We usually use dividend growth stocks as our main vehicle for income generation. The reasons are pretty self-explanatory. Even though the portfolio should be heavily diversified across different sectors and asset classes, at any given time one or more of our positions could go against us. When a position is showing a paper loss, there is both a benefit and a drawback. The drawback is obvious in that there is very little one can do when a position is underwater. In fact, if the respective positions runs quite a distance from the entry-price, it becomes very difficult to sell calls (which we will discuss ) against the long stock especially if volatility is low. Therefore the increasing dividend becomes a huge asset in these types of scenarios because those increasing reimbursements eat away at the original cost price. However the real benefit in these names is the following.
When quality dividend growth stocks get oversold, their yields rise meaningfully. Now our portfolio as already stated is designed to spit out sizable amounts of income every month depending on portfolio size. This income if not totally withdrawn will be looking for a home and quality oversold dividend growth stocks is usually the best destination for these funds. Now one may counter that argument by stating that one should never double down on paper loss losers as it increases portfolio risk (more capital assigned to fewer positions)
This may be true but the best place to “drip” or invest more cash flow is into quality oversold blue chips. Large blue chips usually have their valuations run between certain extremes. So basically their price to sales ratios or price to earnings ratios at times will be at the bottom of their ranges. As long as the respective company’s fundamentals are still sound meaning sustained growth is predicted over the long term, I see no problem in doubling down on a quality stock. However where I would not recommend doubling down would be in stocks that do not have strong competitive advantages or ones which are not diversified as then the risk to the downside really comes into the play. This is an area where investors definitely slip up. There is a big difference between doubling down on a proven strong blue chip over a cheap stock which has no competitive advantage. What do I mean by competitive advantage ?
Does the stock have economies of scale? Does is have customers for life or high switching costs? What about the distribution network or the brand the company has built up over the past decades? These all tie into a firm’s competitive advantages which is why we want to be in a position to take advantage when a proven dividend growth blue chip is on sale. In fact, as stock market declines usually take place at a faster pace that rallies, you will observe that proven dividend growth stocks don’t sell that cheap very often. In fact most of the time, they sell at a premium because they bring an element of “certainty” to the mind of the investor. This definitely plays into our hands as the cavalry will always come to the rescue to a large extent if the stock gets too oversold at any given time. This set-up acts as a nice tailwind (along with the dividend) that keeps the stock elevated over time.
Remember there is a huge amount of investors that only trade dividend aristocrats or strong dividend growth stocks. They trade all the old reliables like McDonald’s (NYSE:MCD), Coke (NYSE:KO), Walmart (NYSE:WMT), etc. They just wait for them to become overvalued which is why a proven aristocrat at a low valuation usually gets snapped up quite quickly. “Proven” though here is the key word as we always have to be conscious of the downside. Always have in mind that stocks could enter a bear market tomorrow. Are you happy with your portfolio? Would you add to all of your positions? These questions are important when one is building an income orientated portfolio.