How many bank stocks should be in your dividend portfolio?

From the mid-1990’s onward, bank stocks were the backbone of dividend investing. Bank stocks increase dividend quarter over quarter and year over year. However, all good things must come to an end and gravy train which was bank stocks paying dividends skidded off its tracks badly.

In 2007, the 5 largest American financial services stocks (JP Morgan, Wells Fargo, US Bancorp, Bank of America and Citigroup) represented 14 cents of every dollar paid in dividend by the S & P 500. In 2010, these same 5 stocks are on track to pay only 2 cents of every dollar in dividend.

Many believe that the banks will not be increasing their dividend soon. All of this bad news raises the question of whether it is time to reassess how many bank stocks should be in a dividend portfolio.

Let’s start with the simple question- are the good times over for banks increasing dividends? The short answer may be yes.

S & P has stated that the historical dividend growth rates is 5.6% per annum. From the period of 1995 to 2008, the smallest percentage dividend increase by Wells Fargo was 7.6% with 7 annual double digit percentage increases. Similar results can be found for each of Wells Fargo’s counterparts.  In other words, banks displayed historically anomalous dividend increase behavior in the last 15 years which can be replicated if the same economic conditions exist.

If you assume that banks will revert back to the norm with respectable 5.6% ish annual dividend increases, it stands to reason that investors, such as myself, have no real reason to be overweight in banks especially since dividend increases for some banks are really recovery of dividend cuts of the past several years.

If you assume the opposite, that banks will eventually regain their shine, the events of 2008-2009 indicate that such rewards come with proportionate down side risk; these are not your grandma’s bank stocks and regulatory freedom gave the banks the rope to succeed and eventually hang themselves as well. Given such risk/reward, should an investor with a less than steely resolve, and a strong stomach for watching paper losses, be overweight in this industry?

Regardless of whatever assumption one believes, since diversification is the only free lunch in investing, what should be the proper weighting of banks? There is no definitive answer other than what is NOT the correct answer for most investors.

A portfolio consisting of over 50% in banks stocks would be overweight. Money could invested in industries which work counter-cyclical to bank stocks (consumer staples) or may be more stable dividend payers (utilities which is regulated on pricing supporting, and capping, earnings).

The question, which I do not have an answer to, is whether one counts bank issued preference shares in determining the percentage of bank stocks in an asset allocation. In a near worst case scenario, a bank could suspend its dividend payments but continue to pay its preference shareholders. But the yield on preference shares is partially a function of the balance sheet health of a bank. Any thoughts are appreciated.

A weighting of under 10% may probably be too low for many average investors, keeping in mind that bank stocks tend to lead both Wall Street and Main Street recoveries and, once upon a time, they were actually safe stocks. If we return to a pre 1991-2008 normal, they may soon be again.

I would suggest as a model dividend portfolio something analogous to Nurse911’s dividend portfolio in terms of sector diversification and mixture of growth/mature stocks. As you can see, his dividend portfolio has a goldilocks exposure to financials- not too hot and not too cold.

Finally, there is a geographic drifting towards bank stocks one has to be aware of. The U.S. S & P Dividend Aristocrats has only a 7% weight in financials. The Canadian counterpart has approximately 39%.  In other words, purchase a dividend ETF tracking the Canadian S & P Dividend Aristocrats will naturally give you a large exposure to bank stocks.

This gap is partially explained by the poor results of the American banks versus their Canadian counterparts and partially by the fact the Canadian stock markets are basically compromised of financial stocks and commodity stocks (which suggests buying a board based Canadian equities ETF in tandem with a Canadian dividend ETF is substantially an exercise in redundancy). Thus, an overweight position in bank stocks may be a function of geography and there should be a greater focus by Canadian investors to ensure they are not drifting into an overweight in bank stocks.