Wouldn’t it be so much easier if we could just have someone tell us EXACTLY how to invest our money? I suppose keeping it easy is the point. Most people just don’t have the interest or the time to educate themselves on the topic of constructing a portfolio. So, having ZOLTAR (from the movie Big with Tom Hanks, by the way) tell us would be sweet.
But it doesn’t work that way so we either put our money into index funds or we do it the old-fashioned way, we educate ourselves. In the mid-1970’s, we had these small stock market research books that listed all companies with relevant metrics (sales, earnings, etc…) in really small print. We had the Dun & Bradstreet books too. We didn’t have the computer information that is available today. Back then, we had to contact the company and have them send us their annual report and several weeks later it would show up in the mail. We have it so much easier now (or is it harder?).
The other day, I plugged the details of my stock portfolio into a website and it instantly spit out a couple of charts. Chart 1 told me what the strengths and weaknesses of my portfolio were and Chart 2 explained the safety of my dividends. I’m not sure how they quantified their decisions or if they had any bit of truth but it was interesting. See the two charts below.
Evaluation of my Dividend Stocks
If somewhat accurate, the Profitability grade (A+) tells me I’m choosing the right stocks for my portfolio needs. I’m focused on buying profitable companies so it’s no surprise to see the “A+” grade. Buying profitable companies that are currently out of favor or just not being valued appropriately reduces downside risk. A profitable company, especially during tough times, is a company to buy at a reasonable price and hold for years (or decades).
The Growth grade (D) is a little tough to see but I’m not sure what the makers of the chart consider to be “good” growth. Yes, I’m buying mature market leaders so their growth has slowed but a “D” seems a little tough. What doesn’t show on this chart is my non-dividend stocks, which would push the score up a little. Honestly, I want growth but not so much that my risk increases. I’d be happy with an “A+” in profitability and a “C” in growth. Most of my dividend stocks have low beta which means they are more predictable and don’t have the boom/bust cycle like higher growth stocks. Overall, it’s good to know that I should keep an eye on the growth aspect of the companies I’m buying.
Evaluation of My Dividend Safety
Again, I’m not sure exactly what they are using to judge my dividend safety but I’d like to assume some standard measurements. In the last 25 years, we’ve experienced the Tech Crash, Financial Crisis, and Pandemic. During this timeframe, many companies cut their dividends. So, I focus on companies that didn’t cut their dividend during that timeframe.
Growing dividends in at least 23 years is important but I’m ok with a temporary growth pause if it’s done for the right reason. Many (not all) European companies are known for their flexible dividend policy, which helps flatten the cashflow volatility you might see in various business cycles. It’s smart business but investors don’t usually like it. I want companies that have been through tough times and shown their business strength. To have 12 of my 14 stocks be ultra safe, very safe, and safe but only receive a 3.15 out of 5.00 score is a little questionable. I’m betting the “not covered” dividend is Nestle and they have a safe dividend.
Overall, these two charts gave me something to think about regarding my portfolio. Portfolio construction has to take longevity, profitability, dividends, cashflow, debt, and many other aspects. I consider most of my portfolio as buy/hold forever but some stocks are built for trades every 3-5 years.
Metrics can only say so much about your portfolio. We need to consider things like SWAN (sleep well at night) or Peace of Mind stocks and simplicity or ease of maintenance. How do you measure these types of things? Everyone has their own definition of what will bring them peace of mind. For some it will mean only AA credit rated stocks and a portfolio with no more than 35% in stocks. And some people will feel peace with 70% in stocks and be fine with BBB or A rated credit quality. Either way, it should be considered.
Credit Ratings
As we’ve seen in the last 25 years, credit ratings aren’t perfect. Still, it’s one of many things you should build into your process when buying dividend stocks. Nobody wants all 25 of their stocks with credit ratings of BBB (or worse). To me, that wouldn’t bring peace of mind.
A corporate credit rating is an assessment of a company’s creditworthiness, measuring the likelihood of it defaulting on its debt. And some have done historical studies that determine probabilities of bankruptcy based on those credit ratings. This is valuable information when constructing your portfolio and be used to determined what is a core/hold forever stock and one that is not.
Most of my dividend stocks can be considered hold forever type of stocks. British American Tobacco (BTI) and Altria (MO) are not. Aflac (AFL) probably is but they have a narrow economic moat and a borderline credit rating. One more notch down takes them to BBB status so we’ll keep an eye on them. Where do your stocks land on this scale? If you don’t know they get to it and find out (it’s pretty easy – Google is your “friend”).
Find Trustworthy Analysis For Your Research (e.g. Morningstar)
The most important thing an investor can do is have quality, trusted information available to make decisions. I get my information from many places but let’s dissect the information that Morningstar has provided on my portfolio. It’s very likely this will shed some light on the original purpose of this article – to construct a quality portfolio.
A stock portfolio is just a collection of individual stocks. The weighting of each stock is important because a stock like Johnson & Johnson isn’t the same as Amazon. But together they, and all the other stocks in your portfolio, paint a picture of how much risk you are taking and what you might expect in return.
“Build your portfolio with intent and not by chance or emotion.”
Take a look below at what Morningstar present for my portfolio (dividend and non-dividend stocks). The net margin of 18.3 matches pretty good with the A+ profitability rating I received at the beginning of this article. The return on equity of 46.1 speaks to it’s profitability too. Generally, 20% is good though each industry is slightly different. And my debt to capital (38.69) rating is great for an overall portfolio ratio (fact: I keep a close eye on debt usage). Finally, the Price/Earnings of 16.71 shows that my portfolio compared to earnings is fairly priced (especially compared to the market).
Remember, you are constructing a portfolio. Only you can decide what kind of portfolio you want and determine what these scores (above) should look like. Build your portfolio with intent and not on emotion, chance, or the price of a stock. Will your portfolio last 25-35 years? How about 50 years? It’s hard to tell at times but at least you know a poor quality stock doesn’t stand a chance to last that long.
Equity Style
Equity style is important though it doesn’t mean much as you are just starting to build a portfolio. Let’s face it, when you buy your first stock your portfolio style will not reflect anything important. But once you get 15-20 stocks then you must pay attention.
When I look at my current equity style, I’m absolutely not surprised by the large company focus. Again, this was done with intent. Once I build out the basics/core of my portfolio, I suspect that I’ll eventually buy some mid-sized companies to help bring some longevity and growth to the portfolio. I would like more large growth but I’d also like to start finding some mid-sized companies that will be the future growth of my portfolio. But for now, I’ll stay focused on what you see – large value and large core.
With my crazier (and younger) investing days of buying junk, there’s no surprise that I’m now focused on buying solid large companies at good prices. To focus a portfolio on large more mature companies, you need to buy them at the right price. If I wanted explosive portfolio growth, then I’d focus on small/medium-sized companies but that also brings more risk.
But for a near-retiree, I’d propose that my portfolio of mostly large dividend paying companies was just what I need. It’s what I set out to accomplish and I’m achieving that. So, I’d say I’m constructing a portfolio that is focused and right on target for my goals.
Fair Value, Economic Moat, and Capital Allocation
This Morningstar page tells a great story about the stocks within your portfolio. The economic moat and capital allocation let you know if you are dealing with a quality company and the price/fair value helps you know if it’s a good time to buy the stock.
Certainly, the individual pieces come together collectively to help you know if your portfolio is heathy. In my case, none of my stocks are crazy overvalued, which might tell me I’m setting myself up for a significant fall if the market turns negative. 70% of my stocks are considered under fair value, which matches nicely with my portfolio P/E ratio of 16.71.
My focus is on companies with wide economic moats, which basically means they have an ability to maintain a competitive edge over their competitors. Only 3 of my 17 stocks have narrow moats so that is healthy. Also, half my companies have exemplary capability allocation approaches and only one is consider poor (MO). Altria (MO) is has a BBB credit rating so the combination of poor capability allocation and credit rating is of concern. I wouldn’t consider this stock a SWAN (sleep well at night) stock at all so I’ll be doing further analysis on it soon.
Not one single metric spells doom for a stock or portfolio. It’s the collective data that helps you determine if the portfolio is constructed to meet your expected returns and risk tolerance. This is exactly why I’m not a fan of having 40+ stocks in a portfolio. First, it’s hard to find that many good companies that will last 50 years. And second, it takes a lot of time to review 50-100 stocks. The more stocks you have the more you’ll find wrong with your portfolio.
Sector Exposure
We’ve discussed this before, but knowing what sectors you want is important. Some will say you should mimic the S&P 500 Index and to that I’d say then just buy the S&P 500 Index. If you want all the sectors then don’t buy individual stocks.
I believe tilting a portfolio into certain sectors helps achieve goals. Whether it’s aggressive growth, defensive, or economically sensitive stocks just pick what helps you achieve your goal. For now, my significant tilt toward defensive is just what I intended to accomplish.
A quick word about the 0% in the Utility sector. I want to own a couple of utilities but low interest rates of the past kept the price of utility stocks high. So, I passed on them (for now) and moved to other sectors/stocks. That’s how it goes and you need to be fluid in your approach. Don’t get so fixated on buying a specific type of stock that you miss the forest for the trees. There is usually always something else you can buy until things come back into value range.
Something Else To Consider
In today’s Information Age, we have metrics and data coming out of our ears. But there are some things that can’t easily be measured and used as a general rule. In particular, I’m thinking about:
- SWAN (sleep well at night) / Peace of Mind
- Simplicity / Ease of Maintenance
What might give me Peace of Mind could be a nightmare for others. Remember, we are only talking about a stock portfolio and not cash, bonds, or real estate. For me, what allows me to sleep well at night is assurance that most (nearly all) of my portfolio will survive, that it will be the when I wake up in the morning. This means profitability, credit worthiness, low debt, and a high probability that the dividend will survive too. It’s a pretty low bar and it doesn’t include a minimum rate of return. Just survive and not loose money for the next 30-50 years …. is that so hard?
I’ll define simplicity as buy and hold almost forever. Collect the dividend and have it go into my money market account. If I’ve got absolutely not need for the dividend funds then I’ll just reinvest them (which is really simple too). Simplicity is somewhat dependent on having peace of mind. If much of my stock portfolio was high risk then it will take more maintenance. All I want is to buy a quality stock, hold it for decades, and collect the dividend. Simple and enough said.
I suppose the easiest way to achieve both SWAN and Simplicity is to buy a couple of ETF’s and go on vacation. That’s an option but not my style. More importantly, how would you define SWAN and Simplicity as you construct your stock portfolio?
Summary
There is so much to consider, so much information and data available that it can be very difficult to construct a portfolio that fits your needs. Don’t make some already difficult even more difficult. Your role is to create a plan – and trust me, that plan will evolve several times so it doesn’t need to be perfect – and get access to data that you trust.
From there, just slowly understand what is important to you in a portfolio and start building it brick by brick. In retirement, you will want peace of mind and simple so figure out how that applies to you and make it happen.
Know what sectors will be important to your portfolio. Understand what types of companies you want in those sectors and and wait for them to become fair value or less before you buy. And if you want to go the ETF or mutual fund route that is fine, as long as it fits into your goals.
And if you become completely paralyzed by the overwhelming data, the complex options to choose from, or you just don’t have any interest in learning about personal finance then seek help from a fee-only financial planner. Most people will need help, especially those that aren’t willing to put in the time and effort to learn. No shame in asking for help … it’s actually the smart thing to do.
Thanks for reading!
Mr. TLR