Background – Why Trim?
In late 2014, I amended the Business Plan for my Dividend Growth Portfolio. I reduced the maximum weight of any stock position from 15% to 10% of the portfolio.
The reason for this change is that I am on a long-term mission to add more diversity to the portfolio. In the past couple of years, I have increased the number of positions from 10 to 18, with an eventual target of 20-25.
In support of that mission to increase the number of stocks, I have also been reducing the maximum size that any single position can be.
This is a strategic guideline in the business plan.
About a year ago, I reduced the top weight from 20% to 15%, and in December, I reduced it again to 10%.
The goal, of course, is to reduce the risk to the portfolio emanating from any one position.
When the maximum weight was 20%, a single position could control 1/5 of the portfolio’s performance.
Increasing the number of positions and reducing the maximum weights lowers the potential impact of any single holding. The portfolio becomes safer.
Not only that, I don’t lose anything. I believe that I can maintain the portfolio’s performance at a similar level to what it had when it was riskier. So there is no downside to making it safer.
Deciding What to Trim
As of the end of December, you can see that 3 positions exceeded the new 10% max-weight guideline.
Two stocks, JNJ and PEP, exceeded the new guideline by more than 2 percentage points, while LNT was fractionally above 10% weight.
I decided to redress the overweight conditions of JNJ and PEP. I will leave the LNT position alone for now, as its slight overweighting could just be market noise.
I should point out that I have no problems with either JNJ or PEP as companies or as stocks, and under normal conditions I would not trim either one.
But the strategic mission to diversify the portfolio outweighs the satisfaction that I have with both stocks. I simply wish to reduce the risk that any stock – no matter how good it may be – poses to the complete portfolio should misfortune strike. If I can do that without hurting the portfolio’s performance, there seems to be no reason not to do it.
Please not that if I were adding new money to this portfolio, I would not trim either stock. I would reduce their respective weights simpy by redirecting new money elsewhere. But this is a closed portfolio with no new money coming in. Therefore, rebalancing requires trimming and redirecting money into other stocks.
Deciding How Much to Sell
After identifying the two positions to trim, I performed a couple of simple calculations to decide how much to downsize them.
- To reduce JNJ to about 9% weighting, I needed to sell 20 of the 95 shares that I owned.
- To reduce PEP, I needed to sell 30 shares out of 107.
I made the two sales on January 15. I used simple market orders that were executed in seconds. Less commissions, the proceeds from the two sales brought in $4,947.
I do not hold cash in the portfolio, so I wished to reinvest that money immediately. I had already researched potential stocks to buy before I made the sales, so that I would be able to reinvest the money right after I made the sales.
Deciding What Stocks to Buy
I have a fairly standard process when I am in buying mode. First, I research stock candidates, and I always have a “shopping list” handy. Research that is a few months old is OK so long as nothing significant has happened to the company in the meantime.
Second, I re-value each of the stocks on the shopping list. While company fundamentals change slowly, valuations change all the time as stock prices go up and down, companies report earnings for completed quarters, companies revise their “guidance,” and analysts revise earnings forecasts.
Here is my current shopping list.
Note that some of the cells in the table are blank. That is because if I run into a number that disqualifies the stock from further consideration, there is no use wasting time gathering more information about it. These stocks were eliminated in that fashion:
- Aflac (AFL): Yield below 2.7%. That is my cutoff for new purchases in this portfolio.
- Kinder Morgan (KMI): I love this stock, but its valuation is too high at this time. The valuation score of 2 is on a 5-point scale. I require at least 3, which indicates a fair valuation. For a valuation review, see Dividend Growth Investing Lesson 11: Valuation.
- Coca-Cola (KO): Same story: Great company but overvalued.
- Procter & Gamble (PG): Same story. It is overvalued at this time.
- Qualcomm (QCOM): At 2.3%, its yield is too low.
Assembling the above information took only 5-10 minutes. This illustrates how a few simple guidelines can cut your work tremendously when you are making decisions like this.
That left 7 stocks remaining as candidates. To make decisions among them, I considered their yields, valuations, and dividend growth records.
Most important, I thought about the role each would play in my portfolio. Keep in mind that I am trying to bring the number of stocks up to 20, and that I want to have a portfolio that is diversified. That means that I want stocks from different industries, with different dividend characteristics, and I am a little biased toward adding a new name when I have the opportunity.
Here is what I decided to purchase:
- Add more AT&T (T). This was my Dividend Growth Stock of the Month for January, and I also reinvested dividends earlier this month into it. I like the high yield as well as the overall quality of the company. Adding more is pretty much a no-brainer.
- Add more Microsoft (MSFT). While its yield is just equal to my minimum (at 2.7%), it has had a strong dividend growth rate history, and I think it is a very high quality company. Its next dividend increase is expected in November.
- Establish a new position in Digital Realty Trust (DLR). This is a company that has only been on my radar for about a year. It is a REIT specializing in real estate used by technology companies. I like that business model as well as its yield and dividend growth rate. By adding DLR, I increase my number of positions, thus bringing the portfolio closer to its target of 20 positions. DLR has increased its payout for 10 straight years, and the next dividend increase is expected in March.
Buying the New Stocks
Having decided what to purchase, the next step was to buy them. With online brokerages these days, it is pretty easy.
I divided the $4,947 cash from the sales by 3 to equal-weight the purchases. That meant about $1,649 was available to buy each stock. The exact amounts spent differ slightly, because you can only buy whole shares.
- AT&T: 50 shares @ $33.32 = $1,676 (includes commission of $10)
- Microsoft: 35 shares @ $45.90 = $1,616
- Digital Realty: 23 shares @ $21.75 = $1,649
So the total I spent, including commissions, was $4,941. The 6 bucks left over stays in cash, and it will be spent the next time I reinvest dividends. That will be in March or April, when the cash from incoming dividends piles up to $1,000.
Making these calculations and purchases took about 5 minutes. I used simple market orders.
When I update my portfolio at the end of the month, all of the 5 transactions – the two sales and the three purchases – will be reflected in the portfolio table. The portfolio will be better balanced, and it will have more diversity with one more position.
It will also have more income. Let’s look at the impact on my dividend stream from these changes.
Before I started, I had a total projected 12-month dividend stream of $2,966. That was a forward estimate based on information known as of the end of December.
Selling the shares of JNJ and PEP reduced my expected dividend stream by $135 over the next 12 months. (No anticipated dividend increases are built into these calculations. I stick with information known right now. I generally do not speculate about future increases, although I know that many dividend growth investors like to do that.)
But adding the shares of T, MSFT, and DLR will bring in an additional $214 over the next 12 months (again ignoring increases that have not been announced yet). So the rebalancing not only leveled out my positions and added diversity and safety to the portfolio, it also added $79 to the income stream.
That may not sound like much, but it represents almost a 3% income raise. It’s like getting a little dividend increase without any company declaring one.
Be sure to check the new portfolio in early March to see the total impact of these changes. Thanks for following the progress of this portfolio. I set it up to illustrate dividend growth investing in action. It is my hope that you can find nuggets of information and ideas that you can use in your own investing.
— Dave Van Knapp
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