Sector By Sector Model Portfolio With Double The Market Yield

Includes: SPY
by: Clay King

Over the past few weeks I've screened the ten economic sectors of the 1500 stock universe that is formed from the stocks in the S&P 500, the Mid-Cap 400 and Small Cap 600. It was my intention in writing a sector by sector analysis to not only examine each sector to identify possible equity selections, but to also highlight the ability to build a well-balanced and diversified portfolio to include all fully weighted economic sectors. Dividend investing to many investors means a portfolio packed with telephone and utility stocks. As we found, there are plenty of selections in each sector. Many investors largest asset account is their IRA, so I have not added MLP's to the mix of our choice of a dividend growth portfolio. A plan B, so to speak.

There is often a question why we should diversify holdings over the economic sectors. The chart below should help answer that question. Returns of the 10 sectors over the past twenty years range from a low in the utilities of 4.4% to a high return in technology in excess of 14%. Obviously asset return does not equal dividend yield or income flow but a balance gives the investor a firmer portfolio in my opinion.

The screens of the last two sectors covered in our series, telecommunications and utilities only comprise about 6.5% of the total sector weightings, but they are often over-utilized in individual portfolios. If one equal weights each economic sector at 10% that is their choice, however, that makes a comparison to that index unbalanced. These two sectors are two of the three in which returns over the previous 20 years were lower than the widely followed S&P 500. Should you own these sectors? Yes, but if one has a goal for higher future dividend growth, then these two sectors deserve their place with lower sector weightings, not equal weighting. If however, one is more concerned with higher yield, then by all means overweight them. For our portfolio in this article, I stayed close to each sector's weighting so that any personal bias is removed.

Model Portfolio Criteria

Sector & Stocks Model Portfolio Weight Over/Under Market Sector Weight Yield Beta Previous Dividend 5 Yr. Gth Rate Dividend Payout Ratio
Consumer Disc 10.3% -.27% 3.3% .83 12% 47%
Genuine Parts (NYSE:GPC) 3.7% 3.5% .87 5% 54%
Meredith (NYSE:MDP) 1.73% 4.3% 1.37 9% 35%
McDonald's (NYSE:MCD) 4.85% .2.8% .53 19% 50%
Consumer Staples 11.92% +.10% 3.4% .56 12% 49%
Procter & Gamble (NYSE:PG) 3.41% 3.4% .49 11% 52%
Wal-Mart (NYSE:WMT) 1.92% 2.8% .53 14% 15%
Phillip Morris** (NYSE:PM) 3.17% 3.7% .70 n/a 64%
Pepisco (NYSE:PEP) 3.42% 3.3% .53 9% 51%
Energy 13.07% +.68% 4.2% 1.03 9% 34%
Conoco Phillips (NYSE:COP) 4.67% 4.2% 1.10 10% 38%
Chevron (NYSE:CVX) 4.3% 3.3% .97 8% 29%
Royal Dutch B (NYSE:RDS.B) 4.1% 5.3% 1.00 8% 38%
Financials 13.75% -.07% 4.6% 1.07 9% 47%
AFLAC (NYSE:AFL) 2.57% 3.4% 1.52 16% 20%
Harleyville Gp. (NASDAQ:HGIC) 2.49% 5.6% .76 16% 55%
Cullen/Frost (NYSE:CFR) 3.42% 4.0% .83 7% 52%
Bank of Hawaii (NYSE:BOH) 2.8% 4.7% 1.09 4% 57%
HCP (NYSE:HCP) 2.47% 5.7% 1.20 2% 83%
Health Care 12.12% +.17% 3.9% .51 13% 46%
Abbott Labs (NYSE:ABT) 4.55% 3.9% .46 10% 43%
Johnson & Johnson (NYSE:JNJ) 3.5% 3.6% .50 9% 45%
Novartis ADR (NYSE:NVS) 4.07% 4.3% .57 19% 49%
Industrials 10.52% +.20% 4.3% .78 5% 41%
Raytheon (NYSE:RTN) 4.41% 4.3% .64 11% 30%
General Electric (NYSE:GE) 1.67% 4.0% 1.26 -20% 43%
Waste Mgt. (NYSE:WM) 4.44% 4.3% .73 9% 61%
Information Technology 17.5% -1.10% 4.4% .92 9% 42%
Diebold (NYSE:DBD) 3.97% 4.4% .88 5% 50%
Intel INTC) 6.78% 4.3% 1.04 12% 33%
Microchip Tech (NASDAQ:MCHP) 4.73% 4.6% .91 6% 44%
Maxim (NASDAQ:MXIM) 2.01% 4.0% .79 13% 58%
Materials 3.05% -.45% 4.6% 1.07 7% 51%
RPM Inc. (NYSE:RPM) 3.05% 4.6% 1.11 6% 58%
TeleCom 3.45% +.21% 7.4% .71 31% 85%
CenturyLink (NYSE:CTL) 1.88% 8.5% .66 76% 90%
AT&T (NYSE:T) 1.57% 6.0% .76 5% 75%
Utilities 4.34% +.54% 4.3% .59 6% 6%
Nextera (NYSE:NEE) 2.49% 4.1% .72 7% 7%
Southern Co. (NYSE:SO) 1.84% 4.7% .40 4% 4%
Portfolio Averages 100% 4.3% .82 10% 46%
S&P 500 Averages 100 2.15% 1.00 -3% 26%

** Spin-Off prevents five year record.

Our portfolio has a current yield twice that of the general market. It is easy to increase the yield of the general market just by eliminating non-dividend stocks. Requiring higher quality, lower payout ratios, strong dividend growth, and a past history of increasing dividends creates an improved quality portfolio. Such a list will normally produce excellent future dividend growth as well, which is illustrated in the following chart. Telecom was adjusted so that CenturyLink was eliminated due to a one time large increase that distorted the sector.

The dividend growth rate of these stocks improved their dividend payments by a weighted average of 10% over the preceding five years. The S&P 500 averaged a loss of 3% during the same time frame.

The model portfolio has a beta of .82, which simply means that this portfolio has a tendency to be less volatile than the general market. If the market declines by 1% then this portfolio should decline about 0.82%. If the market should rise 1.2% then this portfolio will rise only approximately 82% of that move. It is simply a trade-off in one's volatility. Simply put, a portfolio with a lower beta should return less in a rising market. However, over the last three years this portfolio would have returned only 1% less than the S&P 500. Over the last five years, it would have returned 9% more than the general market. What will be in this portfolio's future is, of course, unknown. Would one have picked this identical portfolio five years ago? Likely not.

The chart below shows 4 measures of fundamental criteria of the model compared to the 500 stocks of the S&P. Simply, put, we have a portfolio with less beta and a higher yield, but accompanied by improved fundamental comparisons.

Any investor can take the equity selection list in our model and by increasing or decreasing the weightings of any issue can easily change the yield level or the potential growth rates of dividends. Reducing Wal-Mart and adding to the position in Phillip Morris results in a higher yield. Increasing or decreasing the weighting from sector to sector will change yield. If one wished to equal weight all the sectors, then that would increase the telecom and utility stocks from a 6.4% weighting to 20%, drastically increasing yield. With any changes, there is of course a corresponding change in items such as earnings growth rates, dividend growth rates, and beta. My point is that one can maintain a sector balance with the S&P 500 and greatly improve yield without overweighting high yield sectors.

The model presented above is one that I consider to be an example of a moderately constructged income portfolio offering a balance of yield and growth. One could easily configure a personal portfolio where the yield lies on either side of this portfolio. A portfolio with a high growth rate in earnings and dividends, but with a lower current yield, might be ideal for the young or those with little need for current income. Those nearing retirement, or well into retirement, might need a balance of higher income, but one that promises increases in dividends that match inflation. Each individual should manage their portfolio and adjust as required to meet their needs.

I would like to thank those who have been following this series of building a sector by sector model portfolio. It has been a pleasure writing the series and hopefully I've added some measure of help to the reader, as it has to me.

Disclosure: I am long MCD, GPC, PM, PG, RDS.B, COP, CVX, HGIC, AFL, JNJ, ABT, WM, GE, MCHP, INTC, RPM, T, CTL, SO.

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