This article describes my 2012 Dividend Growth Portfolio plan and illustrates the acquisition and sale discipline outlined in that plan as I construct my Portfolio for 2012. This plan is the evolution of an existing plan and its development reflects a current understanding of today's social and economic issues. It builds on my article, "Constructing the Core of your Dividend Growth Portfolio," and the follow up to that article "Dividend Growth Portfolio Core Holdings Performance for 2011." The reader will get an appraisal of the market, a review of stock selection criteria and stock sales criteria, descriptions of some often overlooked stock evaluation attributes and actionable purchase information on selected stocks. I will present the reasons behind my sale of several stocks.
I designed this plan and created this portfolio to meet my goals and it most likely would have to be modified to meet someone else's goals. One of the beauties of purchasing individual stocks is that you can customize a selection of stocks to suit your needs and accomplish your particular objectives. I took into consideration my abilities and my perspectives; you most likely have different abilities and probably a different world-view. Therefore, your plan and your portfolio will be different, which is fine. This portfolio reflects as much as is possible my real-life dividend growth portfolio. That is, I own all of the stocks listed here in approximately these proportions. The data presented below is from several sources, Yahoo Finance, Morningstar, the Wall Street Journal and Seeking Alpha, which are not in complete concert. I do not believe that any differences, discrepancies or errors herein are significant enough to alter the selections or conclusions.
The Goals
The first goal is to have a continuing and increasing income stream that provides retirement income. To accomplish that I will seek a current yield averaging 4.25% or more. As I have owned some of these stocks for several years, my "yield on cost" will be higher than the current yield. A secondary goal is capital appreciation. Market gains increase investable capital, which allows me to require a lesser dividend yield percentage to earn the same income as I would on a smaller amount. That is, if I require $15,000 of income that is 5% of $300,000. However, if I have $350,000 to invest and my requirement for income stays the same then the yield can be only 4.16%. That means I can invest in higher quality or less volatile stocks, which furthers the goal of safety and security of principal.
Constraining Factors, the Economy and the Market
There is, and will be, a continuing problem in the eurozone. The eurozone is now causing about a 1% drag on the entire global economy. It is a problem of sovereign debt; it is a problem of bank liquidity; it is a problem of high unemployment; it is a problem of political will. It is the sum of these, as institutions pare away levels of experience and expertise to reduce payrolls, as educational needs are unmet, as military protection diminishes, as the infrastructure of a civilization decays. In the U.S. all of these issues apply, but perhaps to a lesser degree. Paramount here, however, is the untenable federal deficit problem. Are we doomed?
No. We are in the recovery phase of the business cycle. Economic activity is increasing, unemployment is easing and indications are that we will be in a period of slow growth for a long time. The Federal Reserve Bank states that interest rates will remain very low through 2013, perhaps longer, to facilitate the economic recovery. Further, the Fed has for the first time chosen to state a goal for inflation, 2%. There may also be additional monetary easing to stimulate the economy. China will regain some of its former momentum. The Europeans will muddle through the sovereign debt and banking crisis, as will the U.S. with the Federal deficit.
The IMF has issued cautious forecasts; jobs creation is an issue worldwide and is seen as a driver of economic growth rather than only a result of expansion. A Booz Report from Davos mentioned a 1-2-6 forecast. That translates into 1% growth for the eurozone, 2% growth for the US and 6% growth for emerging economies.
Markets will remain volatile; however, the dividend growth investor has an advantage here. Dividend paying stocks are somewhat less volatile than those that do not pay dividends.
Volatility, sometimes called "the ride" in stockbroker parlance, is an increasing factor in the securities markets. The astute observation concerning the recent market and the behavior of investors is that "if the ride is too rough, you'll get off." Small investors confirmed that maxim in 2011 as they exited stock mutual funds and purchased bond funds. Amidst all its volume and volatility, the S&P 500 ended the year right where it began the year. Of course, individual investors had losses and gains. A quick fall in stock prices often causes fear of a crash and individual investors bail out at an inopportune time. One basic idea in stock investing is to buy low and sell high, yet investors abandon this precept in the face of fear and sell stocks at a loss to preserve their remaining capital. Even for one steeled against emotional irrationality, volatility increases risk because if one needs cash they might need to liquidate stocks during an untimely downturn. Therefore, investors should mitigate volatility as much as possible in their portfolios as the behavior of the market is beyond the individual's control.
Stock Selection Criteria
Stocks in the 2012 Dividend Growth Portfolio were selected by applying the below criteria while being mindful of the desire to increase stock quality and portfolio stability both in 2012 and long term.
Trade The price the stock is selling for on the stock market.
Fair Value, Purchase at below this value. This is a price calculated as the fair, or intrinsic, value of a stock. The figures presented are Morningstar's estimates. Many different sources provide estimates of stock valuation. One of my favorites is Seeking Alpha contributor Chuck Carnevale's F.A.S.T. Graphs. I would certainly advise a trial of this program. It is simple to use and graphic displays allow one to benefit from it on the first session. Seeking Alpha contributor Dividends 4 Life also has a service available, which includes fair value of dividend growth stocks along with many other metrics on an immense spreadsheet.
Yield, 3% or greater. Yield is the income returned on one's investment. It is expressed as the percentage annual dividend income divided by current stock price. A $3/ year dividend on a $100 stock equals a 3% yield.
Yield on Cost, This is not a selection criteria but a term often used in Dividend Growth investing. If you own a stock and over time, the dividend goes up, say from $3 to $4, and the price appreciates to $145, its yield is then 2.75%. However, since you are earning $4 on something that cost you $100, you could say that your 'yield on cost' is 4%.
Dividend Growth Rate, DGR Minimum 7%. A firm increases their annual dividend at this rate, which is averaged over time. A high yielding stock might be acceptable at a slightly lower DGR. As a quick rule of thumb, I look for a firm to have a combined yield and DGR of 12 or more.
Dividend Growth History, Ten years of increases sought. Some companies increase their dividends as a matter of policy every year, and many companies have a history of doing this for over 10 years and some for over 25 years. All of this dividend history is downloadable at a site maintained by David Fish.
Earnings per Share, EPS, This is the amount of income the firm makes divided by the number of shares. It is the "E" in P/E. The EPS Average Growth Rate is also an important measure. We use Dividend Growth Rate (DGR) as a proxy.
Price/Earnings Ratio or P/E. Must be reasonable. The owners of a firm are the beneficiaries of its earnings. The price of a stock is what you must pay for those earnings. If a firm sells for 80 and earns $6 a share, it has a Price/Earnings ratio of 13.33. A firm's P/E must be looked at in relationship to the average P/E of the market and to others in its industry. A lower P/E may be an indication a firm is undervalued.
Payout Ratio. 60% maximum. The portion of earnings which are paid out as dividends. If the above described firm earned $6 and paid out $3.60 that would be a yield of 4.5% and payout ratio of 60%. Allowances are made for MLPs, REITs and other special entities.
Positive Cash Flow, A look at the bottom line on a company's annual cash flow report will tell you very quickly if it was positive or negative. If there is a negative cash flow within the past five years, do not buy the stock. Exceptions: MLPs, REITs. Massive depreciation and a requirement to pay out nearly all earnings often shows up as negative cash flow on these otherwise profitable firms.
Return on Equity, ROE. 15% plus is desirable. This is often described as a measure of management effectiveness. It is the net income earned on the shareholders equity. ROE = Net Income/Shareholders Equity. This describes a company's profitability, that is, how much the company is returning on the investors' money. Compare to others within an industry for a clearer evaluation.
Long Term Debt to Total Capital, Limit of 60%. This is expressed percentage-wise, 60% or as a decimal, 0.60. Too much debt is a very bad thing. Companies with low debt levels have strong balance sheets and can better weather economic storms. Long-term debt of 0.4 or less, is desirable.
Beta, An influencing factor in stock selection. This is a measure of a stock's volatility. The S&P 500 has a beta of 1.00. If a stock is only half as volatile as the broader market, it would have a beta of 0.50. If it were twice as volatile as the total market, it would have a beta of 2.0. Risk taking industries like leading edge tech firms and mineral prospectors have high betas and electric utilities and soap manufacturers have low betas. The lower beta is desirable, however, extreme limitations on portfolio risk may also limit rewards. Compare within an industry.
Credit Rating, A- or better preferred. This is a quality measure which speaks to a company's security and safety. Morningstar rates about 600 stocks on 4 parameters: business risk, cash-flow cushion, solvency score, and distance to default, then a letter grade similar to that used by Standard and Poor's and Moody's is assigned. Where Morningstar does not rate a stock, I used S&P's credit worthiness rating for long-term debt.
Market Capitalization, over $15B. Benjamin Graham said, "Choose companies that are of adequate size to impact the marketplace." These are also more stable.
Economic Moat, An important consideration. This describes the sustaining dominance a firm has in the marketplace, one that would require great amounts of capital to challenge. Of the companies in the portfolio 14 have narrow economic moats and 8 have wide economic moats. See Morningstar definition.
Analyst Opinion, It is a good idea to review the sentiment of professional analysts before making a purchase. Most reports give last week's consensus and last month's. Sometimes you can spot a trend.
Sector, The economy is divided into a number of different sectors, as shown in the right column of the Portfolio Table. Last year two of the leading sectors were Consumer Staples and Utilities, classic defensive industries. As the recovery continues, I expect that two sectors that have fallen from grace will prosper. That is Basic Materials and Finance. BHP Billiton is a high conviction long-term pick in the Basic Materials sector. Canadian Banks, the soundest in the world, will also prosper. Diversification is attained by selecting stocks from different sectors of the economy, and a table shows the proportions. (Due to space limitations not all values could be shown on the table)
The 2012 Dividend Growth Portfolio
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- In as much as the statistics tell us about each individual stock, the averages of the measurements tell us the characteristics of the portfolio as a whole. The average price of a stock is $61 and the average fair value is $67. That indicates that as a whole the portfolio is 10% undervalued. The average yield is 4.25% and the dividend growth rate is 12.9%. I believe that those are very good numbers on two key measurements. The P/E is 13, which is about the same as the overall market. The ROE of 22% indicates that stockholders are getting a good return on their investments, which are in the hands of competent managers. The long-term debt to total capital is 0.38, which indicates sound balance sheets. The 5-year average beta is 0.82, which means the portfolio is only about 80% as volatile as the market. These powerful companies have an average market capitalization of $187 B, and their aggregate credit rating of AA- attests further to their Blue Chip status. This portfolio will prove to be a safe, stable and profitable investment with a growing return.
Other Portfolio Parameters
The restriction on number of stocks owned has been relaxed. Formerly it was 20 and this year's portfolio contains 23. I do not anticipate that it will grow to 30 for it is difficult for me to keep track of more than 20 stocks.
Regarding the size of investments, I made several changes. I removed the dollar restriction that limited investment in non-US stocks.
I affirmed the dollar limit on High Conviction (Core) Stocks at $24,000; I set a dollar level for Overweight Stocks, $18,000; I set the level on Basic Stocks at $12,000 and I eliminated the restriction on taking Small (Underweight) Positions, which were set at $4,000.
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Stocks Sold in 2011
- Commonwealth Edison (ED) Overvalued, took profit
- CenturyLink (CTL) No dividend increase, excessive payout
- Reality Income Corp. (O) Low DGR, small cap
- Universal Health Realty (UHT) Very small cap, upgrade portfolio
- Cincinnati Financial (CINF) Not profitable enough,small cap
- Conoco Phillips (COP) Uncertainty, company reorganization
- Leggett and Platt (LEG) Small cap, up-grade portfolio
Positions Reduced
- Abbott Labs (ABT) Uncertainty, company reorganization
- Annaly Capital Quality of company, up-grade portfolio
- McDonald's Portfolio Discipline, exceeded holding limit
Evolving Quality
This year's portfolio builds on investments made in the past, and of the 21 stocks in last year's portfolio, 14 remain. While this is a fair amount of turnover for a Dividend Growth Portfolio, I made most of the sales to intentionality to increase the quality of the portfolio. I do not foresee such wholesale change in the future.
An exception to the culling to increase quality was the sale of was Con Ed. Some might disagree with the decision to sell. However, I believe that one should sell overvalued stocks and use the proceeds to buy undervalued stocks. I do not consider that as speculation or even trading, just an aspect of prudent investing. Regarding McDonald's, I was "forced" to sell some stock because appreciation made the holding above my preset portfolio plan limit. With Abbott, I also enjoyed a profit as I sold 30% of my holdings to lower risk in light of anticipated company changes. My only possible regret is in selling Reality Income, a high quality but small company.
High Conviction Core Stocks
BHP Billiton (BBL) is the world's largest miner. Holding a key position in the Basic Resources sector, this company stands to gain as the momentum of the recovery increases. An increase in the price of copper, a leading indicator, confirms the expansion. BHP Billiton is not only a major producer of that industrial metal, but supplies aluminum, nickel, coal, iron ore, oil and gas and other minerals. Concurrent with increased economic activity, the world is experiencing a shortage of natural resources. Copper, 16% of BHP's revenue, is in tight supply. Positioned as a major supplier of essential minerals and energy, this well-managed firm is a long-term high conviction holding.
Intel Corporation (INTC) was once the darling of the dot com era; it is now a mature manufacturer of essential information processing hardware and leads the industry not only in product design but in manufacturing methods and efficiency. Its dominant position in the industry makes it a preferred customer of suppliers of materials and manufacturing equipment, and a preferred partner of and favored vendor to its customers. Nearly debt free, a strong balance sheet and powerful cash flow insure its leadership position both now and in the future.
PepsiCo (PEP) is the worldwide leader in salty snacks, a provider of wholesome foods and a major beverage company. Pepsi dominates its most profitable markets and controls nearly 70% of the U.S. salty snack market, 60% of the market in Brazil, and 45% of the U.K. market. It has great economies of scale and manages its products through direct store delivery. This underappreciated and undervalued company will be a growing player in emerging markets and a most profitable firm for its stockholders for years to come.
I believe I have discussed, with the exception of Westpac Bank, the other holdings in other recent articles. Banking in Australia is in some ways similar to banking in Canada. The number of major banks is limited to five in Canada and four in Australia, and the oligopolies seem to promote good banking health, albeit at the cost of competition. Australian banks pay high dividends and Westpac is my choice as it is the most undervalued.
Conclusions
Last year's portfolio yielded 4.78% and including these dividend payments it had a total return on 12.22%. The 2012 Portfolio will yield between 4.30% and 4.60% depending on the amount of dividend increases there are throughout the year. Total return is more difficult to predict, as there is as much uncertainty as ever about the economy, especially the rate of the recovery. I believe there is a high probability of a total return in the 15% range, but there also is a good chance that something will upset the applecart. Regardless, I feel confident about the solid blue chip companies that comprise this portfolio. They will endure with stability and profitability both in 2012 and into the future.
May you also endure with good health, happiness and prosperity in 2012 and beyond.
Additional Reading
- Evelyn C. Roth "Seeking Alpha's Dividend Investing Primer"
- David Van Knapp "Constitution for a Dividend Growth Portfolio"
- Bob Johnson "The Importance Of Due Diligence"
