Defining risk in a high dividend-paying portfolio. It’s not what most people think.

As the manager of a high dividend-paying portfolio, I necessarily take dividend risk. The yields in the portfolio are, as you might expect, much higher than the market’s miserly 1.6%.  Individual securities in the portfolio have had, can have, and will have yields that can be in the high single digit range, and even sometimes low double-digit range.  Very high yields in a low yielding market is admittedly a sign of dividend risk, but not an assurance of it. And that’s what the goal of the enterprise is: to take an appropriate amount of dividend risk in order to maximize the net present value of the income stream from the invested asset, the overall portfolio. It’s a rather straightforward exercise.

Until it isn’t. Many clients regularly ask, why don’t you just remove those high yielding names at the top of the portfolio’s yield list? They are eyesores. They have 8% or higher yields and are usually down as stocks for the year. Clients and institutional consultants will spend 90% of their time time meeting with us poring over those few holdings. Having been in the position to answer that question over the past two decades, it is sometimes energy, sometime pharma, sometimes tobacco, sometimes financials, whatever is out of favor at the moment.  They eventually recover and cede the highest yielding position to another sector of holding. And in most cases, they do it without cutting the dividend. But it still takes up a lot of time, so it is worth thinking through the logic of managing that form of risk in a dividend portfolio.

If we were to get rid of that highest yielding name, we get rid of the problem, right? No, not at all. In addition to lowering the portfolio’s income generation, we also just elevate a new company to the highest on the list. And the clients will ask the same questions and express the same concerns. Let’s get rid of that one too. And the next one and the next one. In short order we would have a dividend portfolio with no dividend eyesores, but also not much actual cashflow to the client or net present value of the future income stream. If that is the client’s preference, they can buy an S&P 500 Index product. They won’t have to endure dividend cuts, but neither will they be able to enjoy the benefits of an actual portfolio income stream.

What about dividend cuts in a dividend-focused portfolio? They look terrible, as if there is a shortcoming in process. To some extent that might be true, and the optics always favor increases rather than cuts, but the logic is the same in regard to cuts as it is in regard to those supposed high-yielding eyesores. To deliver a meaningful portfolio income stream in an income-deprived stock market means taking dividend risk; it means having, along with dozens of dividend increases each year, the occasional cut. Yes, in a perfect world, you are so omniscient and prescient to deliver both a high yield and only dividend increases. But in this agency cost-filled world, the reality is that in order to produce a portfolio that generates a high and rising income stream, you will generally end up getting one or a few wrong now and again.  If that prospect is too alarming, you can do what I suggested about the high yielding names: just lower the portfolio’s yield so much that you no longer have a risk of any dividend cuts. And just as in the prior case, you also have a portfolio dividend that is not meaningful.

In short, if you are not taking at least some dividend risk—that is, if you don’t have the occasional high-yielding eyesore, if you don’t have the occasional dividend cut from a holding—you have to ask yourself, are you leaving portfolio income on the table? Are you actually delivering the highest net present value income stream from the portfolio that you can?  Investors (and their consultants) need to shift their nearly exclusive focus from individual income streams to the portfolio outcome. In this regard at least, Harry Markowitz was correct.