myself to purchase them. This could be because I want to purchase a security where I have confidence that the business will remain relatively the same and that the company would churn out more earnings and dividends in the next 20 years. Such businesses would be able to deliver for myself, without much input from me. For example, I find the telecommunications markets to be highly competitive, with low customer loyalty, high level of capital that needs to be invested every year simply to maintain the network, and the relative ease of switching providers. In addition, the market is saturated, which presents the risk that carriers are going to gain market share by stealing the share of their participants. While the dividends from AT&T (T) and Verizon (VZ) are high, I view the payout ratios to be too high as well, and the growth pretty low. Therefore, the high yields are not going to compensate me enough for holding on for the next 20 years.

I am hesitant about utilities companies because they currently seem overvalued across the board. This is because yield chasing investors have pushed prices above what a reasonable investor should pay for utilities. Utilities are slow growth enterprises, most of which tend to go through a cycle of raising and then cutting dividends every so often. In addition, dividend growth is not very good, which leads to poor compounding of capital and income over time for the dividend investor. I always encourage investors to always look beyond juicy current yields in their analysis, but let’s be honest, very few manage to do that. Utilities are good for maintaining your capital base, but not very good for growing wealth.

For those sectors, it is not that I am against them in the first place. The problem is that the companies I have found are slow growth, have high dividend payouts and are capitally intensive. As a result, they are automatically excluded from my list after applying my screening criteria. In the case of telecom, there is the possibility of a price war. In the case of utilities, many are at the mercy of regulators on earn certain rates of return on invested capital. The only utility I hold is Dominion Resources (D), which I have held on for several years.

One of the reasons I am underweight technology is because the industry is subject to paradigm shifts quite often. Things change, products change, and consumer tastes change with technology. Therefore, it is difficult to build a moat and consistently profitable company, while innovating constantly. Another reason for the low allocation to technology is due to the fact that I work in a technology related field. Hence, if makes sense to diversify the risk away.

In addition, I do not exclusively seek internationally based companies, for mere diversification purposes. This is because most of the US based companies I own generate a large portion of their revenues and income from outside the US. That way I do not have to deal with currency fluctuations, learning other accounting rules, withholding taxes and finding a broker abroad. With companies like Coca-Cola (KO) or Colgate - Palmolive (CL) I am earning revenues in over 200 countries around the world. I believe this is adequate geographic diversification of my income from these securities.

In general, I build my portfolio slowly over time, one dividend stock at a time. The building of portfolio is dependent on the availability of quality dividend stocks on sale. The reality of it is that different types of companies are available at attractive valuations at different times. For example, Colgate-Palmolive (CL) was temporarily available between 2008 and 2012 for the enterprising dividend investor. Currently, the stock is overvalued. As a result, it is important to focus on individual stock selection first, and only worry about sector allocations later.

Currently, there are some values to be found in the energy sector. However, I am treading there lightly. I want to purchase shares in a company that will be able to withstand continued weakness in oil prices, while still growing my dividend income, and possibly grow earnings per share in the future. Unfortunately, the only company that piques my interest ( outside of energy pipelines) is Exxon Mobil (XOM). With energy companies, I want to avoid chasing yield, and buying companies which cannot cover their dividend based on forward earnings. It is certainly possible that energy prices will rebound at some point by the end of the decade, which would lead to a rebound in profits and share prices. However, if there is more pain along the way, leading to further capex cuts, losses, and dividend cuts or eliminations, I want to avoid those situations. My goal is to be able to generate a stream of income which should be stable and growing no matter what point of the economic cycle we are in.

The other factor to consider with sectors is that sometimes, you might have some connection/links between different sectors. For example, my exposure to the financial sector includes owning shares in the five largest Canadian banks. If you lump the 5 together as one, this would be one of my largest holdings. However, Canada's economy is exposed to the cyclical commodity prices such as oil and natural gas. Therefore, its banks will be more affected by drops in commodity prices than Wells Fargo (WFC) in the US.

You should also avoid purchasing shares of inferior quality and future business prospects merely to diversify risk away. For example, I am underweight basic materials, because it is very difficult to gain any competitive advantage and consistent earnings power, to pay for stable and rising dividends. Of course if your portfolio consists of only energy, or only financials or only consumer staples, it might make sense to branch out a little bit into other areas. Over time, different sectors will find their way into your portfolio. Since accumulation stages can last for anywhere from several years all the way up to a few decades, you can rest assured that by the time you will live off your portfolio, it will consist of many companies representative of different sectors. As long as you paid close attention to the quality of each individual component of your portfolio however, you should do fine over time.

Full Disclosure: Long GE, CL, XOM, WFC, VZ, KO, D

Relevant Articles:

Canadian Banks for Long Term Dividend Growth
Is international exposure overrated?
Diversified Dividend Portfolios – Don’t forget about quality
International Over Diversification
How to value dividend stocks

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