Do Retirees Need A Dividend ETF Or A Portfolio Of Individual Stocks? Part 3

Includes: KO, MO, T, VYM
by: Bob Wells

In the first two parts of this series we have explored how dividend ETFs like Vanguard's VYM might be used by investors in the "distribution stage" of investing. Clearly comments supported the need for such vehicles, particularly dividend growth oriented ETFs, to serve wage earners as part of their companies' 401-K plans. Another cited use for such vehicles was as an available offering for College 529 Plans.

The largest group of commentators on the subject suggested the need for such an investment vehicle when retired investors reached an age when they were either no longer interested in or unable to self manage their stock portfolio. Most called for equal weight portfolios yielding between 3 and 4% with no position greater than 3%. Others were open to a more flexible position size as long as again no positions were larger than 3%. The majority commenting favored only stocks that did not cut dividends as a result of the bear market of 2008. Again the majority favored only stocks with consistent and growing dividends. I think this is an important issue for every retired investor to explore. I'm fortunate to have a son-in-law who has shown an interest in dividend growth investing and it is likely he will likely handle the portfolio should the time come when I become unable.

I'm convinced of one thing, whether a family member takes over or the task is handed to an adviser, the process will likely be smoother if a carefully crafted business plan is in place for your portfolio. My current plan is here if you'd like to examine my approach. Largely as a result of these discussions I am now at work on a second plan - a legacy plan. This plan should, if I craft it correctly, be easier to administrate and require less time and effort.

I'm pleased by how my current plan has served me the past few years. Every year that goes by that I don't have to take a dollar out of principal or sell a single share of stock, I'm growing more confident that I won't run out of money during my lifetime. I also rest a little better knowing I can better handle any unforeseen financial issue life may throw my way.

While I may have appeared to some to be critical of ETFs, I am solidly in favor of ETFs that follow the model described above. I'm going to suggest you can use the top holdings of an existing high yield dividend ETF like VYM to create a solid dividend growth portfolio. Here's the process I used to do just that. First, I examined the 35 largest weighted holdings. Next, I eliminated the 11 holdings that had cut dividends within the past 5 years. Third I substituted the next 11 holdings in the ETF, bringing the total back to 35. I now have a portfolio of 35 stocks that have each produced sustained and growing dividends for 15 years or more. Were I to purchase this portfolio I would give each position equal weight. Even the best stock can cut its dividend. If that happens having no position greater than 3% will help minimize loss of retirement income. If there is news of a dividend cut I can sell that position and invest in the next stock on the list. If I want to boost yield I can substitute higher yielders on the list.

How would this 35 stock portfolio have performed over the past 15 years? I set up a portfolio of these 35 stocks using Fastgraphs' new portfolio function to find out. For the 15 year period these stocks had an average annual return of 7.36% vs. 3.3% for SPY. The 11 stocks that were removed from VYM due to dividend cuts had an average for the 15 year period of 3.4%.

Before the comments begin I know the back test just described has survivor bias. I ran it only to make the point that good stocks with records of sustained and growing dividends did well the past 15 years, delivering sustained and growing income to countless retirees.

I'm assuming that the stock pickers at Vanguard are pretty good at what they do and that picking their top stocks and eliminating those that fail to meet my requirements or yours might not be the worst way to begin to assemble a list of stocks for further due diligence. I know I have new stocks for my watch list as a result.

Before I close this time around let me turn for a moment to the most exciting discussion from this series. The discussion I'm referring to focused around developing a new ETF, one only containing Dividend Champions, Challengers and Contenders (current list available here), all of whom meet the criteria established by the "chowder rule". The Chowder rule developed by SA contributor Chowder has quickly become an important metric used by dividend growth investors in evaluating potential dividend growth stocks for inclusion in a self directed portfolio. Most stocks under this rule require a combined yield and 5 yr. dividend growth score of 12. An exception is made for utilities and REITS which often produce consistent high yields but lower dividend growth. Here a total score of 8 is required.

After so much discussion, I decided to do a short back-test based on this concept. First I went to the most recent list of dividend champions. Next I eliminated all yielding less than 2%. Don't hate me I'm in the distribution stage and it's all about income. Next I eliminated all stocks not meeting the chowder rule. 49 stocks survived this screen.

Next I went to Fastgraphs. How would we do what we do without it? I ran 15 year performance tests for each of the 49 stocks. Of the 49 stocks only five failed to beat the S&P 500. The good news is that because of sustained dividends and dividend growth, none of the stocks loses investors a dime. Some of the stocks showing up as trailing the S&P for this period include a few that might surprise you. How about Coke (NYSE:KO), AT&T (NYSE:T) and Altria (NYSE:MO). I spoke with Chuck Carnevale from Fastgraphs and learned that with Coke it was a classic, excuse the pun, case of a stock that was severely over-valued at the time of purchase. Altria was a company in transition, breaking up its parts during the period. All of this goes to show the importance of due diligence prior to purchase.

The good news in all of this is that if these 49 stocks were held for the entire periods which included two severe bear markets, investors in the distribution phase would continue to enjoy consistent and growing income from dividends. What was surprising at least to this old investigator was the fact that on average each stock in the portfolio delivered a gain of more than $20,000 on each $10,000 investment. This number would in contrast have been just under $6,000 if invested in the S&P 500 index. Since the current yield on this portfolio is over 3%, it seems one could do worse than investing in equal weight positions in these 49 equities. I know, survivor bias again.

Next time will be different. I plan to apply the chowder rule to a list of Dividend Champions from early 2008 as if I were starting a new equal weight dividend growth portfolio and I had a business plan that says I will buy only Dividend Champions that yield over 2% and follow the chowder rule, making an equal purchase of each stock matching that criteria, provided the yield is similar to like equities in the same sector. Come back next time to learn the results.

Disclosure: I am long KO, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.