How To Construct A Dividend Portfolio

Author’s Note: Do not consider any specific stocks mentioned in this article as an investment recommendation. It is merely an illustration of my opinion and point of view. I do not know your risk profile, tolerance for paper capital loss, and circle of competence for making investment decisions. You should only make decisions based on your knowledge of the facts, and fully accept responsibility for your personal finance decisions.

I recently received this mailbag question from long-time reader Stephen MeInykevich, and because of the universality of the question, Stephen graciously gave me permission to share the answer with you.

“Tim,

The site looks great. Just bookmarked it. I have a good question or article suggest for the site.

If you are 30 years old and organizing a portfolio of dividend stocks, what would be your core, what would be your aggressive picks and how would you organize that.

Ideally where should an investor be in terms of portfolio size at 30, 40. 50, 60. etc. What would the ideal dividend return be at each of those stages.

Keep up the great work,

Religious Follower,

Steve”

Stephen, thank you very much for the kind words! Your question is a great springboard to discuss a comprehensive dividend philosophy, which is one of my absolute favorite topics to discuss. I want to start with this line you mentioned: “Ideally where should an investor be in terms of portfolio size at 30, 40. 50, 60. etc.” As you can probably already guess, I am going to give the obnoxious answer that seems to be the response to every finance and investing question: it depends. Despite that, hopefully I’ll be able to get things rolling a little bit.

In terms of where your net worth should be at a given age, that will entirely be a function of the income you generate over the course of your lifetime. If you are a single parent raising three kids while making $40,000 per year, the fact that you accumulate $100,000 in net wealth pumping out $291 in monthly dividends is something to sing hallelujah about while privately knowing that you belong in the investing hall of fame even if no one knows your name.

However, if you are a single doctor making $300,000 per year, did not have to address a meaningful debt burden, and only have $100,000 in investments at the age of forty, you have done something very wrong (most likely, you either lived at your means or traded stocks instead of thinking like an owner that made long-term investments) even if you have that same $100,000 in paper wealth because you had the skill set and personal opportunity costs to do so much more with your hand in life.

I do not mention these things in the “keeping up with the Joneses” sense. Stephen, I do not want to give you the impression that your job is to be the richest man in the cemetery. Last time I checked, there is no prize for that. In fact, dying with obscene wealth represents unused potential, and signals that you could have used more resources to make the world a better place while you were here on earth (on the other hand, it also signals that you produced more than you consumed while you were here on earth, which has a certain nobility to it).

Never forget that money is just a tool, and it is your job to maximize its utility in your own life. Most people in this country, statistically speaking, make decisions that take care of their “current self” more than their “future self.” But delayed gratification is a virtue you can still wield with potency. Almost anything worthwhile that has entered my life has taken time, work, and a bit of blessings thrown in, and investing is no different. I view the act of investing as the pursuit of making decisions today in such a way that a version of myself twenty years down the road will say, “Rock on, brother man! I owe the 21 year-old version of myself a drink!” That is what savings rates and investing is all about: striking the optimal balance between enjoying your life in the here and now while paying proper deference to the kind of lifestyle you want your future self to attain.

John Wooden once said that the measure of our life is not how well we did in comparison to others, but rather, how well we did in comparison to our potential. If you are reading this site, wealth building is probably a priority of yours, and something that you use as a measuring stick of sorts. The question is: What is your investing potential? If you are a single woman in Kansas with no health problems or any children to make demands on your income, you could easily have the potential to save $30,000 of a $70,000 salary, thereby adding $1,200 ($100 per month!) in permanent passive income to your balance sheet just because of your tactical decision to live significantly under your means for twelve months. And if you invest that money in the realm of dividend growth stocks, you are laying the groundwork to see bigger and bigger checks come your way each year. It is the regular and predictable annual growth of the dividend that changes the trajectory of your life as a result of shrewd delayed gratification because more money comes your way each year without any additional effort on your behalf.

Now, with all that said, we can dive into the specifics of stock-picking in relation to the construction of an income portfolio. When I first began investing and thinking about dividend portfolio construction, I thought my job was to simply identify any company that happens to be excellent, and add it to my portfolio. However, it turns out to be a little more complicated than that because companies do not share the same valuation, meaning that some companies allow you to buy more future profits than others when you take into account the current price of the stock in question.

Even though I write about dividend stocks, there is no rule that dividend stocks have to constitute the bulk of your wealth. It is all about the cash generated by an asset in relation to what you pay for it. If we lived in a world where treasury bonds yielded 10% and most blue-chip stocks had 2% dividend yields and 4% earnings yields, I’d shut the heck up about dividend stocks and start writing about the exhilarating world of fixed income that gets everyone’s juices flowin’. In seriousness, it’s all about what the amount of current and future cash we can generate in relation to what we pay.

As I write this here in July 2013, I have spent most of my time buying BP around $40, Conoco in the $50s, and the next object of my affection is Royal Dutch Shell in the upper $60s. I know, I know, I need to go to Goodwill and pick up a Cowboy hat. No, I didn’t focus on big oil because I wanted to embrace my Texas birthplace and do the oil tycoon thing. Rather, I reached this conclusion: unless we are headed for a substantial decline in the price per barrel of oil, those 4-6% dividends from Conoco, BP, and Shell are a great way to generate substantial income over the course of coming business cycles based on current prices.

By the way, the fun thing about investing is that there is no “right” way to build wealth. If you spent the next five years stocking up on shares of Visa stock, Wells Fargo stock, and Aflac stock, it is entirely possible that you could accumulate more wealth than the strategy I practice. It would be dumb of me to say “You should buy x stock, you should buy y stock” because (1) there are a lot of ways to create inflation-adjusted wealth over the long haul in a country with an economy worth over $13 trillion, and (2) you have to do it in a way that is within your circle of competence and fits your style and risk profile for investing. Because I cannot make those determinations for anyone but myself, I leave it up to you to find the path you want to travel.

Now I’ll try to answer the first part of your question: “…what would be your core, what would be your aggressive picks and how would you organize that.”

Here is how I think of it:

When constructing a portfolio, there are ten companies that I consider indispensable, and are the sort of stocks that once you buy, you never sell.

They are:

Exxon Mobil

Chevron

Coca-Cola

Pepsi

Colgate Palmolive

General Electric

Disney

Procter & Gamble

Johnson & Johnson

Nestle

In my case, my long-term vision is for those 10 companies to make up 30-45% of the portfolio. These are the companies that do the heavy lifting in index funds, mutual funds, and trust funds across the world. They are cash machines, and are the kinds of companies that reward you during your lifetime with cash dividends that you can use to live the life you want, and then when the Good Lord calls, you can pass them on to your children, grandchildren, and favorite charities so that those cash machines can then be used to make lives better for the people you care about.

Those ten stocks fit my profile of a backbone, but your list may be entirely different. Maybe you don’t feel comfortable about a permanent commitment to an energy company, so a firm like General Mills, Anheuser Busch, Kraft, Hershey, or Berkshire Hathaway (which presumably will get around to paying a dividend sometime in the next decade or so) would be a better fit on your permanent list given your risk profile. The point is to find the companies with the business models that will give you cash for the rest of your life, generate the capital from your labor to acquire them, and then let the excellent companies do their thing.

Once the backbone of the portfolio is constructed, it’s about finding other excellent companies that are selling at value prices. Maybe you can pick up some Dr. Pepper here, Philip Morris International there, and some Wal-Mart stock on the flipside. But with those companies, I would be more insistent on a value price because, in my opinion, the earnings quality is great, not quite as high as a Johnson & Johnson or a Coca-Cola so it would be more important to create a margin of safety for yourself by getting a good price to ensure satisfactory future returns. But that’s just my style.

There is no magic portfolio size that you should be at given your age, because it is all about your personal opportunity costs. Someone with debt, kids, a low skill set, and a relatively modest salary may be impressive as hell for managing to save $300 per month, while that be a pitiful savings rate if you’re a single heart surgeon living in Dallas. What’s your potential?

When it comes to long-term investing, it often comes down to two things:

(1) Get to the $100,000 savings mark as early in life as you can. Why? Because at that point, it’s not just you working at your salary, anymore. Your investments are working just as hard. Without breaking a sweat, you should be generating $3,500 per year, or $291 per month in dividends at that point. Just by clicking the “reinvest button”, you’d be adding $122 to your annual income before even taking into account the growth of the dividend in your holdings. Life starts to get fun when you are making $9.58 automatically just for waking up in the morning. That’s “I’ve got a snowball about to take off down the mountain” kind of money.

(2) Protecting that money by putting it into the highest-quality companies you can find. Charlie Munger is famous for saying, “In Monopoly parlance, you don’t want to go back ‘To Go.’” Once you have that $100,000, you don’t want to fill your life with bankruptcies and dividend cuts. For most of your holdings, insist on twenty years of dividend growth, an earnings growth rate of 5% over the past ten years, and limited exposure to the financial sector. And be sure to spread it out across twenty companies. If you apply that formula, you can withstand a lot of abuse and still get richer even if adverse events strike. Remember, if you own 33 companies that make up 3.3% of your portfolio’s income each, you could have two companies go completely bankrupt provided the dividend growth rate for the rest of your portfolio is 7%… and you would still be richer than you were the previous year. Diversification mixed with blue-chip dividend growth can be that powerful.

If you treat your investing life as a rat race to $100,000 at as early of an age as you can, and if you diversify that money across the biggest, baddest blue-chip stocks spanning the globe, you have turned your household’s balance sheet into a financial fortress that will be pumping out meaningful amounts of money every month regardless of what you are doing with the rest of your life, and it should definitely put a nice little pep in your step as you work your way through the rest of your life’s journey.

To see how I have chosen to construct a dividend portfolio, you may purchase “My Ten Largest Investments.”

_____________________________________________________________________________________________________________________________

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This is not an ebook telling you to buy Coca-Cola, ExxonMobil, Johnson & Johnson. This a book that identifies truly superior midcap (or on the small end of large cap) businesses and gives them each their fair due in a write up. The ideas presented are credible things that you could actually finding yourself buying and holding for long periods of time, and each of the stocks mentioned remained profitable during the worst of The Great Recession.

To purchase, click here: “The Sainted Seven Stocks For The Long Run.”

If you would like to see my ten largest investments, click here: “My Ten Largest Investments.”

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12 thoughts on “How To Construct A Dividend Portfolio

  1. Matt says:

    Wow, Tim, you are great. I wish I started reading your blog and posts to Seeking Alpha at a younger age. I enjoy reading your website every day. You break down the basics in a very palatable way.

  2. Matt says:

    Tim, by the way, I agree with your points above about the 'core holdings'. I have taken a different route. I like the vanguard funds that have yields in the high 2.0's and low 3.0's. For example, I really like the Vanguard Equity Income Fund. I guess I am just ok with a solid vanguard fund, that is actively managed (but still low cost) and a 2.8 yield. Maybe that is not as dynamic as I should. But I think in the long run, it will get the job done. What are your thoughts on VEIPX (Vanguard fund) ? ~ Matt

  3. says:

    Great article Tim. I'd love to see an article with your thoughts on Disney. I am little concerned about their reliance on ESPN. I'm not convinced that one day we won't see the TV industry revolutionized in some way where folks pay by channel and that makes the franchise (and most cable channels) a lot less lucrative.

  4. says:

    Love your articles Tim! I ran out of your stuff on Seeking Alpha, so here I am. I'm 29 and I've been investing for just shy of a year, and over the past few months have shifted into a DGI strategy. We don't make a whole lot of money, as I'm a stay at home mother, but so far I've been able to put away about $10k for our retirement and a block of Disney shares for each of our 2 sons in custodial accounts. I'm reinvesting through my broker and I can't wait for the big dividends to roll out as I continue to contribute. Thank you so much for your articles…I can't wait to read more.

  5. Barry says:

    Another great article Tim! I agree completely in terms of philosophy. I own about 45 individual stocks right now, and my core has a lot of overlap with yours. In the energy area, I substitute one of the midstream companies (KMI or SE) for one of the oil and gas majors.

    10-12 years from retirement – Portfolio yield 3.2%; 5 year dividend growth rate – 11.8 %. I plan to gradually increase the portfolio yield as I get closer to retirement, depending of course on income needs at that time.

    Your advice to get that first 100K working is invaluable – the motivation level gets high when the dividend checks get larger, and you see the plan start to work>

    Keep it up!

  6. Bob says:

    Tim Great list of companies.Nestle is the largest food company in the world.Itno doubt is a great company,and has been for a long time.I understand being a Swiss company they withhold 35 percent tax on dividends.

  7. says:

    First time reading this blog and I am impressed. I really respect your willingness to admit that "one size doesn't fit all" in many of your article paragraphs. Looking forward to future articles.

  8. jim wiedmann says:

    also my first time here. enjoyed the read very much. we have mut. funds and indiv. stocks, trying to wean away from m.f.s by getting educated. I understand lower the price, higher the yield, but, long term, reinvest, etc. why should yield be such a factor that everyone talks about? thanks, j.w.

  9. Darren says:

    Hello Tim – Thanks for this article! I like your writing style. I am just now constructing a dividend portfolio and it has been quite the learning process. I am wondering if you can address a question I have on building the portfolio regarding actually making purchases. I have seen a few authors caution the new dividend investor to not buy all your stock picks at once but to make the transition over time. Why is this? I assume the authors are telling us to identify the stocks we want to purchase and then wait for the appropriate entry price? Although I understand the share price is important and I do try to find value, If I am buying a quality company for a long-term position how important is share price?

    Theoretically, if I found 20 DGI stocks I wanted to buy tomorrow and I believe they are fairly priced, what is the risk in buying them all in one day?

    I hope my question is clear. Thanks for your insight.

    DB

  10. ConstanceQuigley says:

    Hi, Tim. I’m a faithful subscriber to your DA posts. I hold a nice chunk of most of the aristocrats now, thanks to you. One of my holdings is Leggett and Platt. I haven’t seen you write anything about this one, but it’s been going crazy lately and I’m curious if you could do one of your assessments of this stock.

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