Sector Allocation As It Pertains To Dividend Growth Investing Lilah O- May 20, 2015, 7:17 AM EDT SHARE ON: Sector allocation is an aspect of the dividend growth investing strategy that I’ve been meaning to discuss for some time now. But now that I have some time to sit down and really address this, I hope it provides you readers a ton of value. I brought this subject up very quickly when I reviewed Personal Capital a few months ago, but I didn’t really go any further than just casually mentioning my “ideal” allocation to sectors within my own portfolio over the long term. So I’m going to take some time today to flesh that ideal allocation out, what sectors you might want to strongly look at, and how to think about sector allocation as it relates to building out your portfolio. The Sectors When I look at or think about sectors, I automatically default to the Global Industry Classification Standard. The GICS consists of 10 major sectors, which I’ll list below: Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Those 10 sectors represent the entirety of the economy at a high level. Every single stock you look at will fit into one of those sectors. There are various industry groups, industries, and sub-industries that break it down further, but those major sectors will pretty much tell you all you need to know as far as targeting certain stocks or certain sectors in terms of weightings as it suits your goals and/or needs. The Importance Of Sector Allocation I think it’s important before we proceed to first ask whether or not it’s even that important to think about sector allocation. And if it’s important, how important? I can tell you that I personally only loosely follow a sector allocation strategy. There are some sectors that I almost constantly avoid no matter what, like Utilities. And that’s simply because I’m not a big fan of the dynamics, regulation, or economics of utility companies in general. And then there are sectors that I’ll avoid only when I think I’m too highly allocated there. Again, I’m pretty loose with this. I don’t follow strict percentages down to an exact number. But if I feel comfortable with about 10% of my assets in energy, I start to get uncomfortable when I’m significantly off target. But I will quickly note here that I didn’t even really pay much attention to this until my portfolio was hitting somewhere around $100,000 in market value. If you start overly concerning yourself with something like sector allocation too early on, you’ll really be doing yourself a disservice. Imagine you have a portfolio valued at $25,000. One stock purchase of, say, $1,500 creates a swing of 6% right there. You’ll end up driving yourself nuts trying to make sure the puzzle stays together even while you’re actively adding major pieces along the way. Besides, the puzzle won’t even really start to form a picture until it’s crossed over into six figures, in my opinion. And if you’re too strongly following a sector allocation strategy, you’ll very likely end up letting the tail wag the dog by trying to make sure your portfolio is fitting into preconceived numbers, even if valuations prohibit certain purchases. If, for instance, you want to have a weighting of 5% to energy, you might end up chasing stocks in that sector when you find yourself underweight, possibly ignoring valuations in that sector and/or opportunities elsewhere that might actually be better at the time. In addition, your portfolio is changing and growing with every subsequent stock purchase. It’s evolving, for the better, hopefully. So what your sector allocation might look like today won’t likely be the same a year or two from now if you’re still actively and aggressively accumulating assets that are high in quality and at attractive valuations. Not only that, but you’ll likely change as an investor as you go along. I’m certainly not the same investor I was when my portfolio was 10% its current size. So constantly stressing yourself out about sector allocation numbers will likely be a fruitless exercise unless your portfolio and you are both already fairly mature. I think sector allocation as it pertains to dividend growth investing should be thought of in terms of maximizing dividend safety and dividend growth, while at the same time reducing risk of (temporary or permanent) income loss. Every single investment I make and general strategy I follow is with all of that in mind: Is my income sustainable? Is my income growing at an attractive rate? Will it likely continue growing? Is my income at risk of being reduced? I invest in the highest-quality companies I can find in order to reduce the risk of income loss in the form of a dividend cut or elimination, and then I diversify broadly to mitigate the effects if such an event were to occur. But I also think about sector allocation in terms of reducing risk of dividend income loss and mitigating those effects as much as possible. Sector Allocation For A Dividend Growth Investor As such, I think there are certain sectors that are just more attractive for a dividend growth investor. For instance, the largest single sector that’s represented in my portfolio is Consumer Staples. These are companies that sell products and/or services that people all over the world tend to buy no matter what’s going on with the economy. Think stocks like Philip Morris International, The Coca-Cola Co, and Wal-Mart Stores, Inc. I happen to believe that a dividend growth investor would probably find themselves most interested in this sector and would thus have a substantial allocation to these kinds of stocks. There’s good reason for that. These are companies that are visible. You see their products and/or services almost everywhere you look. It’s unlikely you’ll be able to visit a major city in the US without running into a Walmart store. And try to go into any grocery store and not find Coca-Cola products. Since they’re visible, they’re also tangible. It’s easy to actually see your investment at work. You can drink a bottle of Dasani water and actually feel good about your KO stock. It makes investing tangible, real, and accessible. In addition, these tend to be recession-proof products and/or services. People aren’t going to stop shopping for groceries and other household goods just because the economy is in poor condition. Likewise, consumers are unlikely to stop consuming certain products, like toilet paper and toothpaste, no matter what’s going on with Europe, the presidential race, or interest rates. And then, of course, these are typically branded products and/or services, brands which impart competitive advantages. That brand equity and awareness translates into an ability to raise prices over time, increase profitability, and create an increasingly large and loyal army of consumers. So you can look at David Fish’s Dividend Champions, Contenders, and Challengers list to find the more than 700 US-listed stocks that all sport at least five consecutive years of dividend raises. And what you’ll notice when you scan that list is that a lot of the high-quality branded consumer products and/or services companies tend to have very lengthy and reliable dividend streaks. KO, for instance, has increased their dividend for the past 53 consecutive years. That’s more than five straight decades! Moreover, their results tend to be fairly even across long periods of time, oscillating much less than cyclical companies. Their growth tends to be stable and secular, which allows for someone living off of their dividend income to stay relatively calm even when the economic current becomes turbulent. These types of companies are able to stand the test of time because their products and/or services tend to be ubiquitous. And they’re ubiquitous because consumers and/or other businesses demand them. The supply meets that demand, profits follow, and then these companies end up with so much profit that they start sending healthy checks to shareholders. I also tend to favor the Financials, Industrials, and Health Care sectors. You’ll find incredible companies in these sectors that provide absolutely necessary or certainly in-demand products and/or services. Think companies like Johnson & Johnson, Aflac Incorporated, and General Electric Company. Some of the longest dividend growth streaks around can be found in stocks that hail from these three sectors. The Health Care sector in particular is pretty attractive. The world is growing older, richer, and bigger, all of which foreshadow increased spending on healthcare in general. Now, just like there are certain sectors that I as a dividend growth investor tend to favor, there are likewise sectors that I tend to purposely lighten my exposure to. Information Technology comes to mind first. Technology changes rapidly. As such, it’s difficult to forecast exactly which companies are going to be dominant five years from now, let alone for the next 20 or 30 years. Thus, who’s to say which tech companies will be paying growing dividends for decades on end? Which technology will still be dominant decades from now? What’s going to change? What’s not going to change? Because of the ever-present change in tech, you’ll notice that relatively few companies from the Information Technology sector are represented on Mr. Fish’s list. So I tend to purposely keep a light weighting to that sector. Not only due to the lack of lengthy dividend growth track records, but also due to my circle of competence not all that often encompassing tech stocks due to what is sometimes technology that’s hard to understand. If I can’t quickly and easily understand how a company makes money and will continue making money for a long time to come, I’m moving on. The Utilities sector is another that I remain barely exposed to. Although there are quite a few utilities with lengthy dividend growth streaks, a lot of these same companies tend to sport fairly low dividend growth rates. And that’s because their growth is constrained by geographical limitations and heavy regulation. In addition, I have a hard time imagining that there isn’t going to be a lot of change in that industry when looking out over the next couple decades. Aging infrastructure combined with renewable energy like solar becoming more accessible seems to spell trouble, in my view. My Ideal Sector Allocation So this is my “ideal” allocation to the GICS sectors: 20% Consumer Staples 20% Financials 15% Health Care 15% Industrials 10% Energy 10% Consumer Discretionary 5% Telecommunication Services 2.5% Materials 2.5% Information Technology Again, I don’t follow a hard line in the sand here. But that’s just a general rule of thumb for my portfolio when looking at it in terms of holistic construction and which areas of the broader economy I prefer. I will note that looking at my portfolio right now shows a heavier allocation to the Energy sector than I’d really like; it’s currently over 15%. And that’s really just because I found compelling value in that sector over the past few years even while other stocks in other sectors ran up pretty quickly. Due to that overexposure, I’ve purposely been limiting my stock purchases there over the last few months. And I’ll likely continue to do so over the next year or so, unless I see an opportunity or two that simply cannot be passed up. I’m also a bit heavy on Materials, at over 4.5%. Again, that’s due to me going after value when I saw it. And that speaks to my nature of not really sticking hard and fast to this general outline. I’m okay with veering a little left or right when opportunities present themselves, and I thought BHP Billiton PLC, after a significant drop that began last summer, became cheap enough in terms of its valuation for me to allocate a bit more capital than I had first planned on when looking at the stock and that sector. One other sector I’m heavy on, though not admittedly concerned about, is Consumer Staples. My exposure there is well over 25%, which I’m okay with due to the attractive nature of that sector and the stocks within that sector as it relates to dividend growth and overall quality. Sectors I’m currently light on include Health Care and Consumer Discretionary. I’m actively looking for opportunities to change this as I continue to build out the portfolio. Seeing as how the portfolio will probably be valued at around $500,000 before I switch the dividends from reinvestment to paying bills, and it’s currently valued at just under $200,000, there’s still a lot of room for growth and change here. As such, I don’t really stress myself out too much over these numbers. I will note that the Financials sector includes REITs. I’d like to see about half of my Financials sector exposure taken up by REITs. It’s an easy-to-understand business model where a company generally owns high-quality real estate in high-traffic areas that are specific and purposeful, and then tenants pay a healthy rental fee to use those properties. It seems to me that some investors seem to fear the Financials sector, perhaps unjustifiably. The sector is a lot more than just big banks that got themselves into trouble during the financial crisis by doing things they shouldn’t have. You also have the aforementioned REITs, as well as insurance companies and smaller banks. If you look out across the universe of dividend growth stocks, you’ll find a lot of stocks with extremely robust dividend growth records that hail from these industries. You’ll notice that I don’t have any proposed allocation to the Utilities sector. And that’s due to my unfavorable opinion of the entire industry. That unfavorable opinion is currently exacerbated by the lack of clear value in that sector right now, with many utilities trading well above their historical norms as investors chase yield in a low-rate environment. My exposure there will likely just be a rounding error over the long haul. It’s currently about 1%. The S&P 500 I’ve noted before that I don’t compare my portfolio to the SPDR S&P 500 ETF Trust (NYSE ARCA:SPY). The S&P 500 really has nothing to do with my portfolio, its intentions, or my long-term goals. I really view the best and most relevant benchmark as myself, in terms how well I’m doing relative to the absolute best I can manage. There are a lot of reasons to not compare your portfolio to the S&P 500 if you’re a dividend growth investor building out a portfolio of high-quality dividend growth stocks that can one day generate enough income to pay your bills and grow that income above the rate of inflation. The fact that the S&P 500 yields only 1.92% right now or perhaps the fact that the index doesn’t care about dividend growth should probably be obvious in terms of the lack of usefulness in comparisons. Let’s add another reason. Check out the S&P 500’s sector allocation (according to S&P Dow Jones Indices): Information Technology – 19.9% Financials – 16.1% Health Care – 14.6% Consumer Discretionary – 12.5% Industrials – 10.3% Consumer Staples – 9.5% Energy – 8.5% Materials – 3.2% Utilities – 3% Telecommunication Services – 2.3% Notice something? The S&P 500 has an almost 20% weighting to Information Technology. Now, maybe you do as well, or maybe you want to. But I can tell you that I’d much prefer my portfolio not allocated that strongly to that sector, and I’d venture a guess that most of you won’t, either. Since there are really so few tech companies that actually sport extremely lengthy dividend growth streaks with great prospects for continued dividend growth moving forward, you’d end up with major positions in just a few companies across the sector, and very likely extremely unbalanced across the rest of your portfolio. Then there is the relatively light exposure to the Consumer Staples sector, which includes companies that I love owning, like Unilever PLC , Procter & Gamble Co., and PepsiCo, Inc. So this is just another reason I don’t compare my portfolio to the S&P 500. Not only does the index really have nothing to do with me and my goals, but the sector allocation within the index is completely different from what I’d personally be comfortable with. Conclusion I hope this overview on sector allocation as it pertains to dividend growth investing helps you. Keep in mind that it probably makes sense to refrain from thinking too strongly about allocation until your portfolio is sizable enough to really warrant that kind of attention and focus. Keep in mind as well that your ideal allocation will very likely be different from my ideal allocation. My intentions here are to provide food for thought, which I hope helps you develop a plan for your own sector allocation strategy for your portfolio. I think insofar as dividend growth investing is concerned, it probably makes sense as a general rule of thumb to be strongly tilted toward consumer stocks and perhaps less strongly tilted toward technology stocks. And my opinion results from the fact that there are far more of the former stocks in the dividend growth investing universe and far less of the latter, due in large part to the completely different industries and the business models therein. After all, when it comes to the point to where you’re living off of your dividend income, how comfortable would you be relying on the odds that people will continue drinking beverages and buying toilet paper for the next, say, twenty years? Now how comfortable would you be relying on the microchips that are popular today remaining so for the next couple decades?