RTX - The Science Of Diversification: 6 Impressive Dividend Stock Picks

2023-03-09 08:00:00 ET

Summary

• We start this article with a discussion of diversification, aimed at determining how many stocks sufficient diversification requires.
• The second part of this article is aimed at showing readers the first six stocks I bought for my dividend growth portfolio, and the huge diversification benefits they came with.
• The theories and dividend stocks in this article should help investors with their own asset allocation, especially when building dividend (Growth) portfolios with favorable risk/rewards.

Introduction

Earlier this month, we compared two diversification theories (mean-variance and behavioral), which led us to a discussion of the dividend pyramid. I noticed that this theory led to a very fruitful discussion among readers, as it provided an easy framework to construct portfolios. In this article, we'll continue to talk about diversification. In this case, we highlight how many stocks investors need. The number is lower than one might think. In addition to that, I will discuss the first six stocks that I bought for my dividend growth portfolio (holding 90% of my net worth). Back in 2020, I decided to start with a small number of stocks that would still provide me with decent diversification on top of expected outperforming returns. So far, that strategy has worked out very well. Even better, I expect this strategy to work in the future as well, which is why we will discuss these companies in light of diversification theories.

So, let's get to it!

How Diversified Are You?

Good diversification doesn't require rocket science.

The other day when I was working my way through a number of scientific articles, I found an article with the perfect title: How Many Stocks Make a Diversified Portfolio? Interestingly enough, it was written by the same person who wrote the paper I referred to in the first sentence of this article.

Mr. Statman, who is currently a Professor of Finance at Santa Clara University wrote this article in 1987. While it's more often than not a red flag to use research this old, we can still use it for a number of reasons. First of all, it is still referenced a lot and used in a wide number of related research papers. Second, nothing has changed since 1987 that had a major impact on diversification. The only major difference is that investors have much better access to low-cost diversification via ETFs. However, that doesn't hurt what we're trying to prove here, as we're not focused on ETFs.

If there's one thing even the most inexperienced rookie investors know, it's that diversification lowers risks. Owning two stocks is better than owning just one stock. Owning three stocks is better than owning two stocks, and so forth.

However, where's the limit? Imagine if you owned 100 individual stocks. How on earth would you track their performances and decide whether you want to buy more or not?

Not that it would surprise anyone, but even 40 years ago, smart minds already thought about these questions.

Here are some quotes mentioned in Statman's article.

• Portfolio managers should not become overzealous and spread their assets over too many assets. If 10 or 15 different assets are selected for the portfolio, the maximum benefits from naive diversification most likely have been attained, - Francis
• The results of the Evans and Archer study indicate that a portfolio of approximately eight to sixteen randomly-selected stocks will closely resemble the market portfolio in terms of fluctuations in the rate of return. - Stevenson & Jennings
• The diversifiable risk is reduced as the number of stocks increases from one to about eight or nine . - Gup
• In terms of over-diversification, several studies have shown that it is possible to derive most of the benefits of diversification with a portfolio consisting of from 12 to 18 stocks . - Reilly

Needless to say, these assets need to be either randomly selected or picked in different sectors/industries. Buying a low number of stocks that are similar to each other won't get you anywhere.

However, I was a bit surprised that most researchers found that less than 20 stocks would do the job. As a simple comparison, the S&P 500 holds 500 stocks. The Russell 2000 holds (you guessed it) 2000 stocks. Even the Dow Jones holds 30.

Essentially, it's all about comparing marginal costs to marginal benefits. The benefits of diversification are risk reduction, and the costs of diversification are transaction costs. I would also include wasted time in that category, as it takes a lot of time to assess new companies and manage large portfolios. There's a huge difference between managing 100 and 20 different stocks.

It's basically diversification benefits versus costs .

A model proposed by Elton and Gruber found that 51% of a portfolio's standard deviation is eliminated as diversification increases from one to ten stocks. Adding ten more securities eliminates an additional 5% of the standard deviation. Eliminating another 2% will require ten portfolio additions, bringing the total to 30.

I added my comments to the table below, as they perfectly showed the trade-off between risk and reward. In the middle, we find that the sweet spot is somewhere between 18 and 30/35 stocks .

Interestingly enough, I hold 22 stocks in my dividend growth portfolio.

My strategy always was to invest in a limited number of stocks that I completely trust to get the job done. As I don't have ETFs, I wanted to create a basket of stocks for myself that allows me to consistently invest my money without having to fear that I'm not diversified enough. After all, there's a huge difference between having $20K in 22 stocks or $500K (or more) in 22 stocks. At some point, people want more diversification.

Needless to say, I'm still open to adding new positions, as holding 22 individual stocks isn't too much - it's also backed by the theories we just discussed.

That said, there's more to take into account.

One very important thing is stock selection.

Just being aware that diversification is important isn't enough. The tricky part is picking the right stocks. It's the same as being aware that it's an advantage to know how to swim. Being aware is the first step. Being able to do it is the next step.

Hence, Meir Statman wrote a few important things in his conclusion. Allow me to summarize:

• People do not typically hold well-diversified portfolios, and the reasons for this are unclear (we can debate this in the comment section in case you have suggestions).
• People do not seem to treat their assets as parts of an integrated portfolio, and they display varying levels of risk-seeking and risk aversion depending on the asset ( my entire strategy is based on avoiding this - I try to communicate this in most of my articles).

Hence, in 2004, he wrote a paper highlighting different diversification methods. One of them included the behavioral pyramid, which explains that investors buy a number of stocks for safety, after which they start to go for high-risk investments to bring home the big bucks - to put it bluntly. I discussed all of this in the article referred to in the first sentence of this article.

I used the graph below to illustrate how I would build a diversified portfolio. These findings go very well with the theories discussed in this article.

With that said, let me introduce you to a number of stocks that have guided me extremely well. If investors are looking to buy a single-stock portfolio, I believe these stocks are a great way to start.

6 Terrific Stocks For Outperformance & Safety

These are the first Six stocks I bought and have added to consistently.

While I have traded and invested since 2011, I didn't start my dividend growth portfolio until 2020. Prior to that, I was busy with my studies and other business endeavors. I had some of my money in actively managed funds and used the remaining cash position for trading and investing.

In 2020, I decided to get serious. Since June of that year, I have built a portfolio that currently holds 90% of my net worth.

Back in 2020, I felt a bit like a painter staring at an empty canvas. Where to start?

As I already briefly discussed, the goal was to buy stocks that I would expect to deliver outperforming returns on a long-term basis. After all, I need to justify not buying ETFs by beating the market with a better risk/reward, and I need to buy stocks that I would eventually trust with a lot of money.

The stocks that I picked can be seen below. Most of my readers won't be surprised, as I have frequently discussed these stocks in the past few years - and prior to that, in most cases.

• Average dividend yield: 3.5%
• Average weighted dividend growth rate: 8.5%

Also:

• These stocks account for 28% of my total portfolio (high conviction!)

Before I go any further, please be aware that I always intended to add more companies, which is what I did. Six stocks do not provide enough diversification, as most will know without having read the theoretical part of this article.

However, I still took care of diversification as I did not know how fast I would be able to expand my portfolio. Thanks to my employment situation, I was able to do it quicker than expected.

With that said, let's discuss the stock selection. As usual, I will provide links to provide with you material for further research.

• Half of the companies in the list above are defensive. Duke Energy and PepsiCo operate in extremely defensive sectors. The same goes for Public Storage , which is the nation's largest self-storage operator. All of these investments tend to perform extremely well in times of slow economic growth and falling rates. In these situations, investors rush to buy high-quality yields.
• There is no industry overlap, and I have exposure in utilities, consumer cyclical, consumer defensive, supply chains (transportation), aerospace and defense, and real estate.
• Only two stocks operate in the same sector. Union Pacific and Raytheon are both industrial players.
• All cyclical companies in this list have high moats. While Home Depot is prone to higher competition than Raytheon and Union Pacific, it has figured out how to build one of the best supply chains in modern history. The company has pricing power, massive brand recognition, and a massive tailwind called long-term housing shortages. Right now, the stock is suffering from high rates and poor consumer confidence. As a long-term investor, I am consistently adding to HD at these levels. Raytheon Technologies used to be United Technologies prior to 2020. Since the 2020 merger with Raytheon, it consists of Pratt & Whitney (a leading aerospace engine producer), Collins Aerospace (a well-diversified aerospace supplier), and Raytheon's two defense segments providing intelligence, missiles, and related supplies/services. It also comes with both commercial and defense exposure, which makes it a good play for both segments. Union Pacific has a moat so big it can be seen from space. It dominates Western railroad transportation with its Buffett-owned peer BNSF. While the company currently suffers from economic headwinds and high inflation, there is a terrific long-term bull case based on secular rail benefits, supply chain re-shoring, and the company's ability to generate consistently rising free cash flow. In a recent article , I explained what this bull case might look like.
• All of these companies have healthy balance sheets. DUK is the only company that does not have an A-rated balance sheet. However, DUK is the most anti-cyclical company on the list. Once CapEx demands decline, I'm sure DUK will be upgraded.
• The average dividend yield of this stock selection is 3.5%, which is in the lower range of high-yield territory. However, most of the companies come with high and consistent dividend growth, which is a huge benefit for dividend growth investors like myself.

Based on this context, while I still don't recommend buying less than 20 stocks, these six stocks have provided tremendous diversification.

Going back to 1986, these stocks have returned 16.0% per year. The standard deviation during this period was 14.6%, which is below the market's volatility. In other words, these six stocks were able to provide diversification with a much better volatility-adjusted return (Sharpe Ratio).

Even better, this portfolio consistently outperformed the market with subdued volatility.

Since I bought these stocks in 2020, they have done exactly what I expected.

• In 2020, these stocks underperformed the market by 10 points. This was caused by the massive rush toward growth stocks. It allowed me to buy these (value/growth hybrids) at great prices.
• In 2021, these stocks returned 35%, outperforming the market by a wide margin, as investors rushed back to buy quality stocks (triggered by higher inflation).
• In 2022, this portfolio fell by 4.9%. The market lost 18.2%. In other words, the underperformance in 2020 was quickly erased, despite the fact that this portfolio owns no commodity plays that did so well in 2022.

Moreover, while backtesting always comes with a warning label (past results are no guarantee for future results), this portfolio not only outperformed the market in bear markets, it even outperformed in most bull markets.

With all of this said, I'm consistently adding to these investments. I bought these stocks to form the core of my portfolio. So far, that's indeed what happened. These six stocks account for almost 30% of my total portfolio. I have consistently added to these investments and I will continue to do so.

Even better, I have continued to build on these six stocks. I added more defense stocks after buying Raytheon and I bought more railroads after buying Union Pacific. I also added more self-storage after buying Public Storage When adding these stocks, my total exposure grows to 60% of my total portfolio.

In other words, these six stocks are not just the first stocks I bought for my portfolio, they are still the core of my portfolio.

Takeaway

In this article, we started by discussing portfolio diversification. While multiple paths lead to Rome, I wanted to highlight that investors who decide to buy single stocks instead of ETFs do not need to go overboard to get decent diversification. Investors who buy stocks in various industries and sectors are often better off sticking to 20-30 stocks instead of buying significantly more than that. At some point, cost headwinds more than offset diversification benefits.

However, once investors decide to avoid ETFs, stock picking is where it becomes tricky. In my last diversification-focused article, we talked about the behavioral approach. In that scenario, I like to use the investment pyramid, which helps investors to build diversified portfolios - when done right.

Moreover, I discussed the first six stocks that I bought for my dividend portfolio. These six stocks were highly diversified, bringing growth and value to the table. They also came with a decent average dividend yield, solid dividend growth, rock-solid balance sheets, and large moats.

Not only have these stocks outperformed the market, but they have also done it with subdued volatility.

These six stocks account for almost a third of my portfolio. Since 2020, I have consistently added to these investments and bought new additions that go well with these six stocks. The result is that these six stocks and related investments account for roughly 60% of my total portfolio (12 out of 22 holdings). The other ten stocks in my portfolio account for 40% of total exposure.

Going forward, I expect to benefit from diversification, decent dividend income, consistent dividend growth, and outperforming returns with subdued volatility.

Needless to say, the aim of this article wasn't to get you to buy these exact stocks. It's food for thought, and I hope it inspires investors who are building their own portfolios.

That said, feel free to use the comment section to share your personal strategy. How many different stocks do you own? How are you diversifying? Do you agree or disagree with my approach?

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