- Number one rule after you have picked a possible candidate for your income portfolio is to not overpay for it. Be patient, get it properly valued or dismiss it entirely.
- Rebalancing your portfolio every 6 months or so can definitely add to its annualized return. Remember that many positions are required to rebalance effectively.
- Market awareness is key. You need to stay on top of your underlyings to make sure one of your underlyings doesn’t get caught in a dividend cut.
Dividend investing has definitely become more attractive since the crash of 2008. However the end game here is to get capital growth on our stocks along with dividend growth. Getting a nice 3 to 5% dividend yield from our stocks is not going to cut it long term especially when you factor in inflation into the argument. We need to see steady share price performance in our stocks also over the long term (anything from 3 to 5% share price annualized growth) which will give us a compounded 8 to 10% total growth rate. Nevertheless a lot of research must go into a portfolio that will deliver 8%+ total growth returns over the long term. Let’s outline 3 skills that will enable you increase this figure into double digit growth levels
The first one is obvious but it’s a skill that many investors miss and it is “Don’t overpay for any position in your portfolio”. If you overpay for any underlying, you simply are not going to get the double digit growth rates you are looking for over the long term. How do we make sure that we don’t overpay for our underlyings in our income portfolio? First of all, let’s talk about the mechanics. Good valuation metrics that I use are the price to sales ratio and the price to book ratio. I find these metrics far more accurate measures than price to earnings ratio’s as PE ratio’s can be manipulated by accountants more easily. Furthermore the eight conditions that I list in my articles must be satisfied in order to even think of investing in any respective underlying. Nevertheless phycology plays a role in this decision also. Unfortunately as humans, we are prone to chasing a “good thing”. We see a stock rallying hard (which also pays out a decent dividend yield) and we want a piece of it. This is counter-intuitive for dividend investors because when a stock shoots up, the dividend yield usually drops. On the contrary when a stock comes down in price, the dividend yield usually increases. So this is skill number 1. Do the necessary due diligence and fundamental analysis before you start investing. It will reward you tenfold throughout your investing career.
The first skill ties in perfectly with the second skill. I like to call the second skill “rebalancing” which means you rebalance your portfolio consistently to make sure you are never invested too much in over-valued stocks. Let’s go through an example. Chevron Corporation (NYSE:CVX) & McDonald’s Corporation (NYSE:MCD) have gone nowhere over the last 3 years as the chart below shows. Yes they have consistently increased their dividends but both stock prices over the last 36 month has basically gone nowhere.
Now remember that both of these stocks pass our 8 conditions for entry into our portfolio. Mcdonalds is transitioning and Chevron has definitely been affected by the lower oil price. Also since our total growth aim for our portfolio is at least 8% annualized over the long term, these stocks have a lot of catching up to do if an investor opened positions in each in 2012. Therefore this makes them attractive in my eyes as history has showed us that they have always bounced back violently from recessions or transition periods. So how do we rebalance? Well rebalancing in my opinion can only be done when the respective portfolio has a lot of underlyings invested in many sectors. The more diversified the portfolio is (many underlyings), the easier rebalancing is for the investor. Rebalancing is always difficult because you usually sell the stock you don’t want to sell. If for example, you are holding a dividend stock in the biotech sector. Something like Amgen, Inc (NASDAQ:AMGN) which has tripled in price in the last 5 years. Yes there may be a blow off phase in biotech before it turns over but an astute investor would be looking to sell his biotech position in order to deploy more funds into more undervalued stocks and sectors.
The last skill is “Market Awareness”. This is crucial and ties in perfectly with the 2nd skill “Rebalancing”. Market awareness but more importantly awareness of the well being of your underlyings is imperative in order to avoid dividend cuts in your portfolio. Here is where you need to be ruthless with your capital as an investor. Always remember that you are investing in a particular underlying for dividend growth – never cuts or cancellations. We want to see dividend payouts increase by at least 8 to 10% every year. If one of your underlyings cuts or totally cancels its dividend, I would exit the stock immediately because there is a big correlation between dividend cuts and share price drops. I understand that sometimes these events can’t be avoided but by staying on top of your underlyings by studying earnings, getting on conference calls and by generally getting engaged, you can avoid dividend cuts in your portfolio. Anything can affect a company’s ability in the short term to keep paying a dividend. High debt levels or drops in revenues can affect dividends but the usual reason is cash flow. When this is tight or when the pay out ratio is way too high, try to make plans to exit the stock before you get caught in the ensuing cut.
To sum up, I definitely believe if you actively take ownership of your portfolio and develop these 3 skills, you can get your portfolio consistently returning double digit gains over the long term