Avoiding High Portfolio Ownership of Successful Investments

I have been investing in dividend growth stocks for the past decade. There have been hundreds of other fellow dividend investors, who have also invested in dividend paying companies over the same period of time. There are some, who have invested for even a longer amount of time. Unfortunately, when you invest for a long time, you may end up with a few very successful positions, which account for a disproportionate amount of your portfolio.  The question I have been getting recently has been what to do in this situation. I would note that this problem generally happens to investors who are not adding money to their portfolios anymore. A few examples cited include Realty Income (O), V.F. Corporation (VFC) and Altria (MO), which have delivered fantastic returns since 2008 - 2009.

This of course is a great problem to have. If you are a long-term investor, it is very much possible that after a decade or two of patient investing, the power of compounding will result in many companies which not only pay more and more in annual dividend income, but also result in large unrealized gains for the stockholder. As a result, there may be several companies in your portfolio, which could end up with a very large portfolio weight. In my opinion, you own too much in an individual security if it accounts for more than 4% - 5% of your portfolio’s value.

This article only deals with individual stocks/securities – it is not relevant to mutual funds or exchange traded funds. In some situations like these, investors end up putting their whole portfolio in just one diversified fund, and this could actually be a prudent move from a diversification perspective.

As someone who takes investing seriously, you want to make sure that you are diversified. In my opinion, a dividend portfolio is diversified if it has at least 30 – 40 individual securities in it, and is representative of as much of the ten S&P industry sectors as possible. Preferably, you would have two or three leaders in each of the ten sectors ( now eleven) at the minimum. If you build a portfolio over time, this is not an unreasonable goal.

A position that takes a too high of a weight in your portfolio also increases risks to your income stream and net worth ( as you are overallocated to it and corresponding sector). In an eqully weighted portfolio with 40 components, your target weight for each company would be around 2.50%. It would then fluctuate of course, but this is a good guideline to go for, at least initially.

A position with a higher weight in your portfolio, could be costly if the company’s fundamentals deteriorate over time. As a general rule, you are likely to be a conservative investor who doesn’t just gamble away their hard earned money. Therefore, you need to design a plan to address this issue.

If I were in a situation where I had a very successful investment that had a weight of over 5%, I would do a few things, depending on my personal situation.

One of them would include taking the dividends in cash, and then reinvesting them into other dividend paying stocks. This would mean that I will not be reinvesting the dividends in a position that has too much weight in my portfolio. In a sample 40 position portfolio, I would stop reinvesting dividends if an individual stock position has a portfolio weight higher than or approaching 4%.

This is why I prefer to collect all of my dividends in cash over a one – two week period, and then use that cash to add to an existing position, or to initiate a position in a new company. It is easier to maintain portfolio weights that way, and avoid them from getting out of hand.

The second thing that you could do is a slight variation of the action, described in point number one. It involves situations where you are in a position to be adding money to your portfolio. In this case, you can simply collect all dividends in cash, and then combine them with fresh deposits, in order to add to existing positions or to initiate a position in a new dividend paying company.

I have occasionally had positions that individually accounted for more than 5% of my portfolio value at the time. Those have included Realty Income (O), Kinder Morgan (KMR), National Retail Properties (NNN) etc. I was not worried about it, because I was in the accumulation phase of my portfolio at the time of the overweighting of these investments. Therefore, I knew that this 5% weight would be decreased by half over the next one or two years, merely because I am adding new money to my portfolio. And in the initial phases of portfolio construction, your portfolio values are relatively lower than in the later phases of portfolio build up. Therefore, new money has a much greater impact for you. If you are in a position where you have a static portfolio with no new money to invest, since you are retired and living off that dividend stream, you have a third option.

The third option you have is to simply sell a portion of your position in that company you are overweight in. I believe that this may be the best course of action for investors who are not adding money to their portfolios anymore.

In general, readers know that I am not a fan of selling, and then buying something new with the proceeds. My analysis of past transactions has shown to me that I would have been better off simply doing nothing, rather than engage in too much "trading". In my case, the companies I have sold ended up doing much better than the ones I purchased.

If you however have a position that has a very high weight in your portfolio above 5%, you may have to consider trimming it down a little. If I had the option, I would make the sale in a tax deferred portion of your portfolio first, in order to avoid having to pay taxes on gains realized. Paying taxes reduces the amount of money you have working for you, and is in general something I try to avoid (legally of course – I am recommending about tax avoidance not tax evasion). If I have to sell in a taxable account, I would try to sell the shares with the highest cost basis first, in order to minimize the tax bite on long-term capital gains. Alternatively, I would try to sell the shares that are subject to long-term capital gains, but keep the ones that are subject to short-term capital gains. The latter are taxed like ordinary income, while the former have preferential tax treatment.

If I wanted to trim a position, I would consider trimming it slowly, rather than all at once. For example, if I had a 7% exposure to a given company in a $1 million portfolio, I would sell $10,000 worth of stock on two separate occasions. Knowing myself, I may even spread this to three or four separate sales of $5,000/each, within a 3 – 6 month period.

I would then allocate the cash in the companies that have below average weights, but are attractively valued and have good prospects.

In general, I have found that selling is difficult for multiple reasons. For example, some investors sell after a company becomes overvalued. The problem is that there is risk that the next investment may not do as well as simply staying put with the first one. The problem is further exacerbated, if the first company starts growing earnings after a lull, and the valuation turns out to be not that bad in hindsight.
Other investors may sell because they lose hope after a couple of years of flat earnings. They then project that over to infinity, and start believing that earnings will never go up. Again, things do not go up in a linear fashion. They zig, and they zag. Not everyone is a stock market millionaire because many people lose patience and sell out, the minute they perceive that there may be a problem.

It is quite likely that the company with flat earnings may have a problem. The tough million dollar question is that no one knows in advance whether those problems will resolve themselves, or whether this is the beginning of the end.

Thank you for reading!

Full Disclosure: Long O, KMI, VFC, MO, O

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