I have received a number of emails and comments from new investors about how to construct a dividend portfolio and steps that someone should take. In this post, I will set out my thoughts about how I think about constructing a dividend growth portfolio.
Constructing a dividend portfolio is not a very difficult thing in my mind. It requires some basic research and due diligence to set up, some discipline to implement and follow the strategy and then ongoing monitoring to ensure suitable progress of the business you invest in. The key thing I try and look for is dividend growth rather than just dividend yield.
So where do you begin?
Large Cap dividend stocks
I believe that these should be the anchor points of the portfolio. Large cap growth stocks tend to have a solid dividend yield of at least 3% and a proven ability to grow this dividend over long periods of time, at a minimum of at least inflation if not higher.
The majority of my own portfolio is comprised largely of these stocks. They tend to have less volatility and steady and consistent growth. In fact, the total return from these dividend payers is generally comprised the initial yield that they pay plus the rate of increase in the dividend, according to The Ultimate Dividend Playbook.
The types of Large Cap Growth stocks that fall into this category are once such as McDonalds (MCD), The Coca-Cola Company (KO), Pepsi Co (PEP) .
If you are new to investing or just starting out with a dividend portfolio, you should likely source most if not all of your dividend income from these stocks.
Large cap growth stocks will be characterized by many years of dividend growth, good consistent increases in revenue growth, earnings growth and operating cash flow growth. They will also have sustainable competitive advantages which may be in the form of a strong, well recognized brand, solid intellectual property or some type of network effect.
International Dividend Stocks
For those that are feeling more comfort with their investing, it can be well worth your while to add some international dividend exposure to the mix. This can be valuable for a few reasons, particularly stronger economic growth overseas as well as favorable exchange rate consequences. Many economies overseas have been experiencing higher rates of growth than the US and the dividend growth from some of the dividend payers in these economies is indicative of that.
Also, many of the emerging economies will experience an appreciation of their exchange rate versus the USD over time as their economies grow and attract additional investment. So investing in an international dividend stock from an emerging economy can not only give you higher organic rates of dividend growth, but you will also be able to ride an exchange rate tailwind over the years.
There are a few considerations to keep in mind with international dividend stocks. They typically only pay dividends once or twice a year, in contrast to the quarterly schedule that you get with US stocks. Also the tax consequences can be a little messy, particularly if the country doesn’t have a tax treaty with the US.
Examples of stocks worth considering in this category are Novartis (NVS) and Westpac Bank (WBK).
Low Yield/High Growth Dividend Payers
While I prefer dividend stocks with higher dividend yields, it can be worth your while to look at slightly lower yielding dividend stocks with high rates of dividend growth, particularly if you have a long term horizon. Over time, these stocks will rapidly increase their dividend income paid by virtue of the rapid growth they experience.
Visa (V) is one of the stocks that I hold in my portfolio that fits into this category. While its current yield is much lower than I would ordinarily prefer, the fact that Visa has been growing its dividend so rapidly, and will likely continue to do so into the future makes this stock an interesting one for me to continue to hold.
Mid Cap and Small Cap Dividend Payers
Dividends from this category of stocks, while probably the most risky, can get you the highest rates of dividend growth over an extended period of time. I tend to have a little more difficulty finding these types of dividend payers in the US. The Australian market tends to have many mid cap and small cap dividend payers that pay a reasonable dividend yield and then show consistent ability to grow that dividend at rates exceeding 15-20% over an extended period of time.
It takes time to unearth quality companies that fall into this space, but doing so can be very rewarding. One company in this category that I have a recently initiated an investment in is a company called Quality Systems (QSII) that I feel could provide reasonable long term dividend growth.
I don’t suggest new investors look too long at mid/small cap dividend payers, as one can do just fine focussing on large cap dividend growth stocks that have consistently increased their dividends over many years, have strong competitive advantages, and will likely increase their dividends for many more years to come.
If you are looking to at some stronger growth for your dividend income, then looking at dividend payers in this category can certainly be worth your while.
What are your thoughts on constructing a dividend portfolio? Have you considered looking outside large cap US dividend stocks?
integrator, this is a good question that any investor needs to answer. Don’t simply start investing without a strategy and a plan of how you expect to make it work. Measure your progress along the way to be certain that what you are doing is working.
There are a few strategies that DG typically take to construct their portfolios based on my reading of many DG bloggers.
1) First, many investors might take the ‘safe route’ , that is select different types of stocks in the high yield/low growth (HY/LG) or LY/HG and diversify to a large extent across sectors and regions. If you select this route you may not get a portfolio that is any different than a market index fund. Market index funds can be bought for less than 10 basis points these days (0.1%) making this strategy not worth your time – unless you like to do the research and enjoy it.
2) The second type of DG investor is the ETF hunter. They want to focus on high quality dividend growth stocks but don’t want to buy a DG ETF such as SDY (the dividend aristocrats ETF). You can get a lot of mileage out of simply buying the ETF SDY. The companies in the ETF SDY all belong to the S&P500 and have increased their dividends every year for decades (once they miss an increase, they are out of the index). Why buy anything else, it has companies that increase their dividends every year for decades?
Well, because of cost. At a 3.1% current yield, the expenses are 35 basis points. This means that you will fork over more than 10% of your income every year to cover costs. If you are starting out as a young investor with lower portfolio size this is OK (the costs of buying individual stocks will be higher), but the expenses will be a drag when you get to big bucks.
The ETF hunter aims to buy 20-25 stocks to complete a portfolio that will be lower cost and have an opportunity to beat the ETF or other indices. The investor typically uses a basket of financial criteria (plus some qualitative criteria as well) to screen candidates. You want to be careful not to over diversify.
3) The third type of portfolio design is what I call Buffett DG. This is an advanced portfolio design that looks to invest in only the highest quality businesses and throws out all the rules of DG investing. When you invest in only the highest quality businesses, you don’t care where in the world they are or what sector they are in. In this portfolio, you want to keep your portfolio size small, less than 15 positions.
To make this strategy work, you focus primarily on valuation and return (instead of growth and income). This can sometimes lead you to investments that may not other wise seem like high return investments.
I would put an investment like Visa (V) that you mentioned as a good candidate for this portfolio. This company is not too big to fail, it’s too important to fail. It can’t be brought down by scandal or accounting fraud the global economy depends on it. Given its large moat and secular growth trend, it’s easy to make a case for a large position.
Six Figure Investor,
Thanks for the very detailed feedback. You bring up some very good points here. I also don’t like ETF’s for the expense ratio that you point out. Once your portfolio reaches scale, these expenses are a huge drag . On a $500k portfolio, thats almost $1.5k/yr every year for something that you can research analyze and buy yourself.
In an ideal world, a young investor with a long term horizon should really be looking at dividend stocks as finding the best businesses irrespective of yield on offer (or Buffett DG as you indicate). Unfortunately the reality is that its easy to get tempted chasing more near term yield than being focussed on long term dividend income. A lower yielder like Visa can ultimately bring you a much larger dividend income than a larger slow grower will over time
Integrator
I love dividend stocks and am all about them. There was a bit of opportunity in dividend stocks last year before the tax hikes, because some people thought the government was going to tax the hell out of dividends. Since it didn’t happen, there’s been a nice rally in dividend paying stocks so far in 2013.
I agree College Investor. Its hard to find good value in dividend stocks (or any stocks for that matter) at this price range. I’m expecting a pullback mid year in prices. That’s normally when Europe troubles flair up
. I believe that the US economy is holding up fairly well right now, which is what is helping push along stock prices.
I diversify my portfolio around the 10 S&P500 sectors. As I get more capital to invest I try to even out the weighting between the sectors. Otherwise I probably have a similar approach to you.
Two things I do differently:
1. I have a “high yield” section (~10%) which has a lot of MLPs, BDCs, REITs, etc. This is a cash generating area. I have mixed opinions about whether I should keep it up or not, since capital growth is rather poor.
2. I use long-term puts with dividend growth stocks as the underlying security (~10%) to generate cash as well. I will keep this segment.
I like your long term puts strategy MyFI. Its something I’d like to implement myself.
I’ve looked at REIT’s and BDC’s in the past. I am not a fan of the REIT’s for the amount of capital they return, which typically leads to a large tax event when they get sold. They also tend to be very impacted by higher interest rates given the amount of borrowing they have (which depresses growth and stock appreciation).
New investors should be careful not to be too tempted by stocks with high yields. Often times this is a result of a beaten down share price and a dividend that is in danger of being cut.
As I’m in the early stages of building my dividend portfolio I generally stick with large cap stocks that have a long history of DG to form the base of my portfolio. However I do hold some international dividend payers and recently added Visa to my portfolio as well.
First Million,
High yields are not only a warning sign with respect to a possible dividend cut, but they are also typically slower growing dividend stocks, which may not be in your best interest to hold if you can get a moderate yield with higher growth.
I really like Visa, its a stock that I can see myself holding onto for decades. I own Mastercard as well.
There are a few staples that I include in my dividend, DRIP portfolio. First and foremost I am loaded up with solid companies that continue to produce solid products and services for decades on end. These I call old reliable. They are usually blue chips, but not necessarily American and are often retail, non-secular. The next portion involves those that drive the economy, MLPs, railroads, oil and gas, etc. These pay great! Finally, I am very aggressive with REITs. I don’t subscribe to the idea that a REIT has to follow the American housing trend and as such rarely get involved in those that own residential properties. I tend to focus on the odd ball ones that own a select number of well performing properties in specific niches. One of my favorites are in the health care REITs.
You raise a good point about REITs. Its not necessary that they need to correlate with the housing market. You can correlate REIT exposure with specific industry sectors. I also like health care REITs, particularly those that invest in hospital property rather than individual practices.