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A large diversified dividend growth portfolio, comprising companies with substantial earnings growth prospects, can give investors capital gain along with a nice income. I tried to create such a large diversified portfolio that includes 40 stocks and that should be balanced only once a year.

In order to create this portfolio, I have used the following screen. It is based on an attempt to search for profitable companies with dividend yield and dividend growth rates greater than their industry averages. Those companies would also have to show good earnings growth prospects, and their last five years earnings growth should be greater than their industries' earnings growth.

Back-testing the screen for the last 15 years has given much better returns than the S&P 500 benchmark. The Sharpe ratio, which measures the ratio of reward to risk, was also much better. Furthermore, the maximum drawdown, which normally is much bigger in a small portfolio than in the benchmark, was smaller for this portfolio.

The screen's method that I use to build this portfolio requires all stocks to comply with all following demands:

  1. The stock does not trade over-the-counter (OTC).
  2. Price is greater than 1.00.
  3. Market cap is greater than $100 million.
  4. Dividend yield is greater than the dividend yield of the industry.
  5. The payout ratio is less than 100%.
  6. The annual rate of dividend growth over the past five years is greater than the dividend growth of the industry.
  7. Average annual earnings growth estimates for the next 5 years is greater than 10%.
  8. The forty stocks with the lowest payout ratio among all the stocks that complied with the first seven demands.

I used the Portfolio123's powerful screener to perform the search and to run back-tests. Nonetheless, the screening method should only serve as a basis for further research. All the data for this article were taken from Portfolio123 and finviz.com.

After running this screen on October 14, 2013, before the market open, I discovered the following 40 stocks:

Rank

Ticker

Name

Last Price

Market Cap $million

Industry

1

(NASDAQ:IPAR)

Inter Parfums Inc

30.83

949

Personal Products

2

(NYSE:DFS)

Discover Financial Services

51.78

25,141

Consumer Finance

3

(NYSE:NE)

Noble Corp

37.70

9,550

Energy Equipment & Services

4

(NYSE:MDC)

M.D.C. Holdings Inc.

29.02

1,418

Household Durables

5

(NYSE:HLF)

Herbalife Ltd

64.07

6,599

Personal Products

6

(NYSE:DOV)

Dover Corp

90.35

15,420

Machinery

7

(NYSE:GLW)

Corning Inc

14.45

21,097

Electronic Equipment, Instruments & Components

8

(NYSE:STE)

STERIS Corp

44.93

2,660

Health Care Equipment & Supplies

9

(NYSE:BVN)

Compania De Minas Buenaventura SA Buena

11.76

2,989

Metals & Mining

10

(NYSE:UNP)

Union Pacific Corp

157.37

73,077

Road & Rail

11

(NYSE:CR)

Crane Co.

60.46

3,508

Machinery

12

(NYSE:CSX)

CSX Corp

25.83

26,317

Road & Rail

13

(NYSE:POT)

Potash Corporation of Saskatchewan Inc

31.39

27,213

Chemicals

14

(NYSE:ESV)

ENSCO Plc

54.77

12,792

Energy Equipment & Services

15

(NYSE:COH)

Coach Inc.

54.59

15,389

Textiles, Apparel & Luxury Goods

16

(NYSE:TDW)

Tidewater Inc.

59.72

2,957

Energy Equipment & Services

17

(NYSE:ACN)

Accenture PLC

72.71

46,244

IT Services

18

(NYSE:TGT)

Target Corp

63.21

39,881

Multiline Retail

19

(NYSE:WSM)

Williams-Sonoma Inc.

53.40

5,111

Specialty Retail

20

(NYSE:TUP)

Tupperware Brands Corp

88.06

4,594

Household Durables

21

(NASDAQ:MFI)

MicroFinancial Inc

8.16

118

Diversified Financial Services

22

(NYSE:UTX)

United Technologies Corp

107.01

98,183

Aerospace & Defense

23

(NYSE:TIF)

Tiffany & Co.

76.57

9,797

Specialty Retail

24

(NASDAQ:CBRL)

Cracker Barrel Old Country Store Inc

105.66

2,514

Hotels, Restaurants & Leisure

25

(NYSE:JW.A)

John Wiley & Sons Inc.

49.36

2,894

Media

26

(NYSE:BR)

Broadridge Financial Solutions

32.30

3,844

IT Services

27

(NASDAQ:HWCC)

Houston Wire & Cable Co

13.89

249

Trading Companies & Distributors

28

(NYSE:WAG)

Walgreen Co

55.96

52,882

Food & Staples Retailing

29

(NASDAQ:SCHL)

Scholastic Corp

28.72

916

Media

30

(NASDAQ:CA)

CA Inc

29.52

13,300

Software

31

(NYSE:SWY)

Safeway Inc

33.75

8,188

Food & Staples Retailing

32

(NYSE:SSI)

Stage Stores Inc

19.66

645

Specialty Retail

33

(NYSE:ETN)

Eaton Corp Plc

69.30

32,841

Electrical Equipment

34

(NASDAQ:TXN)

Texas Instruments Inc

40.38

44,465

Semiconductors & Semiconductor Equipment

35

(NYSE:JNS)

Janus Capital Group Inc

9.11

1,726

Capital Markets

36

(NYSE:JCI)

Johnson Controls Inc.

42.10

28,803

Auto Components

37

(NASDAQ:KLAC)

KLA-Tencor Corp

61.68

10,204

Semiconductors & Semiconductor Equipment

38

(NASDAQ:MHLD)

Maiden Holdings Ltd

11.93

865

Insurance

39

(NASDAQ:HOFT)

Hooker Furniture Corp

15.30

165

Household Durables

40

(NYSE:THG)

Hanover Insurance Group Inc

56.13

2,442

Insurance

The table below presents the dividend yield, the dividend yield of the industry, the payout ratio, the annual rate of dividend growth over the past five years, and the dividend growth of the industry, for the 40 companies.

(click to enlarge)

The current yield of the portfolio is at 2.52%, the payout ratio is quite low at 36.3%, and the average annual rate of dividend growth over the past years was very high at 25.15%.

The table below presents the average annual earnings growth estimates for the next five years, the trailing P/E ratio, the forward P/E ratio, the PEG ratio, and the total debt to equity, for the 40 companies.

(click to enlarge)

The average annual earnings growth estimates for the next five years of the portfolio is high at 17.91%, the trailing P/E ratio is at 16.90 and the forward P/E ratio is low at 13.55, the PEG ratio is at 1.13, and the total debt to equity is at 0.58.

Back-testing

In order to find out how such a screening formula would have performed during the last year, last 5 years and last 15 years, I ran the back-tests, which are available by the Portfolio123's screener.

The back-test takes into account running the screen once a year and replacing the stocks that no longer comply with the screening requirement with other stocks that comply with the requirement. The theoretical return is calculated in comparison to the benchmark (S&P 500), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests results are shown in the charts and the tables below.

Since some readers could not get the same results that I got in some of my previous posts, I am giving, in the charts below, the Portfolio123 exact codes, which I used for building this screen and the back-tests. The number of stocks left after each demand can also be seen in the chart.

(click to enlarge)

(click to enlarge)

One-year back-test

(click to enlarge)

Five-year back-test

(click to enlarge)

15-year back-test

(click to enlarge)

Summary

The dividend growth screen has given much better returns during the last year, the last five years and the last 15 years than the S&P 500 benchmark. The Sharpe ratio, which measures the ratio of reward to risk, was also much better in all the three tests.

One-year return of the screen was high at 34.56%, while the return of the S&P 500 index during the same period was at 18.43%. The maximum drawdown of the screen was only 5.61%, while that of the S&P 500 was at 7.36%.

The difference between the dividend growth screen to the benchmark was even more noticeable in the 15-year back-test. The 15-year average annual return of the screen was at 13.51%, while the average annual return of the S&P 500 index during the same period was only 2.23%. The maximum drawdown of the screen was at 52.35%, while that of the S&P 500 was at 57%.

Although this screening system has given superior results, I recommend readers use this list of stocks as a basis for further research.

Source: A Large Long-Term Diversified Dividend Growth Portfolio That Can Outperform By A Big Margin