Constructing the Perfect Dividend Growth Portfolio

I have a rather interesting task before me. My greater goal is to have my passive income and side hustle income cover my expenses. If my passive income were a tree, then things like rental income would be the branches, interest would be the leaves, and dividend income would be the trunk. I can lose tons of leaves and be fine. Even the occasional loss of a branch via high winds would be tolerable. But the trunk…well, if the trunk goes, then the whole thing’s comin’ down. I need a strong and stable trunk to make everything else work.

I currently get some meager dividends, ~$300/mo, from municipal and corporate bond ETFs that I hold in a taxable account, as well as some dividends paid on a handful of stocks in my Roth IRA (Apple, Starbucks, a few others). These portfolios, by themselves, would take a very long time to build a trunk that can support the heavy snowfall of expenses in retirement. The Roth IRA is more geared toward no-dividend, growth investments (NFLX, SWIR, TSLA, etc.), while the taxable account is in muni and corporate bonds that have relatively fixed dividend payments and little to no capital appreciation.

As mentioned in my goals page, the plan is to take my prior-job 401k balance, currently ~$110k, that I’ve built up over the last five years, and transfer it from its current stable of fee-paying mutual funds at Principal Financial to a self-directed Traditional IRA with E-Trade made up of individual companies. I love picking stocks. For those with neither the time or inclination, I’d recommend investing in the ETF “VYM,” which is a Vanguard high-yield ETF made up of blue-chip dividend payers. It yields around 2.8% (much better than S&P 500’s 1.8%), and has a low expense ratio of just 0.10% to pay for solid active management of the fund.

But, alas, that is not for me. I want to self-manage. So, I want to go through some basic guidelines I used in developing the portfolio. I think these guidelines and greater portfolio building strategy make for a good primer to somebody looking to start out in dividend growth investing. I’d also love to hear feedback in the comments.

Diversify Across Many Companies

Things happen. CFOs get fired. Accounting shenanigans are possible. Credit ratings fall. Blackberries go the way of iPhones. Enterprise software

yields to cloud solutions. Insiders sell and buy. The list goes on. Company risk is often tough to detect, but it is absolutely necessary to try to mitigate the effects that can be wrought by one bankruptcy or falling out. One of the first questions you should ask yourself when building a portfolio is, “how many stocks should I own.”

Risk is made up of three components:

Unsystematic Risk (UR): This is about 60% of total risk. These are risks that affect just a company or set of companies (currency, credit, sector, economic, country, etc.).

Systematic Risk (SR): This is about 40% of total risk. These are risks that affect all companies and are not based on fundamentals (market, terrorism, volatility, Acts of God, etc.).

Total Risk (TR): UR + SR

The reason we diversify at all is to reduce UR. SR, on the other hand, is part of the game. This kind of risk ain’t goin’ nowhere. No amount of diversification is going to save you money after two planes take down the World Trade Center, a polar vortex freezes the east coast for three weeks, or Lehman Brothers files for bankruptcy (unless you’re hedging, shorting, or going neutral, but that’s a totally different ballgame). The more stocks you add, the lower your UR and TR gets until it reaches the level of SR (40%). It looks like this graph.

According to a study from the Journal of Financial and Quantitative Analysis, going from just one stock to two decreases your total risk from 1.0 to .76—this is 24% reduction of TR and 40% of UR. Ten stocks instead of one eliminates 83% of UR. My rule is that I want to eliminate 95% of UR; to do so requires at least 25 stocks. For beginners, I’d recommend at least 15 stocks. 15 stocks will reduce your UR by about 90%.

Don’t Overload

The cost of diversifying is both informational and financial, so I follow a few rules to consider in determining how many stocks to own.

Information Costs:

You don’t have to be a CFA to analyze your stocks, but it’s important to at least stay somewhat abreast of company events if you want to invest in individual securities. The rule of thumb is one hour per week per stock. I think this is excessive for most folks. Given the ease of information access, and sites like SeekingAlpha, TheStreet, MotleyFool, Marketwatch, and countless others, much of the material information on companies has already been abstracted and formed into nice, bite-size pieces. I say that one hour per month per stock is adequate, plus read the quarterly earnings call and commentary. By this measure, and because I love investing as a hobby, I could follow maybe 100 stocks per month (about 3 hours a day of reading). For most others, I’d expect this to be much lower.

Financial Costs:

The financial cost of diversification is due to that transactions normally take a commission. The rule of thumb (and this rule of thumb Ifollow) is that a commission should not eat up more than 1% of your principal. So, for my $110k portfolio at $10/trade, I could invest in 110 stocks ($110,000 x 1% / $10). Run this equation (# of Stocks = $Port x 1% / $Comm). If you trade for free (i.e. Loyal3), then this guideline won’t be a constraint for you.

Mitigate Sector Risk

Proper diversification is necessary to ensure the stability of asset prices and their associated dividends. Look no further than the recent plunge in oil prices and the resulting punishment that the oil service and drilling sectors have experienced. Sure, the share prices don’t matter nearly as much as the dividends (the market in the short term is just a voting machine, after all) but understand that share price losses often portend risk in the underlying fundamentals—which can quickly lead to dividend cuts or suspensions. Last week, Seadrill (SDRL) suspended it’s huge dividend due to lengthening weakness in deepwater oil drilling. Transocean (RIG) is probably not far behind in cutting theirs. Even the big integrated plays like BP or RDS might see some slowing in dividend growth given the fundamental weaknesses as their payout ratios creep up. The lesson here is to diversify not only across companies (see above), but also sectors. Sector diversification mitigates Cyclical (Business Cycle) risk, and even economic risk, as recessions sometimes benefit (or hurt less) certain sectors like consumer staples or utilities (Family Dollar, for instance, thrived during the Great Recession).

I mitigate risk across sectors by laying out the 10 Big GICS Sectors (Plus Real Estate, my addition) and assigning a target weight that I’m comfortable with to each sector based on how I think that sector is changing, consumer tastes and trends, technological development, etc. Here are my targets:

Don’t Miss The Forest For The Trees

I must not be the only one to have done this. While identifying companies that I wanted to include in my dividend portfolio, I arrived at the consumer discretionary sector. I have long liked Hasbro and it has a lot of the qualities you want. The toymaker of Monopoly fame has a great payout ratio (54%), a strong yield (3.02%), respectable projected earnings growth (10%) and revenue growth (5%), and a decent 10 year dividend increase/maintenance history (it maintained in 2009). But, then I saw Mattel (MAT). Mattel’s P/E is 15 (vs. HAS’s 20), and yields a monstrous 5.04%. Similar company, too—consumer discretionary toy maker. So, I swapped in MAT—and, like magic, saw my projected dividends jump.

Does anyone see a problem here? Right after I added MAT, I immediately felt bad. I don’t like MAT. I don’t like the toy properties it holds (nothing personal), EPS dropped 20% in 2014, and revenue is stagnant. It’s payout ratio is also 20% higher (73%) than HAS. I chose MAT because I went yield chasing. MAT might pay me more today, but chances are, I won’t get any solid dividend growth. MAT will likely lag in share appreciation and I certainly won’t have as much fun watching the company. Moral of the story: I switched back to HAS because yield is just one factor to consider. Understand that at the core of portfolio building, you’re not buying yield, you’re buying companies. The yield is only as good as the company that pays it.

Don’t Fall for Yield’s Siren Song

Dividend growth is a tricky thing. High dividends are attractive to income investors, but if the company doesn’t have the earnings to cover it or, much less, grow it, then you won’t be getting any solid dividend appreciation. Likewise, dividend payments that don’t leave room for retaining earnings to grow the business is not that great either. In business, you’re either growing or you’re dying. Conversely, you don’t want little or no yield, as that obviously means little or no income, or signifies a corporate financial structure that may not be shareholder friendly. As such, I follow two rules on this to screen for potential candidates:

Payout Ratio (Payout Ratio = Dividend/EPS):

The payout ratio (PR) is the ability of a company to pay its dividend. A low PR means the company has plenty of earnings to pay its dividend. A high PR means the company can still afford the dividend, but not as easily. A PR over 100% means the company is paying the dividend with either cash on hand, by issuing debt, or by selling more shares. I want to see a payout ratio that is at least 20%, but less than 70%–potentially up to 90% if it’s moving in the right direction (earnings are growing fast or the high payout ratio is the result of some one-time event). Ratios in this range signify that companies are in the business of rewarding shareholders, but are also retaining enough earnings to grow operations that will take care of tomorrow’s dividend.

Yield Decile:

Here’s a fun exercise. Write down every stock that pays a dividend and line them up in order of yield and break them up into ten equal groups. 0.01% over here in Group 1, and the crazy 30% Seadrill’s, Sandridge’s, and REITs at the other end in Group 10. This is what you’ll see:

Historically, those in deciles 7, 8, and 9 (especially 7 & 8) outperform the market over the long term. Yields in those deciles are priced to be shareholder friendly (returning lots of cash), but not so friendly as to starve the business of capital. I want the bulk of my portfolio in the 7/8/9 camp. Anything above this (REITs and MLPs, usually) need to have solid dividend coverage. Companies below this decile need to be projected for some serious growth (so it will hopefully grow that dividend significantly over time.)

Results

My build of a dividend portfolio led to the below. Obviously this will change from year to year as I rebalance, change my sector allocations, find new companies I like, and assd share prices change. I’ll also cover in a separate post why I chose these specific companies (other than the reasons above).