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Focusing On Income, Too Many Stocks & Wrong Valuation: More Mistakes You Could be Making

Here are three more investing mistakes many of us do again and again!

A couple of weeks ago, I wrote about two common mistakes done by most investors. But there is more! Here are three more investing mistakes many of us do again and again!

Putting Income Above All

For many DSR members, the #1 reason they choose a dividend investing methodology is to create an income stream from their portfolio. I am sure you dream of living off your dividends while your capital is comfortably secured in your brokerage account. You can then live a happy retirement and make sure you leave something behind. If you hold your shares, you get your paycheck. It is like a pension plan, but you get to manage it! Through the choice of high yielding companies, you see the opportunity to increase your pension check “without taking additional risks”. While I appreciate the desire for additional dividend income, I respectfully suggest you look at the bigger picture.

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Why are you doing this?

If you consider the past 10 years history in the market, you can no doubt understand why I am waving the red flag. After all, high yielding assets have performed just as well (and sometimes better) than the entire market. Why would you change a winning strategy, especially when it helps you live more comfortably in retirement? The search for high yielding stocks makes plenty of sense when you look at the graph below. For similar returns, you might as well enjoy a high yield (sometimes synonym of “guaranteed” income for investors”).

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However, it’s not that simple…

How it may hurt your portfolio

In light of what has happened to the market over the past decade, I can confirm that not all high yielding stocks are bad investments. However, you must take some precaution when it comes to selecting high yield stocks.

First, considering inflation. A high-income solution is only interesting if the dividend increases by at least 2% per year. If you cannot reasonably expect that from the companies in your portfolio, then you are running into potential trouble. Unless you are 80 today (you can skip this part if you are), you will have to generate income for 10, 20 or possibly 30 years. With the likelihood of living up to 90 or 95 years old, no dividend increases should be a concern.

Second, an absence of dividend growth is the first step toward a dividend cut. While the stock market went up and down a few times in the past decade, we haven’t recorded a single recession. If some of your holdings have not increased their dividend payouts in the past 5 years while interest rates were low and the economy was doing well, what is going to happen when we go through difficult times? You are right, a dividend cut is likely to happen.

In most cases, a dividend cut will have a terrible impact on your portfolio. On top of reducing your income stream, your capital will likely take a hit at the same time. Here’s an example of what could wait around the corner if you hold companies that are likely to cut their dividend in the future.

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You will notice the weak dividend increases for a few years just before the company stopped its dividend growth policy. The stock price started to go down before the first dividend cut. Therefore, it is important to follow your holdings quarterly. The market saw it coming, they sold the stock leaving you with an important loss at the first dividend cut and the bleeding just kept going.

This unfortunate situation hasn’t happened much in the past 5 years. It is likely to happen a lot more during the next recession. The positive for you is you can “clean” your portfolio before this happens.

How can you fix it?

Going after high yielding stocks is not the problem here. In fact, we have been able to build two complete retirement portfolio models (Canadian and U.S.) averaging between 4% and 5% yield. While I personally tend to discard most stocks offering a yield over 6%, you can still pick a few good companies in that range too. The key is to track their payout ratios carefully (always discussed on our stock cards) and consider their dividend safety score. A good example would be the stock card we have made for BTB REIT (BTB.UN.TO) last year. Please read the dividend growth perspective section here:

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Big surprise, BTB cut its dividend in 2020 (shocker, isn’t it?).

Companies without the possibility of increasing their dividend (no matter the actual yield) should be discarded. If management can’t increase your paycheck while interest rates are low, the economy is doing well and we reach full employment capacity, what will happen when clouds start gathering and we hit a recession? I’m telling you when it rains, it pours.

In this case, our dividend safety score would likely become your best friend. All companies scoring a “2” means the dividend hasn’t been increased in the past 18-24 months (or worse). You can then go directly to the stock card and read the dividend growth perspective and go inside their financial statement to look at their payout ratio. If there isn’t a very good reason to expect a dividend increase, then you should seriously consider selling that stock. After all, would you work for an employer who has not given you a pay raise for 4 consecutive years?

This means you may have to sell a few of your “best income earners” at the end of the day. Just consider you are better off with a slightly lower yield coming with dividend increases then a high yield getting eaten alive by inflation!

Holding Too Many Stocks

Once you start investing, it’s like opening a bag of Doritos (at least for me) as you can never get enough! (I like the spicy ones). Many do-it-yourself investors will start with a decent number of holdings in their portfolio. At DSR, we would consider that any number between 20 and 40 holdings is good for a portfolio over $100,000 (more on that later). As years pass, some investors may be tempted to add more positions.

Why are you doing this?

On one hand, you like your existing positions, and you follow the proven “buy and hold” methodology that opens the door to some magical dividend growth and total return numbers. After all, I keep telling you to hold your winners and ride them as long as they fit your investment thesis.

On the other hand, there are new opportunities that arise each year as you develop strong buy lists to potentially replace some of your underperforming stocks. Some retail REITs or energy stocks were ready to get picked in mid 2020 after a major crash in those sectors. It makes sense to add a couple of stocks in those industries as the timing was perfect. The problem is that you keep doing this year after year and you wake-up suddenly with 70 stocks in your portfolio.

How it hurts your portfolio

I see three issues in crossing the 40+ holdings mark and start turning into the “dark side”. The first one is a matter of time. How can you effectively track 75 stocks quarterly and not miss important news? Every quarter, I review each of my holdings’ quarterly reports. I review their financial metrics (starting with the dividend triangle) and make sure the company has increased its dividend in the past 12 months. While this task requires some of my time to cover my 35 different positions, it would become a daunting chore if I had to do the same routine for 75+ stocks. The risk of missing crucial information that would put my portfolio at risk increases exponentially.

The second issue is one of diversification. Have you heard the expression “diworsification”? This is the action of adding more holdings to your portfolio without improving its diversification. Adding a 5th Canadian bank to your portfolio is a classic. I like to pick the best stocks for each industry instead of doubling or tripling my exposure to the same industry with similar picks. Finally, having 75 stocks in my portfolio would start to look a lot like having an ETF. Therefore, why would I spend time and energy managing my portfolio that will be exactly like any dividend growth ETF I could purchase within minutes?

Finally, the third issue I see is one of portfolio weighting. When I research a stock and decide I want to add this position to my portfolio, I want my decision to matter. If I add a new stock to my portfolio that weights 0.5% of my portfolio, how can I benefit from my stock research? Even if that stock doubles in price, it would add 0.50% total returns in my portfolio. This is not moving the needle.

How can you fix it?

You can use a good old minimalist rule: One in, one out! When you want to buy something for your house (furniture for example), something else must go out. First, establish the number of holdings you are comfortable following quarterly. Then once you want to add a new position you should review your portfolio and determine if you are still holding only the “best of breed” for each industry. If that is not the case, simply sell one position and add the new stock. You can use our PRO ratings and dividend safety score to make sure you hold strong companies. You can also review your portfolio sector by sector and identify duplicate positions. Since I have National Bank (NA.TO) and Royal Bank (RY.TO), it makes little sense to add TD Bank (TD.TO) to my holdings. I might as well increase my position on one or both of the current positions.

Focusing On The Word "Valuation"

I decided to add this one as I read a lot of articles about the market being overvalued these days. If you focus too much on valuation, you will likely skip buying amazing companies for the sake of “not buy the stock at the right price”. This is particularly true for growth stocks.

When you look at classic dividend payers with steady growth, it is true that you can use stock valuation methods to determine an entry point. However, I have never understood investors who sit on the sidelines until a stock has reached a specific dollar amount.

Why are you doing this?

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The rationale is quite simple as you would be ill-advised to invest in January 2008 when you can buy in March of 2009. There are stocks trading at such high valuations that you wonder how they will ever match the market’s expectations. If you buy a stock at its peak value, you may have to wait for several years before making a penny.

The examples of Microsoft (MSFT) and Walmart (WMT) (graph on the previous page) are shocking. Their PE ratios were so high during the tech bubble that it took more than a decade for investors to get their money back. Would it make sense to buy a well-established company at 60+ times their earnings? You are quite right as it never does.

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How it hurts your portfolio

So how is waiting for the “right price” a bad strategy? If you always wait for the right moment to invest, you will likely miss several trains in the process and never get to your destination. Let’s take Alimentation Couche-Tard for example.

If you look at the stock price chart today, you will tell me "Mike, the right time to invest in ATD was 10 years ago. Now it's too late".

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And I'll answer: "That's also what investors said 10 years ago"

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You probably know the story by now, but some of my top performers (read triple digits returns) are stocks I bought at their 5-year price peak. Companies like Disney (DIS) and Lockheed Martin (LMT), Starbucks (SBUX), Microsoft (MSFT), and Visa (V) were all acquired closer to their “worst entry point”. I feel blessed to have followed my investing strategy and not given too much weight to valuation.

How can you fix it?

The key to take the focus away from valuation is to add more metrics and factors in your investment process.

When you focus on the company’s growth potential, you are less likely going to wait for the “perfect price” which may or may not ever happen. I obviously wish I had bought Visa in 2009, but the second-best time to buy it was when I had money to do so in 2017.

FINAL THOUGHTS

I like to make use of the hiking analogy to describe our investing journey. We know where we start, we know a great deal about the road ahead, and we are certainly aware of our destination. However, we must face various challenges throughout our journey. We sometimes make bad decisions, and we must learn from them. As your hiking buddy, I hope this article found you well and helped you in the management of the potential pitfalls in your portfolio.

As the market continues to evolve with growth (i.e., breaking records pretty much each month!), you still have time to review your portfolio and make sure you are not making any of these invisible missteps. If you think of any other investing mistakes I should add in the future, let me know. As always, you are a great source of inspiration!

Take care,

Mike.

Mike Heroux, Passionate Investor & founder of Dividend Stocks Rock

P.S. On Thursday, November 18th, I’ll be hosting a free webinar about how to position your portfolio for 2022 and I’ll answer all your questions. Register for this new webinar!

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**Please do your own due-diligence before investing in any stocks we discuss in this article**

I may hold shares of companies discussed in this article.

Note: Interested in getting periodic e-mail notifications when articles are published here? Drop your e-mail in the box below!

Also read:

18 Dividend Stocks To Consider For The Next Decade

Hybrid Funds To Complement High Yield Portfolios

5 Discounted Dividend Contenders

2 Investing Mistakes We All Make

The Top 10 Dividend Growth Opportunities

My Dividend Growth Investing Buying Process

How To Generate Income From Stocks You Don't Own

7 Best Utilities Sector Dividend Stocks