Wednesday, February 3, 2016

Concentrated versus Diversified Dividend Investing

Some of the best investors in the world, Charlie Munger and Warren Buffett, have been able to make it by having a concentrated portfolio of securities. Their thinking is that investors who are willing to work hard at investing game should concentrate their bets in their best ideas. It is difficult to argue with the results from those two investing titans. It makes sense that if you really know what you are doing, you should concentrate your portfolio in just a few companies, because the effect on the portfolio will be much more pronounced. For example, if you were smart enough to identify Wal-Mart (WMT) at the time it became a dividend achiever in 1984 - 1985, your portfolio would have done much better if you put a higher weighting to this retailer.

For the know something or know nothing investor however, their advice has been to diversify extensively. Today I am going to discuss why I decided to diversify extensively. This is because I acknowledge that I am not Buffett. I also acknowledge that forecasting the future is difficult, since things can change no matter how much research and conviction behind that research I have.

As I explained in an article a while ago, the number of companies in my portfolio has been increasing rapidly since late 2012 and early 2013. Many readers ask me why I don’t simply sell off a portion of those positions and concentrate my portfolio in my best 15 – 20 ideas. In addition to my response , which is still relevant, I will try to add a more honest twist to it.


I started dividend growth investing in 2008, and launched my site at the same time in order to make myself do the necessary work and also journal ideas about my strategy and goals. I never expected the site to get to be as popular as it is today, but a very big plus for me has been the ability to interact with like minded investors.

For the first three or four years, I generally built my portfolio around the same 30 or 40 companies. Over the past 3 - 4 years however, most of the usual suspects I followed and invested in have become overvalued. This prompted me to buy into more companies that I never before owned, but which provided very attractive entry points. Regular readers know that I tended to put a set amount of money to work every month, after an extensive screening and research exercise. This means that I need to put the money to work at the best possible opportunities at the moment.

In the past seven-eight years, I made mistakes such as selling to early at times, but most of the time I did fine. As I kept spending more time investing and evaluating my results however, I noticed that the companies that delivered the best growth in terms of share price and dividends tended to be companies, which were outside my entry criteria or close to breaking them. In other words, the best investment ideas that I had and to which I put a large portion of the capital I had did not do as well as my next best ideas. This is a very interesting phenomenon, since it ran counter to what Buffett and Munger preach.

For example, back in 2011 I bought shares of Visa (V) for about $32/share. I got in at a dividend yield below my minimum requirement, but at a P/E below 20. I also did very well buying Family Dollar (FDO) at 2% yield in 2008, which then kept raising dividends and tripled in price. Those companies were yielding less than my minimum requirements at the time, yet they performed much better than many of those which fit my requirements. I noticed this early on, and kept on testing to see if this is a trend or a fad. I could go on and on about companies I had purchased below my entry yield, which did really well after that. So no, it was not a fad, but a trend.

This is why I am not interested in concentrating in my best ideas. It seemed that my best ideas were in retrospect not the most optimal uses of capital. If I hadn’t questioned myself beyond those best ideas, I would not have been as successful as I am today. In addition, I am also hesitant about selling portions of my portfolio in order to concentrate on those best ideas and reduce the number of securities to a more manageable level. To me, selling a perfectly reasonable company that at least maintains dividends is a mistake, that is compounded by taxes and reinvestment risk.

I have learned that selling a company is usually a mistake, at least per my experience. I would have been much better off just staying in the original company, even if it “looked” overvalued. This is because by selling, I miss out on any potential new gains in dividends and capital gains, I also pay taxes, commissions and might end up in a company which is actually a worse investment than the original one I sold.

After learning from my mistakes, I have been hesitant to sell companies like Colgate-Palmolive (CL), Automatic Data Processing (ADP) or Brown-Forman (BF.B). As a result, those compounders have done really well. This is why I am not going to sell companies that might not fit my entry criteria today, merely to concentrate on my best ideas. This is because my best ideas might or might not turn as good as the sold ideas whose capital those best ideas end up using. As I have said before, I am not Buffett. Anyone who claims to be Buffett (whether directly or indirectly) but lacks the investment record to back up their claim is likely a fraud that is after your money.

I also managed to spend quite a lot of time learning about other businesses in the past few years, which has increased my business knowledge and desire to buy those permanent positions. The thing is that I was extremely busy/booked between 2010 and 2012, which meant less time to dedicate to this site and my investing. However, the nature of quality dividend stocks is such that they do not require much tending. I hear people ask me how I keep up with so many companies, and my response is always that of surprise. As a long-term investor, I try to pick companies that can sit in a portfolio for 10 -15- 20 years, without me needing to do anything other than cash those dividend checks. Not all will succeed, and some will fail, but that is something that will happen either way no matter how much tending I do. I could theoretically sell a company stock if I see it running into trouble, but then I am risking selling out during a temporary dip in business, which is then reversed. That being said, I do check annual financials that come out from companies I own, and check for significant and material events such as dividend increases, mergers and acquisitions, spin-offs to name a few.

Reviewing those takes less than 5 – 10 hours/week, although this is also intermingled with me trying to type up something for this site, as well as looking up prospective dividend ideas. But either way, I believe that if I am no longer here tomorrow, my portfolio will keep spitting out higher dividends to whoever inherits it, for several decades into the future. Whoever inherits my portfolio will not need any knowledge, since they will receive dividends every month, and if a company cuts dividends, they will receive the capital and any gain back.

The thing I am trying to say is that you might have all the information in the world, and all the beliefs about something. However, the future is largely unknown, which is why it is good to have exposure to different types of companies and have a diverse portfolio. It is also important to keep learning new information, and try to implement it to your own situation. Being arrogant, and thinking that you know it all is actually a very dangerous type of mindset to be in. You need to be humble, and constantly evaluate the evidence you have at your disposal. If your picks are not doing as well as expected, you need to reassess your way of doing things. For example, if you consistently end up buying high yielding companies which end up cutting dividends or failing to raise them, you might need to reassess your strategy.

This is one of the reasons why I am increasing the number of companies in my portfolio. At the end of the day, no matter how much analysis you do, things can change that can prove your original thesis void. I am also coming up to the stage in the game where capital preservation is also important to me. I would much rather end up compounding my money at 8% for the next 40 years with more companies and less risk of failure ( failure = permanent loss of capital), than shoot for the stars and compound at 15% per year but high risk of failure. At this stage of the game, I do not believe to be as good as Buffett at picking investments. And neither are 99.90% of investors who are reading this site (sorry Warren).

With that being said, I am keeping the type of portfolio I have. I am essentially having three types of buckets in my dividend portfolio. The first bucket includes the types of low growth but higher yielding companies such as Realty Income (O).

The second bucket includes companies in the sweet spot of moderate yields and moderate dividend growth such as PepsiCo (PEP) or Walgreen (WBA).

The third bucket includes companies with low current yields but high expectations for dividend growth such as Visa (V).

The larger change I have made in the past two- three years is focusing more on tax-deferred investing. Fortunately or Unfortunately, this limits me in the types of investments I can make. For my 401 (k) and HSA, I am limited to low cost index funds.  While the total returns of my individual stock picks have been fairly close to those of a diversified index portfolio over time, what really sold me on tax-deferred accounts is the ability to save as much as 25% - 38% right off the bat with those 401 (k) and HSA plans. Ironically, rational capital allocation does not translate into more readership. But it does translate into more money and more future dividends for me.

So to summarize, for most investors out there, the best solution for investing money is to be as broadly diversified as possible. This includes not only having at least 50 - 60 dividend stocks, but also some fixed income, maybe even own your home too if prices are reasonable. If you are truly honest with yourself, you would know that a concentrated portfolio could have a higher chance of permanent capital impairment, no matter how much research you do. Of course, if you are a truly talented investor, do not let me get in the way of your success. Just be careful and make sure that you are fine going back to zero if you are wrong.

Full Disclosure: Long O, PEP, WBA, V,

Relevant Articles:

Time in the market is your greatest ally in investing
Dividend Portfolios – concentrate or diversify?
How to properly weight dividend portfolio holdings
How I Manage to Monitor So Many Companies
Is your dividend income riskier than expected?

28 comments:

  1. I think a little humility is always good. Buffett says 99% of investment professionals shouldn't do what he does, much less an individual and his retirement accounts. Nice article.

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    1. Unfortunately most investment professionals are salespeople, who only care about growing their book. This includes advisers, mutual fund managers, hedge fund managers etc. Though there are many who are good people, and worth listening to.

      Buffett has a lot of wisdom, that resonates well with people of all walks of life.

      Delete
  2. Nice article. Thanks. Do you share your portfolio anywhere. Curious as to how many positions and what are the other positions other than the usual suspects in dividend space (other than the ones mentioned in the article.

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    1. Yes, subscribers to my free list get a list of my holdings.

      I prefer that people find “the best dividend stocks” as a result of their process, rather than by blindly following me or others. This is why the list is not as readily available as on other sites.

      Delete
  3. I definitely want to keep a more diversified portfolio than I even expected when I first started investing. I originally figured 20-30 but the longer I invest the more I want to own. For one there's more safety. And also as you start investing and learning more about the great companies the more you realize the competitive advantages and how to spot them. There's way more than 20-30 companies that will be good long term holdings. Not all will pan out, most will chug along steadily and a few will be huge growers. So why limit yourself?

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    1. I think that setting any artificial constraints may result in poorer decisions over time.

      There are a lot of great companies, though they are not always available at good prices

      I also think that owning other assets like fixed income could be beneficial down the road.

      Delete
  4. Like you, I am no Buffett but also like you, I have been frugal. As in your article, I continue to stick with my best ideas. One of them is to have a reasonable number of good utilities. They have treated me well. We put a child through college with their appreciated value and steady dividends. They make up a minor % of our portfolio but they provide real umph to small adventures like Apple. Don't be afraid of utilities. Some day the lack of water will be scary and electricity will be king.

    Until next time, keep up the interesting blog!

    ReplyDelete
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    1. Putting a child through college nowadays, is putting your money where your mouth is. Appreciate the real world reminder about steady eddie, unsexy utilities. Any favorites? Not to hijack,but again, your portfolio has met a real world test...

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    2. Look at NEE, WEC, SRE, DUK for 10 year growth, and D, SO for dividend yield. The only stock I have ever had that doubled in one year was an electric utility.

      Delete
    3. I don’t get how utilities can make a minor % of your portfolio, and still manage to put your child through college. You must have a portfolio in the millions or tens of millions.

      I only hold shares of D. I am not sure whether certain utilities will provide the reliable and dependable returns like they did in the past century. I have had my eye on water utilities in the US, but these always seemed overvalued for me. Though a few UK ones seemed attractive at times.

      Contrary to what your statements say, many utilities tend to cut dividends repeatedly over time:

      http://www.dividendgrowthinvestor.com/2013/07/high-dividend-utility-stocks-are-they.html

      Delete
    4. It took all of our portfolio at the time to pay college expenses and included some mutual funds that were gifts to a minor. I had to rebuild my utility holdings once graduation took place. College was my alma mater and a very good bargain as colleges (now a university) go. Thank goodness IRAs and 401ks came along to provide for our retirement after 48 years working.

      Delete
  5. Great article. One thing to consider...while Berkshire does have a rather concentrated stock investment portfolio they have a rather "investment" portfolio when you consider all the business they own in combination with the companies they invest in via stock ownership.

    ReplyDelete
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    1. The portfolio holds more than 30 – 40 individual stocks:
      http://www.sec.gov/Archives/edgar/data/1067983/000095012315011992/0000950123-15-011992-index.htm
      Good point that Berkshire also includes over 70 individual businesses as well.
      Plus they own foreign stocks that have different reporting requirements than US ones, and famously have at least $20B in cash on the balance sheet
      Too bad Warren is 85 and Charlie is 92…

      Delete
  6. Curious if your low cost index funds in tax advantaged accounts includes VIG? I think there is a lot to be said for that one.

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    1. VYM is similar with slightly more yield.

      Delete
    2. You may like this article:

      http://www.dividendgrowthinvestor.com/2016/01/living-off-dividends-in-2016-my-new-goal.html

      DGI

      Delete
  7. Good diversified stock is worth every penny. Some vanguard indexing would work greatly well as well.

    Thanks for sharing!

    Cheers!

    BeSmartRich

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  8. DGI, would love to learn more about your approach when choosing index funds in retirement accounts - tax deffered 401k or Roth. Is your taste for dividends so active here as well? Or are you sampling a broad market of inexpensive indexes? thank you again for sharing your wealth of information to the masses.

    ReplyDelete
    Replies
    1. You may like this article:

      http://www.dividendgrowthinvestor.com/2016/01/living-off-dividends-in-2016-my-new-goal.html

      DGI

      Delete
  9. I enjoy your articles very much. I was just thinking about what your article is about. Over the pass couple of years I have built up to 14 different dividend stocks. Using limited funds, do you recommend building up to a certain amount of each dividend stock or just buy as many dividend stocks for the funds available at a the best price?

    ReplyDelete
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    1. I like to spread my holdings further - 50 -60 is where most of my meat comes from, though I probably own 100 individual stocks. It is easier to monitor a company you are interested in if you have some ownership:

      http://www.dividendgrowthinvestor.com/2015/09/how-i-manage-to-monitor-so-many.html

      Delete
  10. Nice article, it seems we have a similar investing style. I too was thinking 30 was going to be the max but I have found more that I want to own. I do plan on minimal (I hope) stock portfolio maintenance Set up a portfolio of alerts for news and dividends to keep an eye on it and let it grow.
    My 401k is rather limited in its choices too, as far as having to choose from funds instead of being self directed, so at some time in the future when I roll that over I'll be having to redistribute those funds into dividend payers.

    ReplyDelete
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    1. I think diversification is important. I try to select companies that won’t need a lot of hand holding, and not a lot of changes. Change is bad for investors. I was people eating Hershey chocolate, drinking PepsiCola and then brushing their teeth with Colgate – this is great diversification ;-)

      I have underestimated the ease with which investing in a 401K helps accumulate wealth. If you have low cost S&P 500 and maybe some international and maybe some small/midcap, you can just set it and forget it. The downside is what would happen if everyone starts doing it – it might end up hurting enough people in their 401k plans that the government would have to step in. But that is likely a few decades down the road ( assuming this worst case scenario happens)

      Delete
  11. An interesting article. My core holding is ultra diverdified via trackers and funds. I have not the time or knowledge to do like Warren Buffet.
    In my play portfolio I think I know better and I am concentrated in a few

    For me the conclusion is to stay diversified and get markets returns.

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    1. My main concern with index funds is that everyone seems to be doing it today – this was generally not the case 10 - 15 years ago. In hindsight, this seems like an easy path to wealth after a long bull market. Another question I have is whether savers will stick to index funds if markets do not cooperate for a few years.

      I am wondering, if everyone just puts money in the market every month without regards to valuation and what is in that index tracker, what could go wrong? If you just buy shares you may find yourself buying at insane valuations that could result in lower future returns – this is what happened to those who indexed in 1998 – 2000 and hence saw no real returns for a decade and a half. Plus, if the composition of your index is changed to add companies with no real earnings but inflated valuations, your results could suffer. This is what has happened with Valeant in Canada and Mannkind in Israel ( though not sure how large Israeli index fund market is)

      I mean I have spent a lot of time on valuation, and yet I am buying a small/midcap index fund in my 401K that sells above 20 times earnings. The expected return is low.

      I am also buying an international index fund, which sells at a lower P/E ratio, but earnings could go down from here. Plus, international has done terrible in the past 20 years relative to US – check VGTSX vr VTSAX on Morningstar.

      So long story short, buying index funds is not a magic panacea for the investor who knows nothing and chooses to keep themselves ignorant. Those who buy index funds are sold on the “asset allocation strategy” to hold a little bit of everything. But if you are a bad stock picker, what makes you think you are a good asset allocator? Why do you pick certain assets, and not others? Why one should own assets, simply because they are available? Case in point - I see no point for US investors to hold foreign bonds.

      For example, someone only held US dividend stocks in the past decade, they likely did better than someone who owned 1/3 VTI, 1/3 VGTSX and 1/3 BND. Or even better than someone who is told to own ½ VTI and ½ VGTSX ( or 100% VT). While the index investor likely outperformed their respective asset classes, overall their performance was not good.

      Delete
  12. Your writing is appealing for many reasons. Your transparency and ability to stick to your guns is refreshing. Also your consistency as well. As my investment career has evolved so has my philosophy for managing my own portfolio. For 99% of investors they would do just fine focusing on increasing savings rate more than picking blue chip growth stocks and instead plowing that into a low cost stock market index fund as you've mentioned before in the past. Definitely not a 1 size fits all approach to managing risk, but majority of folks unfortunately do more harm then good after transaction costs, fees, and taxes they face an uphill battle. Let's get savings rates above 50% of after tax income, maximize HSA 401k and IRA, and pay off high interest debts. All things you've mentioned before just thought I would add them here.

    Cheers
    Matt

    ReplyDelete

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