Sunday, April 8, 2012

5 Rules for Building a Dividend-Focused Portfolio

So you want to build a dividend-focused portfolio...

To borrow a phrase from Dickens, it may be the best of times and the worst of times to do so. You can still build a dividend portfolio with a respectable average yield today, but strong market performance in the first quarter considerably shrunk the pool of opportunities. Since yields and share price have an inverse relationship, suffice it to say there are slimmer pickin's now. With that said, here are five rules for building a dividend-focused portfolio in today's market, or any market for that matter.

1. Build patiently

When you've resolved to build a dividend-focused portfolio, it's natural to want to get fully invested right away and get your money working -- especially when cash and money markets pay you effectively nothing. Resist that temptation.

Remember, patience is the individual investor's greatest advantage over the market.

Unlike a mutual fund manager who may feel compelled to be fully invested at all times to keep up with peers or the market, or may be restricted by the fund's objectives, you have no such pressures or obligations to get fully invested straight away. Only pull the trigger on a new investment when the opportunity is right (see rule #2). If it takes six months or a year to get fully invested, that's better than going all-in on potentially over-valued stocks. A scatter-shot approach to portfolio construction may be effective when the market has been depressed (late 2008/early 2009), but when the markets have been on a run as they have, it's more important to be selective and deliberate.

2. Don't buy for yield alone

A stock's yield can be used as a value indicator, but yield alone tells us very little about a stock's value (think about banks' high yields pre-financial crisis and pre-dividend cuts). As such, investors should consider yield alongside other value indicators when making investment decisions.

Each investor has his or her own way of valuing a stock (DCF, DDM, comparing multiples, etc.), but whatever your preference it's important to estimate a fair value before buying a dividend-paying stock (and any stock for that matter). Repeatedly paying $1.20 for $1, of course, is a quick way to sub-par investment performance. Even if the overvalued stock is paying 3%, with a little patience you'll likely get a chance to buy it below its intrinsic value with a higher yield, to boot. Bottom line: always demand a margin-of-safety before investing -- even in a dividend-paying stock.

3. Stay diversified 

High yield stocks tend to cluster in a few sectors. Utilities and telecoms, for instance, tend to feature higher yields than technology and energy stocks, so they tend to carry more weight in yield-based portfolios than in the market portfolio. It's easy to fall into the trap of loading up on high-yielding stocks in just a few sectors in order to maximize yield.

That model can fall apart quickly, however, if one of those sectors falls on hard times (again, financials in 2008/09). Even if you need to sacrifice a little yield today by investing in some lower-yielding stocks from other sectors, don't be afraid to do so as long as those stocks meet your investment criteria and fit your portfolio objective (see rule #4).

4. Set a portfolio objective

Dividend investors tend to have one of two objectives -- maximize current income or generate a longer-term growing income stream. The former group prefers high-yield today at the expense of income growth potential; the latter willing to sacrifice a little jam today for more jam tomorrow. Both approaches have their merits -- a mix of both is fine, too -- but it's critical to define your objective to help you structure your portfolio to meet your needs. Most importantly, write down your objective, keep it next to your work station, and review it every time you make an investment decision.

Because you're in charge of your portfolio, you can tailor your portfolio weightings to meet your unique situation. Want more current yield? Increase your portfolio weight toward the higher-yielding shares. Want more income growth? Put more cash toward companies growing their payouts at double-digit annual rates.

By setting a portfolio objective (i.e. "Generate a current yield >25% above the market average and grow income three points above CPI inflation"), you'll be more likely to stay the course, make prudent investment choices, and improve your chances of satisfactory returns.

5. Keep track of your income

Most broker websites don't do a great job of tracking portfolio income growth -- normally income growth is lumped in with total returns. If you're building a dividend-focused portfolio, then, it's easy to lose track of your income performance if you rely on brokers to keep records for you. And the whole point of building a dividend-focused portfolio is watching the income flow in. You may need to build your own Excel spreadsheet or manually keep tabs on a notepad, but the important thing is to keep records so you can remain focused on your income. Keep track of quarterly and annual income received and review performance periodically.

Hope this was helpful. More to come.

Happy Easter!