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This article is the first of a series that will detail a step by step approach of building and managing a core portfolio of strong dividend stocks. We have written several articles on tactical asset allocation strategies using ETFs. We believe they are a very good complement to more value-oriented strategies like the one we outline here. It is always wise to diversify not only the assets you hold but also your strategies.

Step 1 - Screening dividend-paying stocks to identify a list of candidates

Here is the approach we use to create a stock screening whose purpose is to provide a list of stocks that could form a solid core portfolio of dividend paying stocks with good prospects. This list of stocks serves as a starting point for further investigation before actually adding the picks to the core stock portfolio.

The starting universe is the list of dividend paying stocks available on the DRIP website. The list is broken down into three categories: (i) Dividend Champions (stocks with 25+ straight years of higher dividends); (ii) Dividend Contenders (stocks with 10 to 24 straight years of higher dividends); Dividend Challengers (stocks with 5 to 9 straight years of higher dividends).

The screen is based on tested stock investing principles:

  • High-Yield Low-Payout stocks tend to outperform the market over time.
  • High-Yield High Dividend-Growth Rate stocks tend to outperform over time.

Following these principles, and after cleaning the DRIP list, we establish every month a list of stocks meet all the criteria below:

  • Yield is higher than average.
  • Dividend-Growth Rate is higher than average.
  • Payout ratio is lower than average.
  • The company has increased its dividend for at least 8 years.

Running this screen at the beginning of the month with the latest DRIP data as of December 31, 2012 gave us a list of 12 stocks for consideration:

Company Symbol Industry Div. Yield Div. Gr. rate Payout
AFLAC AFL Insurance 3.05 15.9 33.50
Eaton Vance Corp. EV Financial Services 3.21 13.52 43.43
Illinois Tool Works ITW Machinery 3.08 11.59 36.18
ConocoPhillips COP Oil & Gas 3.62 14.22 33.85
Harris HRS Telecomm 3.11 21.73 25.81
Linear Technology LLTC Tech-Hardware 3.20 12.46 40.34
Nippon Telegraph & Telephone NTT Telecommunications 3.25 19.28 34.26
Alliance Resource Partners LP ARLP MLP-Coal 5.05 13.44 47.69
Hasbro Inc. HAS Recreation 3.76 21.9 43.17
Intel Corp. INTC Tech-Hardware 3.46 19.5 36.36
Lockheed Martin LMT Aerospace/Defense 4.94 21.7 46.78
Strayer Education STRA Education 4.12 30.99 42.78

Step 2 - Choosing the stocks to add to the portfolio

Every month after running the screen, we will assess whether stocks on the list deserve to be included in the portfolio. Decision will be based on whether we see the stocks as currently having attractive valuations.This step is essentially based on earnings history and consistency, future expected earnings growth and current and future Price-to-earnings ratios (PER). In the long run, earnings dictate a stock performance. They always have and always will. Investing in great companies that are significantly overvalued can be extremely costly, even if these companies continue to grow earnings at a solid pace. Several tech giants perfectly illustrate this point: for instance, an investment in Intel (NASDAQ:INTC) in 2000 did not return much if anything to shareholders although the company has consistently grown earnings ever since.

Step 3 - Portfolio construction and management

We will gradually add new positions to the portfolio as our stock screen and valuation assessments signal new candidates. Positions will be held as long as the company prospects, earnings and valuation suggest to do so.

We will build and manage the portfolio to ensure a balanced exposition to different sectors and market capitalization segments. We expect to end up with a portfolio comprised of 20 to 50 stocks maximum.

During the portfolio construction phase (whose length will depend on opportunities), we will track both the total return of the portfolio and the return on invested capital (RoIC). We will benchmark the latter against the SPY (S&P 500).

We started this model portfolio with a hypothetical $100,000 balance on January 6, 2012. Among the 12 stocks mentioned above, 3 of them did not make our earnings and valuation cut: Linear Technology (NASDAQ:LLTC), Nippon Telegraph & Telephone (NYSE:NTT) and Alliance Resources Partners LP (NASDAQ:ARLP). One note on the latter: MLPs are a different breed and we are not comfortable holding single stocks of this kind. We prefer gaining exposure to the Energy MLPs through an index ETF such as AMJ, as we do in our ETF portfolios. We entered a position in each of the 9 remaining stocks for around 3% each (except for Strayer Education: the starting position was only 2% as it seemed less undervalued and is a more volatile stock). This left us with a cash stack of $73,904.69.

As January 15, 2012, we are therefore 73,46% in cash, waiting for new opportunities to present themselves. Since January 6, the RoIC (return on invested capital) has been +2.31%. The total return has been +0.6% because of the cash share. The table below summarizes the current portfolio holdings as of January 15:

Company Symbol Buy Date Buy Price Shares Price Return Weight
AFLAC AFL 01/06/2012 44.24 68 43.18 -2.40% 2.92%
Eaton Vance Corp. EV 01/06/2012 24.10 125 24.82 +2.99% 3.08%
Illinois Tool Works ITW 01/06/2012 47.79 63 49.37 +3.31% 3.09%
ConocoPhillips COP 01/06/2012 72.66 41 70.34 -3.19% 2.87%
Harris HRS 01/06/2012 37.18 81 38.41 +3.31% 3.09%
Hasbro Inc. HAS 01/06/2012 31.90 94 32.69 +2.38% 3.05%
Intel Corp. INTC 01/06/2012 25.25 119 25.14 -0.44% 2.97%
Lockheed Martin LMT 01/06/2012 79.98 38 81.52 +1.93% 3.08%
Strayer Education STRA 01/06/2012 96.69 21 113.92 +17.82% 2.38%

Disclosure: I am long INTC, AFL, LMT. I may initiate a long position in any of the other stocks over the next 72 hours.

Source: How To Build A Core Portfolio Of Strong Dividend Stocks