I am a firm believer that common stock portfolios should be custom-designed to meet each unique individual’s goals, objectives and risk tolerances. With that said, I believe it logically follows that in order to create a successful portfolio, the individual investor must first conduct some serious introspection to be sure that they truly “know thyself.” Therefore, I believe the first, and perhaps most critical step, towards designing a successful equity portfolio is to ask your-self, and honestly answer several important questions.
As an aside, I feel this first step is critical regardless of whether you are a do-it-yourself investor (DIY) or are inclined to hire professionals to manage your portfolio. My point being, that even the best designed portfolio will fail if the person for whom it is constructed to serve is not emotionally capable of sticking with it through all market environments. It is an undeniable truth that there is no such thing as a perfect stock portfolio that is capable of providing uninterrupted positive performance under all market and economic scenarios. In other words, as investors, we must be prepared and capable of weathering the occasional storm. To be clear, this paragraph is alluding to the inevitability of stock price volatility over time, and the respective individual investor’s ability to deal with it.
Consequently, a few of the most important questions that must be honestly answered are: How will I be able to handle the inevitable price volatility that goes hand-in-hand with the long-term ownership of stocks (businesses) in an equity portfolio? Will I be able to stay calm or am I more inclined to panic during bad markets? Am I comfortable being a long-term investor, or do I prefer investing as a swing trader? These are the types of questions that must be honestly answered and considered carefully in order to build and manage an equity portfolio that’s ultimately successful and appropriate for you.
With the above thoughts in mind, this series of articles is offered in order to provide reasonably valued common stocks of various kinds providing the potential of something for everyone. In part 2 and part 3 my focus was on providing ideas for investors most interested in total return. Consequently, growth ideas trumped dividend ideas. In this part 4, and all remaining additions, the focus will shift from growth to income. Therefore, the emphasis of this and all remaining articles will be on dividend income and the growth thereof. Hence, and to summarize, my second and third articles may be more relevant to investors seeking total return, whereas this and all subsequent articles should be more relevant to investors focused on maximizing their dividend income streams.
A Few Words on Total Return Performance Standards and Reporting
There are very rigid regulatory and industry standard performance reporting requirements. The objective is to require and assure that any and all management firms, to include mutual funds, indices, ETF’s and RIA’s etc., calculate and report performance numbers that are apples-to-apples comparisons. Therefore, all performance reporting is presented on a level playing field. In a general sense, this is a very good thing that provides investors a level of confidence when comparing the performance of one group to another.
On the other hand, like most things in life, there are certain weaknesses and flaws with strictly adhering to these standards that can, in effect, be partially misleading. The calculation of total return numbers represents a case in point. Although I agree, that when the rules are strictly followed as they are required to be, total return calculations tend to be quite accurate. In simple terms, the calculation of total return includes both the capital appreciation component and the dividend income component on equity portfolios over the time period being measured. However, a total return calculation, though accurate, does not always or adequately tell the whole story regarding performance.
This point is especially relevant and important to retired investors with the objective of maximum current income. The problem is that the two components of return, capital appreciation and income, are being reported in the aggregate. However, for the income investor, total return calculations do not satisfactorily reflect the area of performance that is most relevant to them. To these investors, the dividend yield or income component is what matters most. However, total return calculations do not separately report the capital appreciation component and the dividend component.
I offer the following examples of calendar year 2013 performance on portfolios that I manage on behalf of clients to illustrate my point. The dividend growth portfolios that I manage produced a total return of 31.64% in 2013. In comparison, the S&P 500 produced a slightly higher total return of 32.39% during calendar year 2013. Therefore, at first glance, it appears that the S&P 500 outperformed my dividend growth portfolios, albeit it only modestly. However, if the two components of return are looked at separately you would discover that my dividend growth portfolios outperformed the S&P 500 on the area of performance that mattered most – dividend income.
The current dividend yield and the total cumulative dividends paid in 2013 were substantially higher on my dividend growth portfolio than it was on the S&P 500. To put it simply, it logically follows that the capital appreciation component on the S&P 500 was greater than on my dividend growth portfolios, but not the dividend income portion. Since my dividend growth portfolios were designed to produce current income at reasonably controlled levels of risk, it is clear that they outperformed the S&P 500 where it mattered most – income.
Furthermore, so far in early 2014, the current yield of my dividend growth portfolios is slightly over 3% whereas the S&P 500 is only offering a current yield of 2%. Accordingly, the yield advantage continues on, regardless of whether or not capital appreciation turns out to be more or less than the S&P 500 in 2014. In other words, I am confident that my dividend growth portfolios will continue to produce more yield in future time than the S&P 500, just as they have in past time. This is important because the dividend income is being distributed without the need to harvest principal.
Moreover, the vast majority of stocks in my dividend growth portfolios are blue chips with long histories of increasing their dividend every year. To be clear, the dividend income on my dividend growth portfolios increased from the prior year in 2007, 2008, 2009, 2010, 2011, 2012 and again in 2013. In contrast, the S&P 500 had a sharp 21% decline of their dividend in 2009. Of course, both my dividend growth portfolios and the S&P 500 experienced sharp declines in stock price (negative capital appreciation) in 2008 during the Great Recession. However, the important difference was that my dividend growth portfolios continued to produce higher income each and every year, which is the primary investment objective of the portfolios.
The above performance examples are not offered to brag or as an excuse. Instead, they are offered to illustrate an important principle that is often overlooked when comparing performance results, especially when the focus is only on total return. Although everyone is happy to achieve high total returns on their portfolios, if the investment objective is dividend income, which is most relevant to retired