How should you build your dividend portfolio? How can you make sure your holdings will weather all kind of markets? What will happen if we hit a recession?
Fear is a powerful emotion that is not easily dismissed. It is often the reason fueling your lack of confidence. A rational behavior in front of a lack of confidence is to seek more information. Your brain asks you to validate if your opinion/belief/investment thesis is right by digesting more information. Unfortunately, the more articles you read, the more people you talk to and the more analysis you do, the less likely you are to act. Words are fun, but they are meaningless if they don’t prompt actions. This is how you can suffer from “paralysis by analysis”
This article will be a great help if you recognize yourself in one of the following statements:
- One of my stocks dropped 30%, I wonder if I should sell.
- I have cash ready, but I won’t invest yet.
- I don’t think adding money to my portfolio is wise right now.
- I’m thinking of selling 30% of my holdings to protect my capital.
- I’ll wait until things settle down before I invest.
- I’m losing money right now; I don’t like it.
- The market is down today. What if it’s the beginning of the next crash?
- I’m paralyzed in front of my computer; I just can’t click on the buy or sell buttons.
This article is how using a simple technique to select the best dividend stocks and which sectors should be part of your dividend portfolio. This methodology is successfully used by Dividend Stocks Rock (DSR) to build the following dividend portfolios.
STOCK SELECTION MADE SIMPLE; THE DIVIDEND TRIANGLE
When we left in our small RV to drive down to Costa Rica, we lived the adventure of a lifetime. It was a wonderful experience because we had a clear strategy. We knew where we were going, why we were doing it and we even had ways to handle more difficult days. The market will keep throwing you curve balls, so let’s make sure you don’t whiff on them.
At Dividend Stocks Rock, we also have a clear strategy: we focus on dividend growing stocks. We handpick companies showing a strong dividend triangle (e.g. revenue, earnings and dividend growth potential) and make sure we understand their business model. It is sometimes frustrating to follow such a clear, but strict strategy. We sometimes must ignore great investing opportunities because they don’t fit in our model. Since our model is quite easy to understand and we know why we are using it, we never doubt ourselves.
The Dividend Triangle is composed of three metrics
Revenues: A business is not a business without revenues. What is the difference between a company making growing revenues versus a company showing stagnating results? We are looking for businesses with several growth vectors that will ensure consistent sales increases year after year.
Earnings: You cannot pay dividends if you don’t earn money. Then again, this is a very simple statement. Still, if earnings don’t grow strongly, there is no point of thinking that the dividend payment will increase indefinitely. Keep in mind that the EPS is based on a GAAP calculation. Accounting principles are not aligned with cash flow. This means you are better off looking at the EPS trend over 3, 5, and 10 years. Use an adjusted EPS which takes off those one-time events revealed by the company in order to have a clear view of what is happening.
Dividends: Last, but not least, dividend payments are the *obvious* backbone of any dividend growth investing strategy. But I don’t mind the real dollar amounts or the yield, I focus solely on dividend growth. Dividend growers show confidence in their business model. This is a statement claiming that the company has enough money to both grow their business and reward shareholders at the same time. This also tells you that the business can pay off its financial obligations and invest in new projects (CAPEX). No management team would increase their dividend if they lack the cash to run their business.
Companies losing market share due to their lack of competitive advantages will see their story unfold through their revenue trends. It is very rare to see any business publishing growing revenues year after year if they are losing market share. For many reasons, a company could publish weaker results. It could be the end of a cycle, a change in the business model, or simply the economy slowing down. However, if this situation persists for several years and management can’t find growth vectors, the red flag must be thrown.
The same logic applies to earnings. Since earnings calculations are based on GAAP, we are not talking about real money. This number is far from being perfect. In fact, you are better off combining it with free cash flow or cash flow from operations to see what is really going on. Nonetheless, if a company is unable to generate growing EPS over a long period of time (5 to 10 years), chances are dividend growth will not happen.
Keep in mind dividends aren’t magic; they are the result of strong free cash flows, not the cause of good free cash flows.
What usually happens when you find companies generating strong free cash flows? They usually offer a reliable dividend growth policy and their share price tends to rise over the long haul making you a richer investor. At DSR we classify dividends and stocks in 5 categories. You don’t need to be a DSR member to rate all your holdings. We use two simple methodologies:
The DSR PRO Rating
5 = Exceptional Buy – Everything is there; a strong business model, several growth vectors and an undervalued price.
4 = Buy – It’s a good company, the short-term upside is good but not flabbergasting.
3 = Hold – A classic “right company at the right price”.
2 = Sell – If we were you, we would seriously consider getting rid of this one.
1 = Screaming Sell – Enough said.
The DSR Dividend Safety Score
5 = Stellar dividend – Past, present and future dividend growth perspectives are marvelous.
4 = Good dividend – The company shows sustainable dividend growth perspectives.
3 = Decent dividend – Don’t expect much more than a 3-5% annual dividend growth.
2 = Dividend is safe but – Not likely to increase this year.
1= Dividend Trash – It has been cut or is likely to be cut soon.
When reviewing your portfolio, you can easily rate all your holdings using a similar methodology. While we do it for you at DSR, you can do it yourself with more research. Then, you should seriously try to justify why you keep all “1’s” and “2’s” in your portfolio. If you can’t come up with a strong investment thesis, chances are those should be sold… not eventually, but now.
Remember, the best time to make changes to your portfolio is now. What is lost is lost. However, you can reallocate your money in a better way going forward. On the following page, we will show you how we manage stocks according to our dividend safety score.
Dividend trash has cut their dividend within the past 12 months or are about to do it. They are usually lost causes and you should get rid of them right away. Considering the COVID-19 impact on the economy, some businesses have decided to suspend their dividend temporarily. It’s hard to make money when your business is closed. For this reason, you can keep companies that used to have a strong dividend triangle prior to 2020. Look at each of them and determine if they are likely to resume their dividend growth policy once this exceptional event is over.
The dividend of “2’s” show no dividend growth for a while. Remember, an absence of dividend growth is the first step before a dividend cut. In some rare occasions, you will find companies using all their money to acquire new businesses. We still prefer those who can do both (acquisitions and increase their dividend), but you may want to hold on to a few “2’s”.
Then, “3’s” should be reviewed quarterly to make sure the situation doesn’t change. “Decent dividend” rated stocks offer a modest dividend growth perspective that should beat inflation. We will often see them in the “income sector” as the yields tend to be higher. If a REIT can increase its dividend by 2-3% yearly, I’m good with that. However, keep an eye on them to make sure management keeps its promise each year.
Dividend scores of “4” and “5” offer great dividend growth perspectives. They usually show a strong dividend history and payout ratios that are under control for the future. The dividend safety is not only about the past, but also about the company’s ability to maintain its dividend growth streak going forward. The stronger the dividend triangle is, the stronger the score should be.
When selecting new holdings for your portfolio, I would favor only companies with a score of “4” or “5”. Those companies won’t let you down should the market turn rocky for a while. You can count on those payments to smooth the path that leads you to retirement.
THE SECRET IS IN YOUR SECTOR ALLOCATION
If you ever read any “investing 101” books, they will all tell you that your asset allocation is the prime determiner of your investment returns. If you were afraid of a recession in early 2020 and put most of your money in consumer staples and gold, you outperformed the market by a wide margin. If you were an oil & gas investor… well, I regret that you made that decision.
At DSR, we have a specific point of view on each sector. I believe nobody should ever invest more than 20% of their money in a single sector. The more you add to a sector past 20%, the more volatile your portfolio may be. When the market drops, it affects all sectors. However, each crisis will be particularly hurtful for a few industries. The problem is that we never know which ones will suffer the most. It could be tech stocks (1999 tech bubble), banks (2008 financial crisis), oil & gas businesses (2015 oil bust, 2020 COVID-19) or entertainment, travel, leisure and retailers (2020 COVID-19). The key is to hold some of the best companies from each industry sector. Here’s my view on how each sector can help you build a stress-free retirement portfolio:
Core sectors include companies you should consider first. It doesn’t mean they must all be in your portfolio, but they are are less likely to be impacted by a global recession. Each one has its unique characteristics.
Dividend growers in this sector are usually “old techs” that are dominant in their industry. They are sitting on significant cash and cash flows and are often ignored by retirees due to their low dividend yields. Interesting enough, they go through the COVID-19 recession without a breaking a sweat. Cash is king during most recessions, and old tech stocks like Microsoft (MSFT), Apple (AAPL), Cisco (CSCO), Texas Instruments (TXN), Open Text (OTEX / OTEX.TO), Sylogist (SYZ.V) or Enghouse (ENGH.TO) are generating plenty of cash. Even if you are retired and looking for income, tech stocks could bring solid growth to your portfolio and you can always sell a few shares periodically to generate the income stream you desire.
Banks are at the center of our capitalistic system. They can get too greedy (2008 anyone?), but in general, they offer a good source of dividends. Canadian banks are by far my favorites (notably Royal Bank (RY / RY.TO), TD Bank (TD / TD.TO) and National Bank (NA.TO). You can also find great companies among large asset managers (such as BlackRock (BLK)) and payment processors Visa (V) and Mastercard (MA) that can be elements of many successful portfolios. I’m less interested in life insurance companies as they must deal with this low interest rate environment we are in now and that complicates their portfolio management.
Classic and boring companies fly under the radar during economic booms, but they suddenly become market favorites during recessions. We all need to eat, brush our teeth and clean our house. I personally don’t invest in this sector as I don’t mind seeing my portfolio value going down during crisis, but they certainly help in reducing volatility. Procter & Gamble (PG), Coca-Cola (KO), Colgate-Palmolive (CL), Loblaws (L.TO) and Metro (MRU.TO) don’t need introduction for most investors and you may value their stability.
Once again, I’m usually not a fan of healthcare companies as it mostly includes big pharma spending billions in R&D. Their drug pipeline is crucial and consumes most of their cash flow. This makes it hard to maintain a dividend growth policy while developing new medicines. Nonetheless, you can find solid dividend growers in this category (Johnson & Johnson (JNJ), AbbVie (ABBV), Pfizer (PFE)). You can also find great businesses in the medical devise sub-sector (Lemaitre Vascular (LMAT), Abbott Laboratories (ABT), and ResMed (RMD)). Healthcare businesses have one thing in common; no matter how the recession hits, our health remains crucial. Therefore, recessions should be less harsh on them.
While you can find growing businesses in all sectors, some industries will offer you stronger growth potential. Many investors would consider the technology sector in this category, but I prefer to classify it as core assets.
The name says it all; when the economy booms, consumer cyclicals follow. We can look to the automobile industry where you will find auto parts makers such as Gentex (GNTX), Genuine Parts (GPC) or Magna International (MG.TO / MGA). Classic restaurant chains such as McDonald’s (MCD), Starbucks (SBUX) or A&W (AW.UN.TO) would also do well when consumers are hungry. Finally, sporting goods and apparels such as Nike (NKE), Columbia (COLM) and VF Corporation (VFC) could be of interest. This is a rare sector where you can go over 20% and still have wide diversification. The buying process for a new car isn’t the same as for a burger or a t-shirt.
The second sector in the growth category is industrials. Like consumer cyclicals, the industrial sector offers a wide variety of sub-sectors that are not linked together. Since each industry follows a different cycle, you often have the chance to pick stocks at a cheap price while several clouds are gathering. A classic example would be railroads. Companies such as Canadian National Railways (CNR.TO / CNI), Canadian Pacific (CP.TO / CP), Union Pacific (UNP) and CSX (CSX) were selling at a great discount during the 2015-2016 oil bust. You will also find long term dividend growers like 3M Co (MMM) offering a great opportunity from time to time. You just must be patient and you will be able to buy several great businesses during their downcycle. We cover many of them at DSR.
Ah! The section you have all been waiting for… the dream of all retirees: living off your dividends without touching your capital! This has become a difficult strategy to achieve as many high yielding stocks get crushed during recessions. By chasing yields (we’ll discuss that at the end of this book), you put your entire retirement in danger. When a company cuts its dividend, you not only lose your source of revenue, but you also suffer from a capital loss. Fortunately, there are some sectors offering a decent yield and some peace of mind.
The tax structure behind REITs is designed for the business to distribute the largest part of their profit to shareholders (unit holders). For many, Real Estate is the definition of stability in the investing world. However, one must be careful about which type of Real Estate you choose. Classic retailers are under significant pressure and many shopping malls have and will deal with bankrupt tenants. Industrial REITs including warehouses, distribution centers, data centers and cell towers are likely going to do well as they are supported by ecommerce and the internet. This is obviously a sector where you can invest 30% of your portfolio and still achieve a great diversification within the various sub-sectors. This sounds like a sound plan for income seeking investors.
Another haven for investors during crises are utilities. People need power and water. In this category, I would go with clean energy utilities such as NextEra Energy (NEE) and Xcel Energy (XEL). In Canada, companies like Fortis (FTS.TO / FTS), Emera (EMA.TO) and Algonquin Power (AQN.TO / AQN) make great choices. Utilities in general should be able to benefit from our current low interest rate environment. Don’t expect much growth as the economy slows down, but the dividends should remain safe.
Telecoms & communications:
In the communication services sector, it will be hard to find companies with low debt levels that will generate consistently growing dividends. AT&T (T) and Verizon (VZ) will continue to pay their dividends. We have been harsh toward AT&T for a while now (it was rated as a sell for a few years!). However, now that the stock price is back to low $30’s and the company is showing stronger cash flow and debt reduction, it looks like a compelling pick. On the Canadian side, stick with a classic pick such as Telus (T.TO / TU) and BCE (BCE.TO / BCE). Their business models are solid, and people will use their services more than ever.
Ignore those sectors
To end this section on sectors, I will go straight to the point: I highly dislike the energy and basic materials sectors. The reason is quite simple: both sectors depend on commodity prices to be profitable. Since they have no control over those prices, their cash flow is often volatile. This situation makes them marginal dividend growers. I understand you can occasionally make a great investment in those sectors, but most people get burnt more than they get rich. This is a risk I’m not willing to take with my portfolio.
I know how hard it is to invest when stocks don’t seem to trade at their fair value
Don’t you hate not knowing when to buy or sell stocks? There are too many investing articles contradicting one another. This creates confusion and leaves you with the impression you will not reach financial independence. It doesn’t have to be this way. I’ve built a free recession-proof portfolio workbook which will give you the actionable tools you need to invest with confidence and reach financial freedom.
This workbook is a guide to help you achieve three things:
- Invest with conviction and address directly your buy/sell questions.
- Build and manage your portfolio through difficult times.
- Enjoy your retirement.