At the end of each quarter I select the stocks that make up my watch list for the quarter ahead.
In this article I take the reader step by step through a process I use for selection.
Finally I present those stocks selected for inclusion in next quarter's watch list.
In my last series of articles starting here, I discussed how I hope to use the important metric of Total Dividend Return (TDR) a/k/a the chowder rule to increase the overall dividend growth and ultimately the income generated by my portfolio during 2014.
A quick recap for those unfamiliar with TDR. In many articles on Dividend Growth, TDR is commonly referred to as the "chowder rule" in honor of chowder, a regular contributor here on Seeking Alpha. Under this rule, a stock yielding 4% along with a 5-year Dividend Growth Rate of 8% would produce a total dividend return of 12%. A stock yielding 3% would require higher dividend growth to produce a TDR of 12%. The rule is relaxed a bit for higher yielding/slower growing equities such as utilities, telecoms and MLPs. With this group, a total dividend return of 8% is sought.
This time around, I thought I would walk you through the process I use in personally selecting the stock positions for my second quarter watch list. This represents the first time I have used the chowder rule in the formal selection process.
Since I'm a Dividend Growth Investor I expect all of my new positions will be Dividend Champions, Contenders, Challengers (CCC) and Near Challengers. As of the end of January, there were 488 CCC listed stocks available here. Since my focus is income, I plan to pay the most attention to those CCC stocks that yield 2.75% or higher. Stocks yielding between 2.5% and 2.75% are within my range for future consideration and could be included in my watch list.
There were 259 CCC stocks yielding 2.5% or better as of January 31st. For this group, the average 5-year projected earnings growth was 6.3%. The group enjoyed a 1-year Dividend Growth Rate (DGR) of 8.7% and a 5-year Dividend Growth Rate (DGR) of 8.5%. The average yield for the group was 3.85%.
My next step was to determine how many of these 259 stocks qualify under the TDR/chowder rule metric. While the group enjoyed a combined chowder score of 12.4, more than 100 of the total failed to individually qualify.
I eliminated those, and I discovered an overall increase in not only the combined chowder rule score, but four additional metrics that I always consider when making a selection to consider adding to my portfolio:
· 5 year Estimated Earnings Growth
· 5 year Dividend Growth Rate
· 3 year Dividend Growth Rate
· 1 year Dividend Growth Rate
The 157 stocks making the cut have a combined chowder rule score of 15.5. In addition, the average yield increases to 4.12%. The group has estimated 5-year earnings growth of 7.2. Its 1-year Dividend Growth Rate is 11.0 with 5-year DGR of 11.4. Between my wife and I, we own 52 of these, leaving just over 100 remaining for further consideration.
My next stop was to the Morningstar website to conduct a 10-year Performance Review looking at performance year by year. Personally, I purchase few stocks for our portfolio with a history that doesn't reach back to at least 2008. The reason is simple. First and foremost, I want ownership in companies that handled the worst of times and actually grew their dividend. I also prefer those companies that sustained losses less than the market during that turbulent period. Since capital preservation is important, I also prefer stocks with no more than three down years during a ten-year period. After the review - 56 stocks remained for further consideration.
For me, the next step is to review my portfolio sector distribution. I am currently heavy in MLPs and I expect to reduce the number I hold in the future so none will be added to my watch list. Forty-seven stocks remained under consideration.
Then it was back to the remaining candidates for final consideration of Dividend Growth rate and 5-year Estimated Earnings Growth. I consider earnings growth to be important. In my opinion, a company with a history of dividend increases is more likely to follow strong earnings by rewarding its shareholders by growth in the dividend.
Finally I look at one, three and five-year dividend growth rates. Personally, I again prefer those where dividend growth is increasing. Consistency within each rate is also something I look for. I eliminated stocks with 1-year DGR of 6.0 or less and 5-year EPS of less than 6.0
My final step was to determine value and I used two sites to do that: FastGraphs and Morningstar. I prefer my limited new purchases to be undervalued.
There you have it. My step by step process I plan to use each quarter for finding those candidates for my watch list. I will do more research into each company before final consideration for purchase.
For me three stocks that stood out from the list were Maiden Holdings (NASDAQ:MHLD), Tal International (NYSE:TAL) and Seadrill (NYSE:SDRL). Each of the three are undervalued, have strong yields and solid one and five year dividend growth percentages.
I included two utilities should the market retreat during the next quarter I might increase my exposure to utilities.
I would be interested in your thoughts and comments about my process as well as the individual stocks making up this watchlist.
Got to go now, I've got some homework to do.
The following represent my second quarter Watch List:
Disclosure: I am long SDRL. 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.