In mid-August, I created three model Dividend Growth stock portfolios based on a U.K. research study's findings regarding subgroups of DG stocks that historically outperformed. Since that time, I also developed some working theories on a potential indicator ( -20% rule ) of future dividend cuts and/or price declines, which I have applied to these models. The table below highlights the performance of these three portfolios, as well as a variation on the Income-Growth portfolio that utilized the 20% rule to actively remove and replace stocks that exhibited that pattern.
All of my model DG portfolios (Small-cap, Div Aristocrat+, Income-Growth) started with $300,000 on August 16th, 2011, and have outperformed the S&P (NYSEARCA:SPY) and S&P Dividend ETF (NYSEARCA:SDY) over the last five months. In addition, with the exception of the small cap portfolio, they did so with lower standard deviation of returns than the S&P as well. My intent is to rebalance the model portfolios once per year, as the U.K. study did. This article addresses the rebalancing of the Income Growth portfolio. The screening process for these models relies on David Fish's CCC list, so again, thank you to him for putting it together each month!
Looking at the 30 stocks in the Income Growth portfolio, there were just 3 with negative returns: Novartis (NYSE:NVS) and Unilever (NYSE:UL) lost less than 2%, and Avon Products (NYSE:AVP) had a -16% total return. About half of the remaining stocks delivered returns between 0% and 12%, which was the S&P's return over this time period. The other half had double-digit gains, with 8 returning over 20%. The big winners were: Kinder Morgan Partners (NYSE:KMP), Medtronic (NYSE:MDT), Community Bank System (NYSE:CBU), Linear Technology Corp (NASDAQ:LLTC), McGrath Rentcorp (NASDAQ:MGRC), RPM International (NYSE:RPM), and Sunoco Logistic Partners (NYSE:SXL). The top gain was from Harleysville Group (NASDAQ:HGIC), which received a buyout offer in Fall 2011 for a 100% gain. This stock was replaced at that time with CBU.
Removing the gain from HGIC, this portfolio performed on par with the SDY, though with a slightly lower standard deviation. The performance spread was higher back in December. The Small cap and DA+ portfolios have higher weightings for industrials, materials, and info tech, which did well in the last few months. The goal for this portfolio is not necessarily to deliver the highest total return, but to deliver a better reward-to-risk value than the SPY and SDY, which all of the dividend models have done to date. Time will tell if this pattern continues.
The Screening Process
This section outlines my screening process. I have tried to make it as objective as possible; readers should be able to replicate the results. The number in brackets indicates the number of stocks remaining after each filter step. For reference, this universe had an average yield of 3.1%, and 1-, 3-, and 5-year DGRs of 9.0%, 10.2%, and 12.4%.
- I began with the January 31 CCC list, combining the champions and contenders, which have 10 or more years of consistent dividend growth. [254 stocks in total]
- I sorted the list by Market Cap, and removed those with a market cap less than $500MM. This portfolio seeks mid and larger-cap firms for more stability. 
- I sorted the remaining list by current yield, and proceeded to remove stocks with a yield less than 2.5%.  The U.K. research found that higher yielding stocks tend to outperform, and also, the purpose of this portfolio is to provide investors with a decent yield as well as growth. Individual readers could choose a higher cut-off, but ultimately, I reviewed survivors starting with higher yielders anyway.
- I sorted the remaining list by 5-yr Dividend Growth Rate [ DGR ] and removed all stocks with a DGR < 4%, since this portfolio seeks equities that are growing their dividend at a decent rate. 
- From this list, I remove Harleysville Group (HGIC) because of its pending buyout and Unilever NV (NYSE:UN) because it is the same as Unilever plc (UL) , and UL is preferable because the UK does not withhold taxes on dividends to U.S. shareholders. Wow…lots of Ux acronyms there!
Screened Group Characteristics
The 89 stocks that survived the screening process had an average yield of 4.02% [close to the 4% that many DG investors look for], and 1-, 3-, and 5-year DGRs of 8.3%, 8.0%, and 10.7%. For comparison, the original Champion / Contender, 254-stock universe had an average yield of 3.01%, with respective DGRs of 9.7%, 8.2%, and 10.3%. So we have generally retained the growth rate, but raised the yield by 100 basis points. I proceeded to add a sector tag for each stock, sort the stocks into sector groups then by yield. The table below shows the group characteristics.
click to enlarge
I calculated the percentages for each sector based on market cap and by representation (count). Since there is a difference between the percentage by count and percentage by market cap, I averaged the two values to obtain a weighting for this portfolio. This average weighting was then used to determine approximately how many of the 30 stocks would be allocated to each sector.
Relative to the December 2011 S&P weightings, the portfolio is heavier on consumer staples, energy, telecom, and utilities. It is noticeably lighter on technology, consumer discretionary, and industrials. This allocation helps to explain the lower beta and lower standard deviation of weekly returns of this portfolio. It also contributes to the higher yield, as some of the higher yielding DG stocks reside in those sectors.
To decide which stocks to select from the screened list, I added 5 columns (Yield Rank, 5-yr DGR, 1-yr DGR, Payout, and 2012 EPS Growth Rate) and assigned point values to help me compare the stocks. More points are better!
- Yield: Stocks with a yield < 3.25% received a 1, >= 3.25% received a 2, >=5% received a 3.
- 5-yr DGR: Since a primary consideration is Dividend Growth, stocks with a 5-year DGR < 6% received 1 point, between 6-12% received 2 points. If the rate was over 12%, I did not consider that sustainable, so I used the same point system based on the 1-year rate. I wish there was a metric for projecting future growth, but for now, looking at historical data will have to suffice.
- Payout: 2 pts for a payout <=50%, 1 pt for <= 80%, 0 if above 80%, and -1 if negative. This was a secondary determinant. After choosing a stock, I verified that it had a positive payout rank. For stocks with a zero, I examined the last four quarterly cash flow statements. If operating cash flows covered dividends paid in at least 3 of 4 quarters, the stock was not eliminated. This was necessary mainly for MLPs in the list.
- 2012 EPS Growth: Negative growth rate (-1), less than 5% (0), between 5-10% (1), over 10% (2). This was also a secondary metric; as long as the payout ratio was low, slow or even slightly negative EPS growth would not likely hinder dividend growth, but it could slow total return. This was more of a tiebreaker, though I preferred stocks with higher EPS Growth, since that would allow for higher dividends in the future and higher stock prices.
- 1-yr DGR: Less than 4% (0), between 4-8% (1), over 8% (2 pts). This was used more as a tiebreaker and for reference.
With this information, I proceed to select stocks from each sector, starting with those that had the highest yield (3 or 2 pts) and highest DGR (2 pts). If the payout was a zero, I verified the cash flow, and removed the stock if it did not pass that test. Before final acceptance, there were two additional checks to see if the average trading volume was under 50,000/day (liquidity requirement) or if the stock's performance was 20% below the S&P's for four consecutive weeks ("-20% gap rule") within the last year. If either criterion was met, the stock was removed from consideration. This process was repeated until the quota for that sector was reached. I favored stocks with higher yield first, then DGR. The final list of 30 stocks is presented in the picture below.
Note: I made one judgment call in the Energy sector. There were so many MLPs that made the cut, I decided I wanted at least one actual company. Conoco Phillips (NYSE:COP) was taken over TC Pipelines (NYSE:TCP) for this reason. TCP had a higher yield, though lower dividend growth rates and negative EPS growth projected for next year.
The final portfolio has an average yield of 4.14%, and its 1-, 3-, and 5-yr DGRs are 8.6%, 8.0%, and 10.5% respectively, which closely matches the screened universe's traits. Compared to the SPY, SDY, and my other DG models, this portfolio has the highest yield and lowest beta.
Of the 30 stocks, 10 are new at this rebalance. The 10 being replaced: Sunoco Logistics , Linear Tech , Medtronic , Mercury General (NYSE:MCY), Genuine Parts (NYSE:GPC), General Dynamics (NYSE:GD), Wal-Mart (NYSE:WMT), Pepsi (NYSE:PEP), NSTAR (NYSE:NST), and Chevron (NYSE:CVX) had an average return of 12.2% since August 16, 2011; half gained over 15%. As a result of their price increases, most of their yields are now a bit lower than when they were purchased. All except for MCY, which exhibited the -20% gap, and WMT, whose dividend is less than 2.5%, made the final screen list, so there is nothing necessarily "wrong" with these stocks. This is an example of rebalancing to lock in gains and redeploy the funds in higher-yielding opportunities. It is also a function of slightly different sector allocations based on the group statistics.
Tax Considerations and Substitutions
Unlike the first time I created this portfolio, there are far more foreign firms / ADRs and MLPs this time. While I like the diversity this adds to the portfolio, it can also add some tax considerations. I'm not an accountant, so if others have more accurate information, please post it.
- Unilever should be fine, as the UK does not withhold taxes on U.S. investors.
- Shaw (NYSE:SJR) should be fine for an IRA, as Canada does not withhold taxes on IRA dividends.
- Novartis is Swiss, and from what I've read, an investor can submit a claim for withholdings above 15%, plus you can claim a U.S. tax credit for the rest (non-IRA).
- Investors can purchase Kinder Morgan's (NYSE:KMR) shares instead to avoid UBTI tax issues in an IRA.
For those who would prefer to avoid foreign shares or who want a little more yield, here are some stocks that just missed out on my screen, mainly because they haven't reached Contender status yet. Omega Healthcare (NYSE:OHI) just barely failed my cash flow test.
Years of DG
I have updated my virtual IncomeGrowth portfolio with the new holdings as of the closing prices on February 1, 2012. The total account value was $352603.54, so approximately $11,750 was invested in each of the 30 stocks after commissions (~$358). I will continue to track this portfolio and report on its performance relative to the S&P, S&P Dividend ETF, and my other DG model portfolios. The next full rebalance will occur in one year, unless there are major market movements that necessitate the need for action. If any stocks cut their dividend, get bought out, or exhibit the -20% gap rule, they will be removed and replaced with another stock from the same sector based on the screening process.
I welcome feedback on this screening and selection process, as I continue to refine it based on comments, observations, and new learning. I hope SA members find the process and the recommended list useful for identifying potential candidates for their portfolios.
Additional disclosure: I have been waiting to open positions in: MDP, ARLP, CBU, and T, and may do so in the next 72 hours if we ever get a nice correction!