Build A Proper Portfolio With Dividend-Paying Veterans

 |  Includes: LANC, LOW, NDSN, NWN, PH, VVC
by: Alexander Valtsev


Seventeen stocks have been paying increasing dividends for at least 50 years. Many of them are well-known to readers.

These equities have demonstrated outstanding equilibrium returns and fared better than the market in relative terms.

The mathematics of dividend growth even in its simplest form is a powerful tool for long-term investing.

Several customized portfolios can be constructed from this sample of securities to meet needs of different types of investors.

Inspired by an article here, on Seeking Alpha, which featured a list of oldest dividend-paying stocks (to be more specific, stocks that have raised dividends over the past half-century), I have decided to conduct a more thorough analysis of these securities and present certain allocation strategies readers can employ should they wish to include these names in their portfolios.

Why are dividend-growing stocks such a great bet? Well, let us do some math. A stock that has a current yield of 3% (after-tax) and grows dividends at CAGR of 5% for two decades returns the investor the entire cost incurred at the beginning. While this might be a stretch for a company, especially for such a considerable period of time, think about a stock that has been paying dividends over the last fifty years (any of the 17 on the list), had been acquired at a yield of 2% (quite conservative), and been growing dividends at a rate of 3% CAGR (in tandem with GDP, even lower in some time periods) since then. This one would deliver a 69% return just from dividends, without reinvestment. A 3% initial yield would result in a ~153% gain. If we combine a 3% yield with a 3% dividend growth rate, we will get a staggering 238% return on cost by the end of the period. The message is clear: dividend growth matters, market timing (i.e. current yield) - not so much.

The list of securities is not only useful because it consists of stocks that have consistently been growing dividends over a long period of time, but also because it is large enough to construct a portfolio with a considerably low non-systematic (i.e. firm) risk (as the number of holding grows, this risk reduces at a decreasing marginal rate). The 20-year returns for the portfolio holdings and their covariance are presented below:

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American States Water (NYSE:AWR), Cincinnati Financial Corporation (NASDAQ:CINF), Colgate-Palmolive (NYSE:CL), Diebold (NYSE:DBD), Dover (NYSE:DOV), Emerson (NYSE:EMR), Genuine Parts (NYSE:GPC), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Lancaster Colony (NASDAQ:LANC), Lowe's (NYSE:LOW), 3M (NYSE:MMM), Nordson (NASDAQ:NDSN), Northwest Natural Gas (NYSE:NWN), Procter & Gamble (NYSE:PG), Parker Hannifin (NYSE:PH), Vectren (NYSE:VVC).

I have made a number of observations from this list. First of all, over a half of the securities in the table (10 out of 17) have betas smaller than the market's. This can partially explain the second observation: higher betas have generally translated into higher returns. The plot chart is given below:

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One can see that, generally, equities with higher betas have delivered higher weighted-average returns, while the opposite also holds true. The strength of the relationship is semi-strong at R=0.67.

Finally, the holdings trade at an average yield (2.59%) below the one of the 10-year US Treasury Bond. The yield composition and the 10-year debt yield chart are given below:

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(Data courtesy of Bloomberg)

I believe that the difference of 18bp can be partially explained by the equity premium (i.e. paying more to participate in the upside) investors are willing to pay for top securities such as the ones on the list. Although the average P/E ratio for portfolio is 20.5X LTM earnings, I think the main reason for the smaller and riskier yield market participants are accepting is the portfolio securities' quality and dividend growth.

Portfolio Scenarios

Apart from the usual portfolio construction scenarios I have used in the past, a couple of more methods are introduced. Because in this instance I used equities instead of ETFs, I have introduced a "Minimum P/E Ratio" scenario with the limit of 10% of the portfolio for individual holdings. This portfolio has historically returned more than a comparable "Maximum Dividend Portfolio" at a lower risk, too. Remarkably, its average return supersedes average total risk by over 10bp per year. It has a price-to-earnings ratio of below 17X.

Although I have used the metric "diversification ratio" in the past for my other articles on portfolio management, I have specifically included a sample portfolio with the minimized ratio for reference purposes. This portfolio has some restrictions in regards to weightings in order to model a realistic case for an average investor.

The output of the model is presented below:

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Key Findings:

  • The equally-weighted portfolio, the one an average investor would start from due to the limited knowledge of statistics, has fared better than its "value" peer and came 6th on the list, having achieved such returns at an average risk for the group;
  • The Maximum Beta Portfolio has come in 4th, while taking the 2nd place in terms of risk against its better-scoring peers;
  • The Minimum Diversification Ratio portfolio scored the lowest standard deviation of returns among its aggressive and special goal peers;
  • The lowest risk among the realistically sound and optimal portfolios was just above 8.5% with an expected return superseding risk by over 250bp (0% to 20% Risk Minimized Portfolio);
  • The Maximum Dividend Yield portfolio offers ~1% more than the 10-year US Bond at an expected return of 13.5% (dividend represents over 25% of the figure) and a total risk of ~15% per annum.

An illustration shows some of these scenarios plotted on the risk-return chart:

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Readers should notice the risk-return ratios are better than the ones for most ETFs I have analyzed in the past, whether dividend-biased or risk-oriented. An observation I cannot explain is that portfolios of individual stocks (the high quality ones) tend to have smaller risk-return spreads than portfolios of ETFs with comparable qualities. Ideally, ETFs by themselves offer a level of diversification, while a portfolio containing them, consequently, has a second degree of diversification. Yet, if one compares diversification ratios of such portfolios from my previous articles with the aforementioned scenarios, s/he will find that they do not differ a lot. On the other hand, portfolios with securities on this list tend to provide better or comparable returns at less risk.

In conclusion, I would like readers to consider the Minimum P/E Ratio Portfolio that is the cheapest in relative terms to other versions, pays an equal dividend yield to long-term US debt, has a low diversification ratio, and risk-return ratio closest to 1.0. The portfolio is equally composed of the following securities:

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.