It is that time of the year when many of us reflect back on the year and start thinking about how we would re-balance our portfolios. We always read about re-balancing our portfolio on various blogs or investment wisdom. Almost all of these sources show us that we should have diversified asset allocation. Now, when it comes to actually doing re balancing, that’s where, I find such resources fall short of a methodology. If I am reading any literature from investment advisory houses or brokerage firms, then I find a fixed template, which ironically remains same for everybody (albeit with some minor tweaks). I have asked few certified financial planners or advisers and almost everybody just repeats the same tape of diversification but misses on how it should be done. There is a school of thought that says sell good ones that have increased value, and buy ones that have reduced in value. Now, why should I sell something when it is consistently giving me returns (and I expect it to continue), or why should I buy something that has reduced in value. The reduced value should be an indication that something is not working, right?

In my view, the process of re-balancing is an ongoing effort. It should be always be part of investor’s ongoing buy and sell decision making process. Depending upon your investment goals and risk profile, individuals should have a set of predetermined criteria which should guide them in making buy/sell decision. This way they are proactively managing their asset allocation.

As a dividend growth investor, I have a decided a set of constraints for myself. I am a buy and hold investor as long as any given company keeps performing to my objectives. The set of constraints that I use on an ongoing basis are as follows:

1. Continuity of meeting my buying objective: Here, my attempt is to make sure that my stocks portfolio continue to meet my buying objective of dividend growth, or continued value preposition, or index exposure. Whenever, I a buy a stock, I make sure why I am buying it and how it will help my portfolio. For example, when a company cuts dividends, I sell it if it was bought for dividend growth.
2. Maintaining asset class allocation: This is related to my overall assets, ideally, which are supposed to be not related. But I always wonder in the inter-related global world, is there anything that is not related? My attempt here is to make sure, I do not over expose myself of any particular class, like REITs, emerging equity, or commodity related stocks.
3. Maintaining diversification: As a dividend investor, I believe this is a very important aspect for diversified asset allocation. Like in any other style of investing, dividends have appear to be favorable in few industry sectors such as REITs, CONROYS, consumer staples, large caps, etc. Until last year, financial sector was a darling of dividend investors. I try to limit myself up to 10% allocation in any given sector.
4. Dividends from a single stock should not exceed 5% of total dividends: 100% investing success is an illusion. Similarly, a dividends will never be cut is also a mirage. Last two years have shown us that dividends will be cut, no matter how great the company is. The only way to reduce the impact is makes sure dividends from a single company does not exceed 5% of your portfolio dividends.

It may seem that using these criteria is a cumber process. It may feel like overwhelming or over engineering. But in reality it is not so. When your buying and selling frequency is less than 24 times a year, it does not feel as a tedious process. I have discussed my risk analysis to show how a quarter reviews helps maintain a diversified allocation. It is my hope that it will minimize the down side risk in long term.

How do you perform your portfolio re-balancing?

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Few weeks back I read an interesting comment to an article on seeking alpha; Investor’s sole objective is to maximize capital appreciation (or returns) and in doing so follow a path of minimum risk. This is not a quote but essentially what it meant. I pondered over it and came to conclusion that comments section is not a place to divulge or express the target and goal. In essence, it does sound right.

So I talked to few other folks about their investing objectives and almost everybody had a similar thought process. Maximize your returns within minimum risk, devoid of any target or methodology. Even after few probing questions, it was clear to me the lack of a target. I even gave examples like, I have 100K to invest, now what should I do and how should I grow this capital. With few exceptions, the response I got was; do this for x% return; do that for xx% return; or wait for this opportunity and then invest to xxx% in three years, etc. I was pretty surprised by this.

Surprised because without an end goal, or target, how will an individual attempt to maximize the returns and how will one determine the minimum risk. Many folks were more focused on figuring out returns, instead of identifying a goal and working to achieve it.

• One goal could be to make 1000K in 10 years which forces me to plan 10% annual returns. I can then decide which investment opportunities should I be using and what is risk associated with it.
  

• Another goal could be to make 1000K in 5 years, which forces to plan for 20% annual return. And here also I can then execute accordingly.

• Still another could be 6K cash flow every year with increasing capital appreciation reaching 500K in 7 years.

But to say, invest in this vehicle or do this for such returns, is something I could not understand. It’s like keep running, someday, you will reach somewhere!

In last few weeks, I have looked at dividend stocks (aristocrats and achievers) that have dividend yields of less than 2%. There is a school of thought among dividend crowd that low dividend yields will take more than 10, 12, or even 15 years to match income from high yielding CDs or money market accounts. Furthermore, when low yield dividend stocks are compared to high yield dividend stocks, considering conservative dividend growth rates, low yielding stocks will often lag by significant amount. I agree that, mathematically, there is no argument for low yielding dividend stock providing lower income. Purely based on numbers, it is always good to go for relatively higher yield dividends stocks. In general, the cut off used by dividends investors vary such as 2% absolute dividend yield, 3% absolute dividend yield, or dividend yield higher than market (i.e. S&P500 yield).

In general, I have always tried to compare dividend stocks yields to S&P500. But I have not had a minimum dividend yield floor value, below which I have not invested. Another aspect is, it is likely that the low dividend yield is perhaps due to the higher stock price which in turn could mean good quality stock. As an example, I have been holding on to LOW stock for a while now. I tend to look for quality of the dividends, risk to dividends, and core competency of the company. Let us take two examples.

• John Wiley & Sons (JW.A) is in publishing industry where there is a general concern about industry’s continued decrease in profitability. Contrary to this trend, JW.A continues to have stable gross and operating margins, generates stable operating and free cash flows. Its core competency is digital publishing that focuses on the subscriber based products. It does not have to depend upon advertising revenue alone. Notwithstanding, the low payout and low dividend yields, the company will last longer than 10 years. Therefore, I believe low dividends yield alone should not be a show stopper.

• Becton, Dickinson and Company (BDX) is another example of low dividend yield stock. The company does not have excessively high debt levels and hence, is not affected by financial turmoil. It does not depend upon the credit markets. BDX generated more than half of its sales from outside of US which seems to be recovering faster than US economy. Yes, it does have challenges such as regulatory driven change in spending patterns, health care reforms, or recession driven slow down. But these issues will affect the whole industry and not BDX alone.  Contrary to general belief, BDK operates in an industry with high barriers to entry. The quality and reliability requirements for end products in this industry are among the stringent ones. It has build business around its core competency which makes me think and believe that it will last for more than 10 years.

I am still in my early thirties and have a long way to go before I stop investing. So if I think the company has some core competency, competitive advantage, low risk to dividends, and will survive beyond ten years, then I am open to invest in such low yield dividend stocks. I believe the slow steady earnings will provide capital gains and help me moderate out total returns.

If you are like any other do-it-yourself individual investor, you would have been through this dilemma. When should I initiate a position? As per our individual investing style, criteria and risk profile, we have done our due diligence and come up with price that we are ready to pay. Now if we are in bull market, we do not hesitate and take a plunge. However, if we are in the bear market (like these days), then we hesitate to initiate our position. We start contemplating, should we wait a little bit more? This dilemma is more in case of dividend investors because YOC is sensitive to initial yield.

I have been through this dilemma quite often. Let is think this through with some rational reasoning.

• It is just not possible to predict stock prices. If it were possible, everybody would rich and nobody would be losing money.
• Any type of fundamental analysis that is done is based on past data, based on past economic environment, and based on how past managements have performed. A great company in past, can end up in mess with new management. Do we need to go through any examples?
• Any type of technical analysis or chartists theories claims to predict short term movements in next few days or in some cases next few weeks. These are typically 5% to 10% differentials. If I am investing for long term with 10years, 15years, or even more, than these differentials are of no consequence.

I have made mistakes and learnt my lessons. The key is to learn, adapt, evolve, and move on. The well defined investment process based on principles of risk management helps me get over this dilemma. No amount of analysis (fundamental or technical) will save me from losses, if my process of evaluating an investing opportunity is wrong, or if my investing process has shortcomings, or if I do not have ability to stick with my risk criteria’s. If I am listening to market chatter, and continuing to wait for a stock to go down for higher initial yield, then I am deviating from my process. I am listening to folks who themselves have no clue what they are taking about or it may not be relevant to you.

What do I do?
Like any other do-it-yourself investor, I spend quite a bit of time to analyze a company and come up with fair value range. This fair value range is based on my personal risk profile (and not necessarily a fair value in absolute terms). I do not make any one time stock purchase for any given opportunity. In general, I spread it over a period of time. When the stock price falls in my fair price range, I initiate a small position equivalent to 30% of final expected allocation. I then continue to watch for six months or more. In this way, I can minimize my downward losses due to falling knife (note – I cannot avoid, only minimize). The next two installments are kept of future depending upon when there is next opportunity. If it is in fact a falling knife, then it will be obvious. If it is in fact an opportunity to invest, I add to my position, and hence help averaging down.

The message is, ignore the market chatter, identify a process for yourself, and stick to it. There is no investing process which is based on zero risk methodology. Accept the fact that we will incur short term losses.

In a well defined investing process, these short term differentials (loss or profit) will not have any noticeable impact in your longer term objectives.

The continued challenges and slow down in various sectors of the economy is putting stress on dividends paid by many corporations. During year 2008 and so far in 2009, investors have had to experience dividend reductions and/or dividend cuts, thereby affecting their continued dividend income. My dividend portfolio was also affected by dividend elimination/reductions by C, BAC, and PFE. In order to minimize the risk of dividend reduction/elimination from each stock, I have been using the pre-determined maximum limit of 5% of total dividends. This method does not provide a means to measure the changes in risk-to-dividend on continued basis. Therefore, I have come up with the method that I have started using for my dividend portfolio. Here I am discussing a measure of risk-to-dividends, which can be used by individual dividend investors. To calculate any measure of risk-to-dividends, we first need to understand what are the factors or variables that will affect the payment of dividends. I believe current prices, profitability, payout factor, yield, year-over-year growth of EPS, and financial leverage are variables that will helps us measure the risk on continued basis.

Current Price (P): The current price of the stock reflects the general market opinion about the company and its fundamentals. The objective here is to capture the historically based fair value vs. the current pricing. As a part of my dividend stock analysis, I calculate the range of fair value of the stock. This range is based on average (with standard deviation) of five different measures. The range is calculated as [average fair value + (0.5 x Standard Deviation)]. If the current price of the stock is below this range, I assign it high risk (value of 3). A current price within this range is assigned moderate risk (value of 2). A current price higher than this range is assigned low risk (value of 1).

Current Yield (Y): The rationale for inclusion of yield is to gauge the corporation’s current yield with its historical range. I calculate the average yield and standard deviation for the last 10 years. The range is calculated as [average yield + (0.5 x Standard Deviation)]. If the current yield of the stock is below this range, I assign it low risk (1), within this range is assigned moderate risk (2), higher than this range is assigned high risk (3).

Current Payout factor (PF): It is always better to have a lower payout factor. The purpose of including payout factor is to measure how it differs from corporation’s historical average payout factor. I calculate the range of payout factor based on average payout factor and half standard deviation for last 10 years. ‘Current payout factor’ within this range is assigned moderate risk (2), higher than this range is assigned high risk (3), and lower than this range is assigned low risk (1).

Profitability (GM and OM): This includes corporation’s gross margins and operating margins. I calculate the range values based of 10 year average and its half standard deviation. Current margins lower than this range is assigned high risk (3), within this range is assigned moderate risk (2), higher than this range is assigned low risk (1).

Financial leverage (FL): The notion here is that corporation’s should effectively manage its debt. I calculate the average value and its standard deviation. The current value within this range is assigned moderate risk (2), lower is assigned low risk (1), higher is assigned high risk (3).

Growth of EPS (Delta EPS): The year-over-year growth of earnings is what will facilitate the growth in dividends provided corporation is able to maintain its profitability and low debt. Here, also I calculate the range based on average EPS growth rate and its half standard deviation. The current EPS growth within this range is assigned moderate risk (2), lower is assigned high risk (3), higher is assigned low risk (1).

Now the risk factor is calculated as arithmetic average of all these seven parameters.

Risk Factor = [P + Y + PF + GM + OM + FL + Delta EPS] / 7

The range of this risk factor is from minimum of 1 to maximum of 3. Since we are measuring three levels of risk (low, moderate, high), we can divide this into three equal parts. 1.00 to 1.67 is low risk, 1.68 to 2.34 is moderate risk, and 2.35 to 3.00 is high risk.

The key advantage of this measurement is that it measures the current risk profile to corporation’s own historical standard.

As an example, this excel sheet shows the risk analysis of Proctor and Gamble Co (PG). Similar following are calculated risk factor (i.e. risk-to-dividends) for few stocks in my dividend portfolio:

High Risk Category: GE (2.57), HCP (2.61)

Moderate Risk Category: JNJ (2.14), SYY (1.86), BP (1.86), INTC (2.13)

Low Risk Category: PG (1.43)

While I do not have any position in KMB (2.57), it is under high risk category.

Now that we have calculated this measure for risk-to-dividends, the next question is how to use it in dividend portfolio management process? The way I plan to use it is, stocks in high risk category will not receive new capital investments and are likely candidates for selling, stocks in moderate risk category and low risk category are ‘candidates for continued investments’.