As if identifying promising dividend shares [1] wasn’t tricky enough, knowing how to properly assemble the shares in a portfolio can be an even greater challenge.
How do we assemble dividend shares in such a way that we maximise their value and utility?
The good and bad news is that there’s not a single answer to this question, as much will depend on your unique objectives.
As such, the first order of business when building a dividend portfolio is – you guessed it – establishing your aims:
- Is your primary goal dividend growth & capital appreciation, or is it to harvest high levels of current income [2]?
- Do you usually base your buy decisions on screening results or do you like to roll up your sleeves and research [3] individual companies?
- Do you want to passively or actively manage your portfolio?
Knowing the answer to these questions will help you evaluate what I consider the four broad approaches to dividend portfolio management.
Let’s briefly look at each turn.
1. Target yield approach
In this approach, you decide how much income you want the portfolio to generate this coming year, list the forward yields [4] of the shares you’d like to include in the portfolio, and weight your holdings accordingly so that the average yield equals your desired income level.
Pros: It’s fairly straightforward and there’s a clear and quantifiable objective that can also serve as a guidepost when making future portfolio allocation decisions. When you’re looking to add fresh cash to the portfolio, for example, you can invest in such a way that your target yield is maintained.
Cons: First and foremost, it assumes that the dividends are sustainable and will be paid as expected. If you set your yield target too high and invest too much in ultra-high yield shares [5], there’s greater risk that one or more of the dividends could be cut, rendering the strategy less effective.
The target yield strategy can also be a bit short-sighted, with too much focus placed on near-term results at the expense of longer-term performance. And since higher-yielding shares tend to be found in only a few sectors (such as utilities and telecoms), you may be overexposed to certain industries.
2. Bucket approach
Divide the portfolio up into value, growth, high yield, and quality buckets and select shares that fit those categories.
[6]
The ‘value [7] bucket’, for instance, may consist of shares with P/E ratios at least 15% below the market average, while the ‘quality bucket’ may only hold shares with high returns on equity and low leverage ratios.
Pros: The bucket approach forces you to focus on the type of shares you’re buying and helps you to avoid investing too much in one theme. You get to decide what qualifies for value, growth [8], high yield, and quality, so there’s a good amount of customisation available. As such, you can set up screens for each bucket that enable you to easily generate new ideas when needed or to know when it’s time to shift a share from one bucket to another.
Cons: Investors skilled at identifying shares within a particular theme (e.g. deep value or growth) may not feel comfortable buying shares that don’t fit their usual strategy. Consider that value investing legend Ben Graham wouldn’t likely have bought the shares that growth investing pioneer Philip Fisher [9] liked, and vice versa. Investing outside of your specialty can result in sub-par performance.
3. Mechanical approach
A system of selecting shares and building a portfolio that’s primarily based on a specific screen or ranking system. The HYP method [10] popularised by Stephen Bland [11] and frequently discussed [12] on Monevator is an example of this type of approach.
Pros: One of the great things about the mechanical approach is that it’s simple, consistent, and easy to put into practice. Just set up a screen based on a handful of financial metrics, rank the shares based on those metrics, and build a diversified portfolio of shares that score well in the screen. Wash, rinse, repeat.
Cons: A mechanical system that’s worked in the past may not work in the future. In other words, the parameters may be too rigid in a changing market environment. Also, if too much faith is placed on the screening results or the portfolio is managed too passively, you can overlook important red flags that might have been identified with a little sleuthing.
4. Custom approach
This is the freestyle version – select the best dividend paying shares you can find without adhering to a specific formula or strategy.
Pros: By definition this approach doesn’t have any hard-and-fast rules, so if you consider yourself a strong stock picker and aren’t concerned with generating a specific amount of dividend income, this might be the most attractive option.
Cons: Some parameters can be helpful when building a dividend-focused portfolio. Going in without a strategy can also result in poor decision-making in volatile markets.
At this point, you might be asking, “Couldn’t I just borrow a little from each approach?”
Absolutely you can! This is only meant to outline a few of the major schools of thought when it comes to dividend portfolio management. If you want to combine the bucket and target yield approach, for example, go for it!
How many shares is enough?
Investors building dividend portfolios are often concerned about being adequately diversified across industries – and for good reason – but I don’t think you necessarily need to own one or two shares from each industry to be properly diversified.
If you’re building a portfolio mainly of large cap shares, for instance, consider that larger companies are often internally-diversified. For example, Tesco has a bank division, GlaxoSmithKline has a consumer goods business, and Reckitt Benckiser has a pharmaceutical business. You might even be doubling up in certain sectors where you may not have meant to.
Also, if you’re not knowledgeable about a certain industry or morally-opposed to owning certain shares (e.g. tobacco, alcohol), you don’t necessarily need to have exposure to those sectors.
Personally, I’d rather own two stocks from an industry that I know inside-and-out than force myself to invest in an industry that I don’t know much about.
That said, I think you can have a diversified dividend portfolio with as few as seven large cap shares. If you’re including smaller companies [13] in your portfolio, I believe that number will probably be closer to 20 given that many small caps have niche offerings.
Getting started
Whether you’re starting with a large lump sum or building your dividend portfolio one share at a time, the key is to go in with a strategy and objective in mind. The four portfolio management approaches outlined above will hopefully help get you started.
Please post any questions or comments below. It’d be great to hear how all you active dividend investors build and manage your own income portfolios.
Note: You can bookmark all The Analyst’s articles on dividend investing [14]. The archive will be updated as new dividend articles are posted. The Analyst owns shares of Tesco, GlaxoSmithKline, and Reckitt Benckiser.