In my previous post I introduced my Dividend Dream and gave better insight into the topic of Enduring Value that I’ve adapted to create a long-term investing approach focused on value and dividends. This post will look inside my decision criteria for this group of stocks, what companies comprise the DivG portfolio and what decisions I made on how to construct and organize the portfolio.
To review the current organization of my portfolios:
- Short-term Cash/Savings comprise 17.5% of my invested assets and is held in a high interest savings account.
- RSP includes only Canadian bonds, international ETF’s, US equities and ADR’s of international companies. This maximizes the efficiency of taxes on foreign income (dividends) and interest bearing investments. My RSP comprises 25% of my invested assets.
- Dividend Growth is my non-registered dividend growth portfolio that comprises 57.5% of my invested assets and concentrates on Canadian dividend/income paying equities that are eligible for the Canadian dividend tax credit.
Remember that the intent for my Dividend Dream portfolio in the future will be where money provide me with flexibility to do the things I want, give me the ability to make decisions independent of finances and allow time to create that wealth for myself and my family.
When I initially decided to create a dividend growth portfolio I had a number of decisions to make that included how many stocks to hold, what stocks to target & buy, what sectors to include and how to increase efficiencies as best as possible.
I started out with a fairly simple list of requirements as a guideline for how the portfolio would be constructed.
- A cap of 25 total common equities held within the portfolio
- Each individual stock would represent only 3-5% of the overall portfolio to mitigate risk
- Targeted portfolio pre-tax yield of 50-100bp above the Government of Canada 10-year bond
- Stock selection method requiring Enduring Value
Targeted dividend growth rate of 5-8% (per annum)
- Targeted CAGR of 8-10% (including re-invested dividends)
- Maximize tax efficiency and create a growing tax-efficient cashflow that outpaces inflation
This is one of the most difficult phases for any investor attempting to construct an equity portfolio. While ETF’s give you exposure to an entire market, sector or group of stocks there are advantages to owning individual equities. While an ETF (such as XIU or XDV) gives you broad exposure to a large number of stocks cost effectively you gain exposure to both the good/ bad and under/over-valued within that specific group.
As a value oriented investor I have a preference of owning stocks based on a collection of my own individual criteria. In an ETF the good stocks that are under-valued can be disproportionately represented to the bad stocks that are over-valued. This leads to some obvious problems for a portfolio of Canadian dividend paying equities that isn’t nearly as diverse as a US or International group.
Another issue presents itself if I were to target owning only the bluest of dividend payers; specifically all five major banks (BMO, BNS, CM, TD & RY), all the major insurers (GWO, MFC & SLF) and all the utilities/pipelines (ACO.X, CU, EMA, ENB, FTS, TA & TRP). If I took this approach I would already be over half way to my limit of 25 common stocks before I even started to look at anything else for the sake of diversification. What about consumer stocks, the railways, the grocers, telecoms or wealth management companies? Suddenly XDV doesn’t appear to be such a bad compromise, but you don’t gain equal exposure to the entire group. My decision was to use some simple logic.
I knew I wanted to apply Enduring Value to this portfolio and I wasn’t motivated to beat the market for ego, fame or fortune. There also isn’t a financial product that cost effectively allows me to do what I want to do. What I realized through my research was that each individual company has different competencies that emerge once I began to conduct a situational analysis on them and compare within a group. Some companies have strengths in one area and weaknesses in another. Was it possible to compliment one with the addition of another without creating excessive or repetitive overlap?
I first turned my attention to the five largest banks: Bank of Montreal (BMO, Bank of Nova Scotia (BNS), CIBC (CM), TD Bank (TD) and Royal Bank (RY). I wanted a balance of exposure to a number of different banking operations and through my SA’s I determined that I wanted exposure to investment banking, retail banking and a growing presence to international banking outside the North American markets. RY fit well for its strength in investment banking, TD for its dominant retail presence and BNS for its unparalleled expansion into international banking operations. CM & BMO didn’t offer significant diversification away from the main three aside from yield and additional risk. I decided that exposure to RY, BNS and TD was sufficient for the bank section of the portfolio.
Next I turned to the insurers: Great-West Life (GWO), Sunlife (SLF) and Manulife (MFC). Each company does certain things well and has exposure to different domestic and international markets. Owning all three made sense to me for the long-term, but with GWO as part of the Power family (POW & PWF) I could easily gain exposure to Great-West indirectly through either of the two parents. I knew I wanted exposure to IGM Financial (IGM), a large wealth management company under the umbrella of the Power group, to gain a higher exposure to asset management outside of the banks I could invest into a lesser weighting of (IGM). To determine the exact ratio of how to balance IGM and a Power component initially proved to be difficult, so I bought MFC, SLF and a small position in IGM. Later I bought a heavy weighting of PWF for exposure to GWO and additionally to IGM. The decision between Power Financial (PWF) and Power Corp (POW) was simple: I didn’t have any desire to gain exposure to media assets which POW held and PWF was the better fit for more direct exposure to the key European and energy assets of the company.
For industrial exposure I chose exposure in Canadian National Railway (CNR), Canadian Pacific Railway (CP) and Russel Metals (RUS). I chose both railways companies for the distinct differences in their operations since CNR is largely a North-South operator and CP an East-West. CNR is a much more efficient railway and better managed than CP and I hold CNR in a higher relative weighting in the portfolio. RUS is a diversified metals distribution and processing company with a heavy-weight dividend. The company supplies steel infrastructure to the oil & gas industry in Western Canada and has operations in metal services and steel distribution throughout North America.
For telecom exposure I chose both Shaw Communications (SJR.B) for its western Canada exposure and more recently Rogers Communications (RCI.B) for its competitive advantages and dominant positions over national industry rivals. Both stocks hold the highest prospects for growth in my analysis and their increasing cashflow makes them attractive investments over the long-term in a capital intensive industry. While RCI.B currently holds a competitive advantage in their 3G network that will be eroded slowly over time, their competition face high costs and a changing technological environment that allows RCI.B to continue offering premier products that operate solely on their network.
For consumer stocks I chose to invest in North American cheese maker Saputo (SAP), pharmacy retailer Shoppers Drug Mart (SC) & Canadian woman’s retailer Reitmans (RET.A). As a compliment to a more predictable aspect of consumer demand I invested in Metro (MRU.A) and Empire (EMP.A) for their grocery operations across Canada. Each consumer company adds a different element of growth to the portfolio and exposure to discretionary or consumer staples in various areas of the country.
Choosing stocks for my energy exposure proved difficult. I often say that a value investor expresses humility in their actions and understanding the various elements of the energy industry is not more forte. I’ve gone with simplicity and infrastructure as the main themes for my exposure to this sector. I chose to invest in Husky Energy (HSE) for its upstream, midstream and downstream operations and a commitment to increasing its dividend. After careful study I added a complimentary natural gas & energy infrastructure company by the name of Alta Gas (ALA.UN).
Utilities and pipelines have presented one of the significant challenges to the construction of the portfolio. As with the banks I wanted to gain exposure to a number of various operations and long-term fundamentals of the specific industries. With the weakness in markets throughout 2008 valuations finally seemed more tolerable and I initiated positions in utilities Fortis (FTS) and Atco (ACO.X). Both companies have international exposure and service different regions of Canada with their operations. ACO.X has a controlling interest in Canadian Utilities (CU) and although I continue to want exposure to Enbridge (ENB) for its strong pipeline operations the valuation continues to be too expensive.
As a hedge against inflation over the long-term I decided that a prudent objective would be to invest in real estate assets away from the railway stocks and utilities. Real estate investment trusts (REITs) were the most cost effective method of investing directly in real estate and I chose two companies: Calloway REIT (CWT.UN) and Cominar REIT (CUF.UN). CWT.UN provides my portfolio with exposure to commercial shopping real estate and indirectly to Walmart who is their largest tenant. CUF.UN, a Quebec based REIT, provides exposure to commercial business real estate with large office holdings in Montreal and Quebec City.
One element of diversification that I’ve included in this portfolio is gaining exposure to preferred shares. Now these aren’t usually exciting, but with high volatility in credit markets throughout this year many preferred shares are trading on a tax-advantaged basis well above their respective commons. Since my original intention was to hold 25 common stocks I felt that exposure to an additional five preferreds would decrease the overall risk in my portfolio from common equities and decrease the long-term volatility of the portfolio when compared to the overall market. Each preferred gives me additional exposure to a sector that I felt was lacking in my portfolio. Specifically BAM.PR.J for real estate, CU.PR.B for utilities, LBS.PR.A & NA.PR.L for financials and ENB.PR.A for my desired exposure to pipelines.
For exposure to supplementary business services and business infrastructure I hold shares in Thomson-Reuters (TRI).
For any investor starting out a portfolio of dividend stocks there is the eternal debate of whether an investor is better to own a stock of high yield and low dividend growth or a stock of low yield and high dividend growth. Throughout my stock selection process I was very keen to attempt to create a balance between both.
Stocks in the portfolio such as EMP.A, MRU.A, RCI.B, SAP or SC have always had low dividend yields, but grow those dividends in the double digits annually well above the blue chip banks or insurance companies. An investor may state that it takes a stock such as SC years to reach a cost-based yield of what a bank offers today, but for an investor with a long-term investing horizon concentrating on low yield and high growth stocks offers a very attractive method of growing my annual income at an expedited rate. It will entirely depend on the individual investors priorities, but I think a rational investor constructing a portfolio of stocks benefits from the accelerating cashflow provided by higher growing dividends over the long-term than concentrating exclusively on stocks that yield over a minimal requirement (>2%). An investor would still hold a large portion of their portfolio in 3-4% yielding equities, but yield growing stocks add a nice element of diversification for cashflow purposes that help to provide cash to fuel continued purchasing.