A Dividend Income Portfolio Operating System

Jeremy Glaser: Do you need an operating system for your portfolio? I'm Jeremy Glaser with Morningstar.com. I'm joined today by Josh Peters, Editor of Morningstar DividendInvestor to take a look at some systems that you could use to keep your portfolio running in great shape.

Josh, thanks for talking with me today.

Josh Peters: Good to be here today. Welcome back.

Glaser: Yeah, thank you very much.

Peters: It has been a few weeks.

Glaser: Josh, you know that you managed two model portfolios for DividendInvestor, both the Harvest and the Builder. Talk a little bit about the Harvest? What kind of operating system do you use there to keep it running smoothly?

Peters: Well, what I try to do is think in terms of, you know, what does a retiree want or what is anybody who wants to maximize their current income want. That is essentially to maximize their current income, you can go out in the marketplace right now and if you're willing to suffer through the disaster potential with little tiny specialty finance companies that have double-digit yields, I mean you can certainly maximize your yield. So I put some constraints around that.

First, I only want to buy stocks whose dividends I think are safe even through, let's say, a double-dip recession or some other problem that might be thrown at them. No dividend is guaranteed forever, but some are certainly safer than others.

The second point is that I am only interested in dividends that can grow at least as fast as inflation. For a low yielding stock, I want a lot more growth than inflation. If you think of inflation as kind of 2%, 3%, 4%, maybe as a long-term average, the stock only yields 3% today, I'm not going to settle for inflation. If the stock yields 6% today, like one of my favorites Magellan Midstream Partners, I'd be a pretty happy guy as long as that distribution grows at the rate of inflation, because then that 6% yield is my real return. I am putting that in my pocket.

Then the third point is diversification. You wouldn't want to be restricted to just one stock. I think there were a lot of investors in the last downturn who for a variety of reasons found themselves, let's say, a ton of bank stocks, Bank of America or Wachovia or something like that and along comes the crash and it got wiped out.

You do need to be more diversified than that, but it still pays to concentrate in the sectors of the market where you find good businesses, good dividend yields, and a combination of forces that treat the shareholder well. So  those constraints of safety, growth of income, and diversification really kind of create a nice model for the Harvest to follow.

Glaser: That may narrow down stocks that you want to put in there, and when you're evaluating yourself, you just say, okay, at the end of the year, I am up 7%, I am down 5% or should be focused on some other metrics as well?

Peters: Actually, I think the most important metric within a dividend strategy is to look at the income that you're collecting not just the market value. If you're in the market for dividends, especially if you're looking for higher yielding stocks and looking to live-off of that income, just watching the stock market gyrate and taking your portfolio's value, statement value up and down where they can be misleading, it can be disconcerting, it can cause all kinds of problems and you're going to react then primarily to price movements.

As an investor for dividends, I want to react to dividend changes and dividend developments and what I want to do is try not to manage the market value of the portfolio so much as it's annualized income. That's really just a pretty simple process.

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You take the individual stocks that you own, you have their current dividend rates, you multiply each dividend rate by the number of shares you own then you sum up each of those figures to give you a sense of where you're at right now, how much your portfolio was earning. Once you've got that, now you could compare those statistics at different points in time and see whether or not you're moving in the right direction.

Glaser: Now, a lot of people are more active traders, you know, they want to get in there and look at it all the time. There's more people who just want to kind of take a step back let the portfolio work itself. If using these constraints, how often do you think that you'd have to go in and evaluate what your yield looks like?

Peters: Well, it depends on why you are checking. I mean I think it's a good idea to check in on your portfolio holdings on a regular basis. It certainly doesn't need to be every minute of every day, but it's a good idea to know about what time of the year that a company raises its dividend, for example. If the dividend isn't raised, then you might start wondering, you know, is something wrong here, I need to react to maybe make a change.

If you hear big news like Kraft Foods decides to buy Cadbury a year ago. I read that on my iPhone in the middle of the night on a Labor Day weekend. Okay, well, now I have something I need to evaluate and react to it.

Those sort of tactics to keep apprise of things that could be going wrong, that's pretty important. It's also I think a good idea at least every couple of months to scout around a little bit and see if there is anything that you might like to buy. When I am investigating individual companies, I don't look just at the companies I might buy at the current price, I look for anything that might be interesting because prices are going to change. I might want to be able to take advantages of those opportunities.

When it comes to performance measurement, you know this is something that you can probably get away with doing just once a year. As a manager of your own funds, I mean you're not being compensated like a mutual fund manager or a hedge fund manager or something like that, where you have to try to beat the market every day or every week or every month, but to be able to look back over a 12-month period and say, here is how my income grew and here is where it came from, I put such and such more money into the account and this is what I got from dividend increases, you know, these are the effects of buying and selling other stocks. That is a better way I think of judging whether you're moving in the right direction, then you just look at prices.

Glaser: So good operating system could be making sure you're putting in the right stocks that meet the right constraints that you are checking somewhat regularly make sure that everything still meets that and then focusing on making sure you're getting that yield and not just worrying about the bottom line.

Peters: Yeah, and try to see to it that your individual holdings are each carrying their own weight. You might own 15 to 20 stocks, that's kind of what I target for each of the two model portfolios I manage, but there's got to be a couple of dozen stocks on the outside of these two portfolios that I would be very willing to own if prices lined up.

So if something is kind of deteriorating, you are not seeing the dividend growth that you expected or the price has gone way up, the yield has come way down and you think you might have an overvalued stock on your hands, take advantage of those signals perhaps to make some kind of a change.

Glaser: Josh, thanks for talking with me today.

Peters: Happy to be here.

Glaser: For Morningstar.com, I am Jeremy Glaser.