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I love dividends, I always have. There is something ethereal about receiving money from a company in which you are part owner, it makes investing in companies tangible rather than the spin-the-wheel approach so many people take to when investing today. What is even better than a company that pays dividends is a company that has a track record of increasing dividends, the Dividend Aristocrat. When I retire in 30 years I want my dividends to replace my salary and the dividend increases to replace my annual pay raises. Luckily, no screening is needed for searching out companies that reward shareholders with annual dividend increases; our friends at Standard and Poors has done the work for us. There are currently 52 companies in the S&P Dividend Aristocrats list, all with more than 2 decades of annual dividend increases.

My challenge, construct two theoretical portfolios using the dogs of the Dividend Aristocrats, which are the 10 highest yielders. Once constructed, monitor the progress of the portfolios against each other, against the broader S&P benchmark, and against sanity.

Portfolio 1 - The Buy and DRIP (see you at Christmas) Approach

I will allocate $10,000 to each of the 10 holdings. At dividend payment time, full shares will be DRIP’d in. On December 28, 2011 (Day 1) the portfolio purchased:

Passive Portfolio

This portfolio is reasonably diversified with no exposure to Tech or Banking. (NOTE: I consider AT&T to be telecom, not tech.) As constructed, this portfolio will yield 4.73%, not too shabby. If a person were to try and replace their income using such a portfolio, an investment of just over $1,000,000 would be required to replace a $50,000 income.

The next step would be to sit back and wait for those dividends to start rolling in. Since we should all be aware of what is going on with companies in which we are owners, I will add one rule to these holdings; any cut, suspension, or elimination of the dividend will result in an immediate sell in the position and the capital re-allocated. The capital would be re-allocated to the 11th highest yielder on the list, Emerson Electric (NYSE:EMR).

Portfolio 2 - The Active Approach with Options

While a 4.73% yield on a basket of stocks is good, I wonder if those returns can be juiced a little bit using options to collect premium while entering and exiting positions. I regularly write covered calls and cash-secured puts as a tool in my portfolio, but I am selective. And truthfully, with a family and career it can be tough to find the time to manage a portfolio with options. The Buy and DRIP approach requires a grand total of 10 transactions. Consistently using options in a 10 stock portfolio could mean having 120 or more transactions in a year. Options are not for everyone but they are a very effective tool for defining risk and bringing extra income into the portfolio.

The premise for Portfolio 2 will be the same as the Portfolio 1. I will have the 10 Dogs of the Aristocrats, each with a $10,000 allocation. The construction of the portfolio will happen in 2 steps; first to buy the odd lots as a simple purchase. This approach will get me immediate participation in the stock and partake of any dividends that may happen. Step 2 is selling cash secured puts to get into the lots of 100. I will sell ATM (At The Money) or ITM (In The Money) puts. My goal is to collect the premium, but I want to be in these stocks so ATM or ITM is my maximum play. There are folks that make a nice living selling OTM (Out Of The Money) puts, again, my goal is to get into the stock. Once in the stock I will sell covered calls against the position. If called away, I will sell puts to get back in.

One downside among solid dividend payers, i.e. boring stocks, is that there is often not much premium or much of a market. The key is consistency in putting the play on, whether it be selling calls or puts and using limit orders. If a thinly traded option is only selling for $0.30 it is best to have a tight limit order against that. If you put in a market order, the thin market may give you a nice haircut down to $0.20. I will try to keep my trades in the forward month but market activity may occasionally force an option out 2-3 months. Since I do not have a great crystal ball and this is a dividend portfolio, I will refrain from writing options outside 90 days.

Using these basic premises, my portfolio at Day 1 looks like this:

There are a couple of things to note. First, there was no activity for options on Cincinnati Financial or HCP Inc., forcing a purchase of the entire amount. However, on HCP there were calls to be written for February expiration. The portfolio had an original balance of $100,000 and by using puts only $35,432 went directly towards buying stock. Selling put the portfolio generated $2,237 in premium plus the call option premiums was an additional $50. All-in-all the cash on hand is still over $66,800. With barely 1/3 of my capital in the market, the current expected dividend payments for the positions is $1,633.

I will look to update the two portfolios a few days after 21 January which is expiration date for all but one of the option positions.

Disclosure: I am long ED.

Source: Dogs Of The Dividend Aristocrats: A Tale Of Two Strategies