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Dividend growth investing, growth at reasonable price, long-term horizon
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Through reading articles from many Seeking Alpha contributors such as David Van Knapp, Bob Wells and Tim McAleenan Jr., I have learned how to treat my portfolio more like a business than just a group of stocks. The set of rules and goals must suit an investor's personal preferences, and therefore they will differ for investors with different personalities. An income-orientated investor's set of rules will undoubtedly be very different when compared with a growth-orientated investor's set of rules.

Therefore, in an effort to give myself a clearer sense of my target, and to give readers a better understanding of how my business works, I am going to write about a few rules that I keep in mind when handling my portfolio. I expect to oblige to all the rules at all times, only allowing certain exceptions when there is a good reason for accepting them.

Like Mr. David Van Knapp stated in this article, one should make the business as realistic as possible. This is a quote from Mr. Van Knapp that was stated in the article linked above.

Give it a name. Have a plan. Create rules, procedures, even a culture that give your business its particular character and keep it on track. Define goals and strategies to reach them. Keep emotions at bay. Anticipate changes in your business environment and how you will react. Constantly learn: You should be better at your business after five years than when you started.

The aforementioned is exactly what I'm aiming to achieve. Although there are many ways to improve my management skills, I plan on improving mainly through reading more articles on the various investment sites (like Seeking Alpha, MSN Money).

Strategy And Goals

Name

Kang's Dividend Compounding Portfolio (KDCP)

Mission Statement/Goal

To provide myself with capital appreciation and a steadily growing stream of predictable and reliable dividends to be reinvested into their respective companies. I also aim for a portfolio that will yield around 4%, and expect the compounding, along with the returns in the stock price itself, to be able to beat both inflation and the major indexes over the years.

The Strategy

In addition to reinvesting the dividends paid out by a company, I plan to add at least $400 to the account every month. This will ensure that at least some money is contributed regularly to the dividend account for compounding over time.

Portfolio Management

In terms of portfolio management, I plan to be rather active. Don't get me wrong- I do not plan to trade actively. I plan to keep myself on top of the news, looking out for any signs that may not be favorable to me, and researching about new stocks that may be a good pick for my portfolio at the same time. One stock I found while researching this way was Textainer (TGH).

Number Of Positions

I plan to hold between 25 and 33 positions in the portfolio for now, with every stock representing around 3- 4% of the portfolio. This number may change in the future if I want to expand my portfolio of holdings.

Without further ado, here are the seven buying guidelines I keep in mind when handling my portfolio.

Buying Guidelines

1. The company must be included among the CCCs

The CCCs stand for Dividend Champions, Contenders and Challengers, as maintained by David Fish monthly. The list can be obtained here. For those who are unfamiliar with the CCC list, Dividend Champions are companies that have increased their dividends for at least 25 consecutive years, while Dividend Contenders and Challengers are companies that have increased dividends for at least 10 and 5 consecutive years respectively.

This essentially means that I insist on owning stocks with a past record of increasing dividends. In fact, in my portfolio of 28 at the moment, all the companies but one [Kraft Foods Group (KRFT), which is a spinoff from the former Kraft Foods] have increased their dividends for at least 5 consecutive years. This is one of the most important guidelines that I follow. Dividend growth is one of the most essential elements of my portfolio, as it ensures that my business will be able to safely compound over time- which is my main aim.

2. The company must have dropped less than the S&P 500 during the past two recessions (2002, 2008)

26 of my 28 stocks fulfill this point. There are two exceptions (TGH, AFL) that I will elaborate on later.

I feel that this point is rather important, as it lowers the probability that a company's stock may plunge a substantial amount if there is another recession. Although depressed prices are favorable to me, since I am reinvesting the dividends, I do not want my portfolio to be too volatile. I try always to reach my goal with as little volatility as possible. Another metric I use to measure volatility is beta. I do not have any limit for beta on individual stocks, but I make it a point to have an average beta of at most 0.70 for the entire portfolio.

Textainer is my first exception. It had dropped 70% during the recession. Even so, it still had increased its dividends through those hard times, albeit rather slowly. More information about why I accepted Textainer despite this flaw can be found here.

Aflac (AFL) was my next exception. Like other financial stocks, Aflac had dropped around 80% during the recession. I still accepted the company as it had maintained its dividends straight through the recession while other financial dividend aristocrats, including State Street (STT), Citigroup (C), JP Morgan Chase (JPM) and Bank of America (BAC) cut their dividends by a big deal (BAC cut its quarterly dividend from $0.64 to $0.01 during the recession, and it has stayed at $0.01 ever since). For more information, click on this link to read one of my articles about Aflac.

3. The company must have a purpose for existing

Good companies, in my view, have a sustainable and understandable business model and a competitive edge over its competitors. But for all these to happen, the company has to provide a needed service and have a purpose for existing.

Therefore, I only pick companies with a purpose for existing and a competitive edge over competitors. For example,

  • I have Textainer, which is the biggest provider of intermodals to shipping companies and other organizations (including the U.S. Navy).
  • Wal-Mart (WMT), which is the largest big-box discount retailer in the world with 2012 revenues of $447B.
  • Coca-Cola (KO) and PepsiCo (PEP), the two leaders in the soft drink industry by market share, whose products are loved by people all over the world.
  • AT&T (T), the main telecom company in USA by 2012 revenues and market cap.
  • Exxon Mobil (XOM), ConocoPhilips (COP) and Chevron (CVX), a few the largest oil majors that provide oil, a needed commodity.
  • Kinder Morgan (KMP) (KMR), which offers its pipes as a "toll road" for oil and other energy-related products.
  • Colgate-Palmolive (CL), Kimberly Clark (KMB) and Procter & Gamble (PG), a few of the largest manufacturers of a diversified range of personal products around the globe.
  • McDonald's (MCD), the largest and most well-liked provider of fast-food.
  • Kraft Foods Group and General Mills (GIS), which are the biggest providers of food around the world by revenue in 2012.
  • Automatic Data Processing (ADP), the largest provider of payroll services (to corporations) in the world.
  • Intel (INTC), the largest semiconductor company in the world by 2012 revenues, fuelling many of the world's technological devices through its chips.
  • Waste Management (WM), providing its needed rubbish collection services to people.
  • Genuine Parts (GPC), providing consumers with auto parts to repair their vehicles.

People (and/or corporations) need these companies and services.

4. The company must have

  • A dividend yield of more than 2.3%
  • At least 4% in dividend growth
  • Must adhere to the Chowder Rule

To ensure that my portfolio's flow of dividends outpace inflation, I require every company to pay dividends of at least 2.3%. There is nothing magic about the number, it is just the amount of dividends I would feel most comfortable receiving. Besides this, I also require the company to have its dividends growing at least 4% over the past 5 years, with the exception of really stable utilities and high-yielding REITs.

Even so, none of the companies in my portfolio has dividend growth under 4% at the moment, with my slowest grower, Southern Company (SO), carrrying a 5-year dividend growth rate of 4.0%. My next slowest dividend grower, AT&T, has a 5-year dividend growth of 4.4%. Since the two companies are stable utility companies that people cannot do without, I can accept them even if their dividend growth rates dip into the 2-3% range.

Another metric I use is the "Chowder Rule." This formula, developed by fellow Seeking Alpha dividend investor Chowder, requires a company to have a 4% yield and a dividend growth rate of 8%, thus adding up to 12%. I require most, if not all (with the exception of utilities & other mature companies) to adhere to this 12% rule. At the moment, I have 22 of my 28 companies passing this "Chowder Rule" test.

5. Payout Ratio (Dividends/Earnings, or Dividend/FFO) must not exceed 80%

Although people have their eyes always attracted to the highest-yielding stocks in a certain list of dividend growth stocks, the one with the highest dividend may not be the best pick. The company may have a dividend payout ratio (Dividends/Earnings) ratio of over 90%, which is a sign that the dividend may be in danger. I generally would not consider companies that have such a high payout ratio, with my portfolio's long-term objective being a steadily growing stream of reliable and predictable dividends.

At the moment, only one of my holdings has a payout ratio of above 80%, with Omega Healthcare (OHI), a REIT, carrying the highest payout ratio (dividend/FFO) in the late 80% range.

6. The company must have at least a 3% growth in EPS (or the equivalent in FFO) over the past 5 years

I consider this factor almost as important as dividend growth, with EPS growth being one of the key drivers in dividend growth. A steadily increasing EPS figure also ensures that a certain company has a stable business, being able to generate increased earnings numbers over the years. In addition to this, I would especially favor stocks whose earnings have weathered past recessions. These companies should have their EPS figures increasing for at least 10 consecutive years, over two recessions. One such company is Wal-Mart. Its EPS numbers over the past 13 years are shown in the table below. As seen, the big-box discount retailer's earnings have weathered all recessions over the past 13 years, increasing steadily, year after year, over this period.

YearEPS ($)YearEPS ($)
19991.2820062.92
20001.4120073.16
20011.4920083.35
20021.8120093.73
20032.0320104.18
20042.4620114.54
20052.7220124.92 (estimated)

Of the 28 stocks in my portfolio at the moment, only two companies do not meet this expectation of having 3% EPS growth - Procter & Gamble, with a 1.9% 5-year EPS growth rate, and Waste Management, with a (-0.6%) 5-year EPS growth rate. I accepted Procter & Gamble, bearing in mind that the company is a famous dividend aristocrat (56 consecutive years of dividend increases) with a very established portfolio of brands and a great business model. On the other hand, Waste Management was accepted as it has a competitive edge over its competitors, as I described in this article I had written previously.

My portfolio's holdings have an average 5-year EPS growth of 8%.

Valuations

7. Do not buy overvalued stocks

I always make it a point to not buy stocks priced at a premium as compared with their 'normal' valuations. Firstly, I believe that what goes up must come down - there will always be better opportunities to buy shares in a company at a later date. This being said, I am not bent on trying to buy shares only at the bottom. I acknowledge that it is impossible to buy at exact bottoms - I just want to buy the shares at a price that I feel is reasonable and comfortable for me.

Secondly, I feel that buying stocks at a premium to normal value may reduce returns going forward. Overvalued stocks generally correct to a more reasonable value in the future, with the exception of some constantly overvalued growth stocks (but these stocks are not what I'm looking for). For example, many believe that the sideways market that we have been in for the past 13 years (2000-Present) is a result of the gross overvaluation of stocks during the internet boom.

I mainly determine whether a company is overvalued by comparing its current P/E ratios to its 5-year average P/E ratios. For example, I consider Colgate-Palmolive overvalued, with its current P/E ratio of 21.03 much higher than its 5-Year average of 19.34. (Shown here)

With this, I conclude this article about my portfolio and the buying guidelines I follow. In my next article, I will write about my other selling guidelines in detail, along with some general portfolio guidelines. I would also appreciate it if you could voice out what you think about these rules in the comment box below. All your opinions will be greatly treasured.

Source: My Dividend Growth Portfolio: 7 Buying Guidelines