[This column originally ran on June 10, 2003 and was a hit. In honor of our exciting new Income Investor, Tom updates his focus on dividend-paying stocks.]
Is your portfolio allocation consistent with your level of comfort? Not only should you divide your money among companies that provide growth at a reasonable price, but that present risks with which you are comfortable.
Here's what I follow as a rough guide:
- 40%-50% in sleep-at-night, dividend-paying stocks; large, dominant companies; low-expense S&P 500 index fund; and cash waiting to be invested;
- 30% in value -- mostly in small-capitalization stocks using Ben Graham-influenced principles; and
- 20%-30% in informed speculations -- Rule Breakers, unprofitable development-stage companies, shorts, and even a few put and call options. High risk.
I don't sell arbitrarily to maintain this percentage allocation. Rather, even if a winner assumes a larger percentage of the port, business performance and valuation still determine whether I buy more, sell, or hold. To a point, of course. If a holding simply becomes too large, it invokes the "Don't put all your eggs in one basket" rule -- though that's a great problem to have.
Today, in honor of The Motley Fool's new Income Investor newsletter, I want to focus on finding dividend-paying stocks for my first group. This is the second of four columns taking a mid-year look at the ol' portfolio in light of portfolio-allocation goals. The first was How Much Risk Do You Want?, while the third and fourth, respectively, were Value Stocks in Your Portfolio and Putting Risk in Its Place.
The first group
If a doctor's Hippocratic oath is "First, do no harm," this likewise applies to my 40%-50% group. This category is the "sleep at night" bedrock, a combination of:
- Dividend-paying stocks of businesses with at least some potential for growth
- Low-expense S&P 500 index fund
- Stocks of large, dominant, well-managed companies priced reasonably
- Cash (usually between 5%-10% waiting to be invested)
My goal here and overall is to outperform the S&P 500, which may not offer much in the coming decade. Berkshire Hathaway (NYSE:BRK.A) chief Warren Buffett has made the case that the market represented by the S&P 500 may bring low- to mid-single-digit returns, and money manager and writer John Mauldin regularly presents persuasive evidence for flat returns in what he calls a "muddle-through" economy, though he notes that value investors may do well.
Just as in the Great Depression, some businesses will outperform. It's a stock picker's market, and it may be for a long time.
Why dividend-paying stocks?
Like many of you, most of my investable dollars reside in tax-advantaged accounts. For me, that's a Motley Fool 401(k), a Roth IRA, and a traditional IRA rolled over from a former employer. All are ideal for dividend-paying stocks -- even the 401(k), because our plan allows the option of investing partly in stocks through a brokerage account (we are, after all, a financial education company!).
But now that new tax laws reduce (with some exceptions) the dividend tax to 15%, dividend-paying stocks become attractive for taxable accounts as well. So with research showing that dividends comprise almost half of the long-term return from the S&P 500, all investors should give dividend-paying stocks serious consideration, whatever type of account.
Finding ideas
For ideas, a great place to start is with Foolish analyst Mathew Emmert (TMF Gambit) in Income Investor. Each month, Mathew seeks not just any old high yield, but high-quality businesses that pay you while they perform. He applies the following criteria:
- Safe, proven companies characterized by stable, dependable earnings growth through good times and bad
- Market capitalization of over $1 billion
- Dividend yield over 3%
- Payout ratio under half of free cash flow (with one exception, to follow)
- Low valuation
You want stable businesses for a stable dividend. If a dividend does decline in a given year for legitimate business reasons, a sustainable business can return the dividend to its former level and beyond. The 50% payout ratio limit is to ensure that the company still has cash to invest in its business for future growth. A ratio over 50% can mean that the company is starving itself to pay a dividend, endangering the future not only of the business, but of that dividend itself. (For fun, read this glib treatment of dividends I wrote in October 2000 and have a laugh. It's proof that people do learn.)
Applying his own criteria, Mathew wrote a series for Fool.com that included RPM International (NYSE:RPM), Altria Group (NYSE:MO), ConAgra Foods (NYSE:CAG), BellSouth (NYSE:BLS), Stanley Works (NYSE:SWK), and Newell Rubbermaid (NYSE:NWL).
Three dividend-paying stocks
Many dividend investors are considering Altria Group, owner of Philip Morris, 84% owner of Kraft Foods (NYSE:KFT), and 36% owner of SAB Miller. The latter two non-tobacco businesses may balance the litigation risks to Altria's Philip Morris tobacco business, but it's those risks that keep its shares at a market capitalization-to-free cash flow ratio under 10. And Altria's dividend yield is a nice 6.7%.
When this column first ran in June, I owned Altria and didn't see the contradiction that's now obvious: It doesn't fit my major criterion for the first part of my portfolio -- sleeping at night. Yes, it may be tremendously undervalued and offers a great dividend, but I want my dividends-plus-growth choices to be the bedrock of the portfolio, not cause for worry. The litigation risk means that Altria would belong in my third category of high risk, but it doesn't satisfy the criterion that in exchange for risk, the potential return must be huge. So I sold.
Altria may fit your investing strategy perfectly, but if you think that the dividend comes with low risk, examine your reasoning carefully to be sure you're comfortable.
On my own
Here are two other dividend-paying stocks that offer lower risk. The first is smokeless tobacco, wine, and cigar maker UST Inc. (NYSE:UST), which I first took seriously upon reading UST: Double Dippin' by TMF Money Advisor manager Buck Hartzell (TMF Buck). (Buck also turned me on to the TiVo (NASDAQ:TIVO) TV service, for which I am almost as grateful. It doesn't pay a 5.9% dividend but is certainly addicting.) Buck's piece details UST's many business strengths.
The second is a business that crosses the first two categories. I recently wrote about diagnostics and recombinant protein manufacturer Meridian Bioscience (NASDAQ:VIVO), a small-cap value investment that at the time yielded over 4% and still offers 3.4%. Its dividend is especially tasty given its rapid free cash flow growth the last four quarters.
Performance of dividend-paying stocks is a little more difficult to track. If you have a portfolio tool that calculates Internal Rate of Return (IRR) for you, accounting for multiple purchases and dividends, that's great. I use a spreadsheet I developed that compares performance to the S&P 500, using SPDRs (AMEX:SPY), but it requires manual input of dividends. If you would like this free work-in-progress, email me at [email protected] with "spreadsheet" in the subject and I'll shoot it to you.
That's the case for dividends and a few sample stocks. Have a most Foolish week, and thanks for reading.
Writer and Senior Analyst Tom Jacobs (TMF Tom9) is confused: He thought he was supposed to labor on Labor Day. He owns shares of UST and Meridian Bioscience, as well as other companies listed in his profile . Motley Fool writers are investors writing for investors .
