This Is Why We DiversifyDIVIDEND GROWTH INVESTOR
I have spent the last month discussing CVS Health (CVS) and Walgreen’s (WBA) with a lot of readers on my site. I have spent even more time discussing these companies than thinking about any of the ther companies I have a stake in.
The number of questions intensified after Walgreen’s issued a terrible profit miss, and guided no earnings growth in 2019. This brought the stock down a lot to the lowest levels in 6 years. I personally believe that the stock was already priced very bearishly. It is likely that the company faces a lot of headwinds with increased competition, rising scrutiny and a pressure on revenues and margins. Check my analysis of Walgreen’s for more information about the company.
CVS Health has these issues as well, along with the high levels of debt after acquiring insurer Aetna and freezing its dividend payment.
As I discussed before, I am more likely to add to Walgreen’s than CVS Health, mostly due to the fact that the former is still growing the dividend. The latter is a more diversified entity, but has more debt, faces integration risks and froze the dividend.
Needless to say, I own stakes in both companies. I have added to both in the past year. However, I have been adding to other companies as well. I would hate to throw money into a bottomless pit, but I also hate to miss out on a bargain. I do have some controls in place, in case I am wrong in my assessments however. I require a decent valuation before buying a stock, because that means I get more dividend income from my initial investment right away. If a stock I buy at a 3% initial yield fails in a decade, I at least get to recover at least 30% of my initial stake. I still lose money, but my loss is smaller.
I also tend to build my position over time, which allows me to average down my cost basis if there is a decline in the share price. Since I build my positions slowly, I also see gradual changes in underlying fundamentals over time. As a result, I may stop adding to a position if I believe that fundamentals are deteriorating.
Last but not least, I also tend to limit the amount of capital I allocate to every investment idea. I do not want to depend on a single entity for the success or failure of my portfolio. I know I will make mistakes along the way, which is why I am trying to lessen their impact on my overall well being when they happen. This is why I diversify my portfolio as much as I can. I do not want one bad apple reducing my dividend income significantly. For example, one dividend cut is more painful if my portfolio consists of 20 individual names and I have a 5% allocation to the company that committed the ultimate sin of dividend investing. The dividend cut will be less painful if I have a portfolio consisting of 100 names, and the dividend cutter represents 1% or 2% of the total portfolio.
While we have an idea of an investment, and can control the screening process, and the portfolio weights, I do not know in advance which of my ideas will do the best and which one will fail miserably. This is why I try to buy over time, I diversify, and try to allocate money as equally as possible. I also try to reinvest dividends selectively into more companies to further diversify my portfolio. As a result, I believe that my portfolio can withstand potential dividend cuts without much reduction in dividend income.
The risk management controls in place include:
- Dividend safety analysis and valuation analysis before purchase
- Diversification by number of companies, different sectors and through time (dollar cost averaging)
- Using dividend income to invest in other companies, in order to further diversify my portfolio
- Selling dividend cutters, and reinvesting proceeds elsewhere
- Placing limits on position sizes
I believe that the winners will take care of themselves. This is why my job as a portfolio analyst is to manage the risks. I can do the best job in the areas within my control, in order to place the odds of success in my favor. That way, my portfolio’s will not be dependent on the success or failure of a couple of companies, but on the overall investment process of implementing my strategy.
Thank you for reading!
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Article by Dividend Growth Investor