Diversification


Proper diversification is very important, because it generally insures investors up to a certain point that they won’t lose all of their money at the same time. In general it is not a good idea to put all of your eggs in one basket.

As a Dividend Income Investor, my goal is to generate a rising stream of dividend income. Thus I would have to be selective not only about picking individual stocks, but also about selecting companies from a variety of industries, countries and size, in order to avoid the possibility of a widespread implosion in overall dividend income.

Large Caps versus Mid Caps

One troubling fact is that most of the successful dividend growth stocks that I am likely to end up focusing on will be large cap stocks. This could be both good and bad for my portfolio.

Most large cap companies are the ones that are mature and stable cash flow generators, which throw off enough cash to expand, reward shareholders with increasing dividends and maintain liquidity.

It would be difficult for a company with £10 billion in sales to expand at the rate that a company with £100 million in sales could. Because of this fact stable dividend growth stocks tend to enjoy a lower price earnings multiple.

In comparison, most small and mid cap stocks could spend most of their earnings to reinvest back into the business, thus paying little or no dividends to shareholders in the process. These type of companies are not of interest to me as a Dividend Income Investor.

A potential negative for holding the large cap market leader in any industry however is that if the activity in the whole sector declines significantly, chances are that the leader would feel the pinch as well. Despite the fact that the market leader could likely gain market share if competitors go bankrupt or by acquiring weaker rivals, a broad slowdown could hurt it badly.

At the same time a smaller competitor could be flexible enough to gain market share by utilising some sort of a competitive advantage and actually achieve superior earnings growth.

If and when these type of companies pay a dividend they may be able to reward investors with higher dividend distributions as its sales skyrocket. These type of companies are potentially of interest to me as a Dividend Income Investor.

Smaller dividend growth companies could have a higher price earnings multiple as the market prices in solid future growth. On the other hand, if earnings growth slows down, the price earnings multiple could shrink, leaving investors with large unrealised losses.

Even if we select a promising small or mid cap dividend growth stock, chances are it could get acquired by one of the leaders in the industry. Thus, investors won’t be able to fully realise the full growth potential of the small dividend stock. Although shareholders could generate a large capital gain in the process, they would have to find a new promising candidate for their money instead of patiently reinvesting their dividends.

Large Caps versus Mid Caps – in conclusion

Most dividend growth stocks have solid competitive advantages as well as large economies of scale, against which few competitors could compete. In addition, entry in those markets might be too costly for a smaller company to challenge the “big guys”.

Nevertheless, depending on the circumstances I may add a few small or mid cap dividend paying stocks to the Dividend Income Portfolio in order to allow my dividend income to be diversified further.

Diversification – Portfolio size

The level of diversification an investor will be able to achieve will depend, in a large part, on the financial resources available for investment.

When a share protfolio is to be launched with only a few companies it is prudent to make sure that the shareholdings are in companies operating in different industries.

As more capital becomes available, additional stocks can be purchased, positions can be enlarged, other industry groups can be added.

With a starting capital of approximately £75,000 I am limiting myself to establishing a portfolio of maximum 25 dividend companies, initially purchasing around £3,000 worth in shares in each of them.

I intent to try to rebalance the portfolio on a half yearly basis through properly allocating and reinvesting dividends received.

From a diversification perspective, 25 companies will provide me with adequate diversification. Chances are that a more concentrated portfolio would not be diversified internationally enough or diversified into small and mid cap dividend stocks.

Over time even the best investment opportunities may take a longer time to live up to their full potential especially if the market ignores a group of stocks such as large caps, while favouring international or high growth stocks. It is difficult to forecast which would be the best performing sectors or stocks over the next few years.

Diversification – Sectors

Over time, we intend to invest in a representative sample of as many sectors as possible. We will try not to be overly concentrated on specific sectors and instead try to be as equally weighted sector wise as possible.

Diversification – Local versus global

Diversification will allow me to achieve my financial goal to create an ever increasing stream of passive income through investments in dividend paying stocks which have the history and the capabilities to increase their dividend payments over time.

In order to achieve my diversification goals, I will be focusing on UK listed companies, both large, mid and small caps, as well as foreign large caps. It is unlikely that many foreign high quality dividend paying companies are readily available to buy in the UK.

It is not that difficult to find foreign companies, in particular listed in New York, which have increased their dividends consistently for more than 10 years. However, there are taxation issues to consider, which could potentially turn holding foreign shares into a complicated matter, such as securing their dividends ‘tax-free’.

Nevertheless, we intend to invest in a geographically spread portfolio of historically undervalued high quality dividend paying companies.

Therefore, we will also be including several dividend paying companies not listed on the London stock exchange, but listed within the S&P 500, Euronext 100 or even much further afield.

That will produce a universe of approximately 2,500 dividend companies with hundreds meeting our initial criterion of being capitalised at £100m or more.

In order to safeguard the UK element in my dividend income growth plan, I have rather arbitrarily decided that any foreign stocks may be considered only after I have invested in at least five UK companies.

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