There is nothing easier than buying a dividend stock. Who would ignore owning shares of a company that sends you a cheque quarterly? The whole idea of building a passive income portfolio is very seductive. On top of that; it seems pretty simple at first. Once you run a stock filter, you will always find a great list of attractive companies generating passive income. The problem usually comes once you have bought shares of a few companies.
Will you stick to the same sectors?
Should you buy both US and Canadian stocks?
How do you diversify from one stock to another?
How can you generate more growth for your portfolio?
Should you buy another company or increase your position in a current holding?
These and many other questions come to any investor’s mind when it’s time to not only buy or sell a stock, but to build a solid portfolio. I’ve received several emails with regards to portfolio management from my readers and I hope this post will answer a good number of them.
I mention that I want to answer some, not all questions regarding portfolio management. This is because I manage my portfolio according to two different philosophies at the same time. I separate my own holdings into two different segments: A core portfolio and a Growth portfolio. Today’s post is about how to build a dividend growth portfolio. We’ll talk about the core portfolio later on.
What is a Dividend Growth Portfolio?
The first question to answer is obviously what a dividend growth portfolio is. The answer is pretty simple; it depends on who you ask! This is why it is so important to define what the word growth in a dividend portfolio means. In portfolio management theory, we usually find two types of portfolios: Value and Growth. By definition; a dividend portfolio is more often seen as being managed with a value approach. Several dividend paying companies are blue chips or well established companies. This is the part of my portfolio that I call the core portfolio.
However, the growth component is crucial for all portfolios. Considering dividend stocks, do we talk about dividend growth or capital growth? What about looking for both kinds of growth? When I discuss the topic of a dividend growth portfolio; I’m looking to buy companies that will both contribute to increasing my payouts but also boost the value of my holdings. Therefore, a dividend growth portfolio includes companies that have a great potential to grow in value as well as keeping dividend payouts increases at the center of their priorities.
I always start my research by applying my 7 investing principles. This is the same starting line when I want to work on both my core portfolio and my growth segment. The difference happens once I sort the list of potentially interesting stocks. This is why it is important to understand which stock would qualify for the core portfolio and which stocks are more growth oriented.
What is the Difference with a Regular Dividend Portfolio?
The previous definition of dividend growth is a little bit counter intuitive for some investors. After all, how can a company focus on growing their business through acquisitions, selling new products or developing new markets and keep increasing its dividend? All the above mentioned business strategies requires the same thing above all; cash flow. If we know something in finance is that cash flow is limited. It’s a very difficult task to hit both growth within the business (sales) and outside the business (dividend payouts). In theory, the “best dividend payer” would not be companies showing the best growth potential.
There are plenty of solid businesses which are mature and prefer to pay additional cash to their investors rather than try to risk precious cash flow towards a development strategy (tell the Target (TGT) CEO about it!). When I think about a solid dividend stock with limited value growth potential, I think of a utility stock or a consumer defensive stock. These two sectors are known to deliver solid dividend payments but the company will not really show double digit sales or earnings growth for a long period of time. These companies will be selected to be part of my core portfolio; those I will keep for several years if not forever.
Therefore, the main difference between a regular dividend portfolio and a dividend growth portfolio (according to my own definition) is that the growth portfolio will include stocks showing a great potential for capital appreciation in the first place. This is the number 1 criteria to select a stock in such portfolio. The idea is to select stocks in a position to generate a double digit capital growth. This leads to the next question; what will bring this potential growth?
What Will Bring Growth to the Portfolio?
A strong capital gain realized on a trade will be the result of three factors:
#1 Buying an undervalued stock
#2 Buying a company that will surprise the market in the years to come with stronger than expected results
#3 Buying stocks with higher risk
Let’s start with #1 as buying and undervalued stock is probably the most obvious tip any investors will receive in his life; buy low, sell high. The problem is that this hint is so obvious that it is probably the hardest thing to do in investing. The market rolls 24/7 with people analyzing every tidbit of news, every report, and every data release very carefully. Therefore, it is very hard to buy an undervalued stock with information everybody gets. However, there is an easy way to achieve it. If you buy sound companies evolving in a “bad” sector, you will be buying undervalued stocks. For example, during the 2008 credit crisis, all banks, without exception, took a hit in their price value. The big 6 Canadian Banks (BMO.TO, RY.TO, TD.TO, BNS.TO, NA.TO, CM.TO) dropped more than 50% around December 2008. A wise investor who bought them during this period is making over 125% return in six years. At the moment of writing this article (February 2015), the oil crisis is creating a new opportunity for investors to buy undervalued stocks. I added more shares of two of my holdings (Black Diamond Group BDI.TO & Helmerich & Payne HP) during this period. I am convinced both companies will survive the storm and will continue to pay generous dividends in the meantime.
While my trick to buy undervalued stocks usually works, it is harder to find a trick that works all the time when you look for companies that will surprise the market. The street is full of wannabe gurus who pretend to know what the next big thing is. But they don’t know, and I don’t know either! I’ve successfully bought Disney (DIS) and Apple (APPL) at moments where investors didn’t see these companies potential to surge. Disney sustained its amazing growth through successful movies (Frozen in 2014 and Star Wars to come end of 2015) while Apple’s “rebirth” with sales stronger than ever after disappointing the market for several quarters in a row. I don’t have any process to find these stocks. They usually appear after a screener and I give some thought on where the company is heading. I could be right, I could be wrong. From time to time, I hit a homerun as I did with the above mentioned stocks. The key is to first identify companies with strong fundamentals, then, you can see where the growth will come from.
The third way to generate capital gains with a stock is to buy a company with higher risk that has overcome its challenges. The perfect example is probably Seagate Technology (STX). I often use this example to illustrate how you can pick stock in a very challenging moment and make lots of money with them. When I bought STX, it was trading under a P/E of 5. The problem was the market didn’t see a bright future for hard disks plus the company’s manufacturing plant was flooded the previous year. I bought the stock knowing there was high risk, but I bought STX thinking the company could continue selling hard disks for a while and use its cash flow to develop other technologies (cloud computing). It doesn’t always work that easy, but this is why it is call “buying a company with higher risk”. A good example right now would be Mattel (MAT) which lost 41% from January 2014 to February 2015 all because of bad sales. The company struggles to find growth and its toys are losing popularity. However, nothing is over yet with this company and it could definitely bounce back.
Sometimes, there is a combination of three factors that makes you a hero when you are able to find the ultimate dividend growth stock. Still, even though the idea is to find a stock with higher capital gain potential, I don’t pick stocks to hit a homerun each time. I often prefer to start my research in a sector that several investors leave or show a great potential in the future. It’s always easier to pick a stock in a good sector than picking a good stock in a bad sector!
Which Sectors are Generating Additional Growth?
The answer to this question will obviously change from one year to another. Each year, you will find an abandoned or unloved sector by investors. At the beginning of 2015, this sector is the resources & energy sector. Not so long ago, it was the financial industry. There are also sectors providing higher chances of growth such as consumer cyclical and technology. The consumer cyclical will ride any positive economic wave and generate powerful results during the expansion part of the economic cycle. Disney is a good example but you can also find interesting picks in the automobile industry at the moment. Uni-Select (UNS.TO) recently sold its US division to Icahn fund and saw its stock price soar by 16% in one day. Magna International (MB.TO) has literally crushed the S&P TSX over the past 5 years showing a capital appreciation of 329% vs 32%. Finally, Genuine Parts (GPC) has beat the S&P 500 since January 2013. Not bad for an “old aristocrat”, huh? As you can see, the automotive part business is definitely a good sector for investors right now. But the best moment to buy those stocks was 2 years ago.
More and more techno stocks have started paying dividend. The yield is not always very high if you take AAPL for example, but mature companies are usually sitting on piles of cash. At one point, they don’t have enough profitable projects and decide to pay a part back to investors. This is how Microsoft (MSFT) started a while back ago. I remember that I once read that MSFT would not pay dividend to investors when Bill Gates was still the CEO. Time changes and now investors can count on a solid dividend payer when they buy Microsoft. Still, technology advancement can bring any techno stock to a whole new level. MSFT did it with cloud computing services, Garmin (GRMN) is growing due to technology applied to fitness gadget and Apple keeps selling more smartphones.
As you can see, if you want to build a dividend growth stock portfolio and be successful, you have to follow several stocks in different sectors at the same time to make sure you find the perfect match. This obviously includes more trades in a year than a regular dividend portfolio. As the dividend investing thinking is closer to the “buy & hold forever” model, the dividend growth portfolio aims at a higher rate of rotation.
How Often Should You Trade in a Dividend Growth Portfolio?
I often receive this question by email from readers. What is the perfect number of trades in a portfolio to make money and not eat your time going through financial statements while managing your money? The first part of the answer lies in the size of your portfolio. The larger it is, the more often you will trade. In the dividend growth part of my portfolio, my time horizon to hold a stock is 2 to 3 years. This is usually the time required to materialize the potential I *think* I see in a company. After this period, the stock is either sold or it becomes part of my core portfolio. For example, when I bought Apple, the goal was to pick a falling knife as the price dropped from $700 to $400 something. However, today, I see this stock as a core element of my portfolio since it shows very strong fundamentals.
Other stocks are sold mainly because I don’t see additional potential and fundamentals are not strong enough to convert into a core stock. This was the case with STX as I sold it when sales started to plateau again. The stock kept going up, but I don’t mind; my money was made.
I don’t have a specific amount of trading established for my portfolio. I prefer following my holdings quarterly when all companies post their financial results and then, I make trades if necessary. I basically sell a stock whenever the reason why I think there will be growth fades away.
How Can you Apply All your Investing Principles to Find Dividend Growth Stocks?
If you have read about my investing philosophy and the criteria I use to manage my portfolio, you noticed I’m quite picky. If you follow the same rules, you may find that the number of dividend growth stocks is limited. I usually find my best picks for growth purposes when I allow myself to cheat a little. I’m not saying I ignore my investing rules; I simply bend one or two at a time. The most common rules I bend is with regards to dividend yield and payout ratio.
I tend to select stocks with a 2% dividend yield and higher. Even at 2% I often ignore them to concentrate on everything that pays higher than 2.5%. But from time to time, I find a gem hidden in the low dividend yield basket.
The same thing applies with the payout ratio. In an ideal world, none of my holdings would show a payout ratio exceeding 85%. But sometimes, you have the possibility of buying undervalued stocks with a high payout ratio. If you can explain why it is high today and how it can go down in a year or two, you are set to pick a very interesting company.
If I can explain why earnings or revenues don’t show positive growth over 3 or 5 years, I might also consider buying shares as long as I can see the potential of higher sales in the future. There is one very important thing: don’t ignore all rules at the same time. I never pick a stock that shows a low dividend yield, high payout ratio and erratic sales and earnings. That would be closer to gambling than investing. The goal remains to invest in line with my principles, not to forget about all of them because I read good news about a company in the newspaper!
A Real Example of a Dividend Growth Portfolio
If you read this whole article till the end, it’s because you are very interested in dividend investing and therefore, you deserve a reward ;-). I’ll share with you my positions in my Dividend Stocks Rock dividend growth portfolio for $25,000. This portfolio was created on October 2013 and shows a total return of 28.42% as at February 2015. The portfolio includes 5 Canadian and 5 US stocks and beat our benchmark by 12% since October 2013.
Obviously, this portfolio evolves rapidly and trades are made from time to time. I’ve made a total of 12 dividend portfolios including growth and core component for all budgets (from 1K to 500K+). The purpose is to build real time portfolios you can follow and use as a starting point for your own holdings. All portfolios are offered to Dividend Stocks Rocks members only and they receive a real time email when a trade is made. If you wish to take a look at what Dividend Stocks Rock looks like, you can hit this page and learn more about our dividend investing platform.