Updating Our Dividend Growth Investment Strategy

|
Includes: AFL, GE, JNJ, MA, MO, PG, SBUX, T, V
by: The Dividend Bro

Summary

How has our investment guidelines changed over time?

We'll discuss how we are using F.A.S.T. Graphs in the purchasing guidelines for my wife and I's portfolio.

We'll demonstrate our updated strategy with a real life example.

Investment Strategy Update

In the short time I have been actively investing for retirement, I've used several different strategies in order to find what works best for my goals and risk appetite. At first, I would simply invest in stocks I saw on TV or read about on investment blogs. As you might guess, this was a terrible strategy and was a waste of time and money. After a very short time, I quickly pivoted to dividend growth investing. The idea of getting paid to hold shares of companies seemed like a no brainer. Companies that pay dividends tend to have more of a stable financial footing than those that don't. Having to pay a dividend every quarter requires that companies be focused on where every dollar they earn goes. Before companies can pay a dividend they have to have enough money to pay their workers, fund capital expenditures, manage their debt, etc. Companies that can pay and raise their dividends every year have to have excellent cash flows. If companies don't and have to freeze or cut the dividend, they will be kryptonite to a whole slew of investors. This could crush the price of the stock. To me, investing in dividend paying stocks in order to (hopefully) live off of that income in retirement is the proper way to invest for my wife and I.

Even while I am a dividend growth investor, my strategy has changed over time. At first, I wanted the biggest yields. I used to think that settling for companies with low yields was silly when I could purchase shares of companies that yielded 5, 6, or 7%. I felt that the larger the yield, the larger the dividend reinvestment. What I didn't consider is that stocks with large yields often have those yields for a reason, usually deteriorating fundamentals which led to a large drop in share price. At that time, I didn't really consider dividend growth so much as dividend yield. I thought as long as a company raised their dividend each year, it wasn't important how much they raised it. This thinking led me to ignore companies like MasterCard (NYSE:MA), Visa (NYSE:V) and Starbucks (NASDAQ:SBUX). All of these companies pay yields of about 1% or lower but all have fantastic dividend growth rates over the last five years. They also have had really good capital appreciation over the past few years keeping their yields low. In the last two years or so, I've aimed my investment focus more at these types of companies. I've come to the realization that I shouldn't ignore a company just because I think that the yield is too low. I want to own shares in a company that dominates its sector of the economy and is dedicated to paying and raising a dividend even if the yields are lower.

Shift in Strategy

This brings me to my most recent shift in strategy. Prior to this past month, we used a combination of S&P Capital's twelve-month price target and current fair value and Morningstar's current fair value to determine which stocks were undervalued. A flaw that was pointed out by some readers in the comments section of the previous article is that this ignored how over or undervalued stocks were compared to their historical price to earnings multiple. Lucky for me, I already subscribed to F.A.S.T. Graphs and the answer on how to fix this problem was sitting right in front of me. What I like about how F.A.S.T. Graphs, as opposed to other financial websites, is that instead of displaying the trailing twelve-month price to earnings ratio, they provide a "blended" P/E. The blended P/E uses a combination of previous actual financial earnings and the most current estimate. The current P/E is then compared to the five-year average to see how much over or undervalued the stock is currently. From now on, I will compare the current price to earnings multiple with a company's five-year average. This valuation will then be used in combination with S&P Capital fair value and price target as well as Morningstar's fair value.

In addition to this change in strategy, I am changing how much I am willing to pay for a stock. Much of this change is due in part to Chowder's work here on Seeking Alpha. Whenever I read his articles, his investment ideas and thesis just seem to make sense to me. He argues that paying more for a stock than it currently is worth is justifiable if the company dominates its share of the economy. In tough economic times, investors will flee to the safety of companies that have long histories of paying and raising dividends. Companies like Johnson & Johnson (NYSE:JNJ), AT&T (NYSE:T) and Procter & Gamble (NYSE:PG) have multiple decades of paying and raising dividends. These companies have paid and raised dividends through a wide variety of economic times. They are all also considered overvalued by my investment criteria and thus not eligible for purchase. Investors have run up these stocks since the beginning of the year, in part because these types of companies offer solid, dependable dividends. If a company is considered safe and reliable investment, that is something I want to own shares of. Waiting for these companies to reach a point where they are not significantly overvalued might never occur.

I will always want to acquire shares of companies when they are undervalued, but I am willing to pay up to a 5% premium on companies that have raised their dividends for at least ten years. Companies that have shown dedication to rewarding shareholders with an annual raise for at least a decade are those that have been able to weather good and bad economic times. Going forward, companies with ten plus years of dividend growth will be eligible for purchase if they are no more than 5% overvalued by our criteria.

Shift in Portfolio Allocation

In a previous article, I discussed my wife and I's allocations for stocks and sectors. I aim to keep each stock at under 10% and each sector under 20% of our total portfolio. While that is still the case, I wanted to have a target allocation for each individual stock. Our portfolio consists of thirty stocks as well as a 403b through our employers. Here are the current allocations as of 3/27/2016 for each stock we own:

Ticker

% of Portfolio

MO

8.43%

GE

6.10%

JNJ

5.76%

T

5.43%

PM

4.22%

BA

4.00%

MSFT

3.99%

O

3.78%

VTR

3.76%

ABBV

3.74%

SBUX

3.28%

JPM

3.12%

VZ

3.02%

AFL

2.89%

KO

2.88%

CVX

2.84%

MA

2.78%

AAPL

2.37%

XOM

2.19%

TGT

2.14%

GILD

2.04%

COP

1.80%

CSCO

1.42%

PG

1.41%

CVS

1.29%

PEP

1.28%

LUV

1.26%

V

1.18%

MMM

0.61%

GIS

0.22%

403b

10.12%

Cash

0.64%

Click to enlarge

As you can see from this table, our top four stocks make up more than 25% of our total portfolio. That is a little too top heavy for us. While I won't be trimming these positions, I most likely will not be adding to them aside from reinvesting dividends. As far as the other holdings, I will consider 5% of the total portfolio as a full position. If a stock meets our investment guidelines and is under this 5% threshold, it is eligible for purchase. Currently, the only stocks that are above this 5% mark are Altria (NYSE:MO), General Electric (NYSE:GE), Johnson & Johnson and AT&T. A half position will be 2.5% of the total portfolio. My goal for the remainder of this year is to get as many positions as possible to at least a half position. This rule doesn't apply to our 403b through work because that part of the portfolio is really limited on options. I've chosen twelve different funds in this part of the portfolio.

Strategy in Action

The first purchased made using our updated investment strategy was Aflac (NYSE:AFL). Shares of the supplemental life and health insurance were purchased on Thursday, March 24th.

Purchase Price

F.A.S.T. Graphs Current PE

F.A.S.T. Graphs 5 Year Avg. PE

$63.17

10.1

9.6

S&P Capital 12-month price target

S&P Capital Fair Value

Morningstar Fair Value

$67

$71

$69

Click to enlarge

At the purchase price, Aflac is 4.95% overvalued based on F.A.S.T. Graphs' current blended price to earnings ratio when compared to the company's five-year average. Because the company has raised dividends thirty-three consecutive years, the company would be eligible to purchase because it is less than 5% overvalued using this metric. By the rest of the metrics, Aflac is undervalued. The company trades at a 6% discount to S&P Capital's twelve-month target price, 28.70% discount to S&P Capital's fair value and 14.66% discount to Morningstar's fair value. Add it all together and Aflac is 9.76% undervalued. That is more than good enough by our investment guidelines to make a purchase of shares. Prior to this purchase, Aflac was just 1.71% of our total portfolio. After the purchase, the company now represents 2.89% of the portfolio. Aflac is just over the half position threshold. Note: Morningstar has announced they will stop following Aflac as of 3/22/2016.

Conclusion

My investment philosophy has changed slightly since I began writing on Seeking Alpha. I have decided to include a company's blended price to earnings multiple versus its five-year historical average in our fair value calculations. This is found using F.A.S.T. Graphs. I've also shifted our purchasing guidelines so that I am willing to buy stock in companies that are no more 5% overvalued as long as they have at least ten years or more of dividend growth. In addition, a holding will be considered a full position when it accounts for 5% of our total portfolio. I don't arbitrary make adjustments to my investing strategy. Each change has been thought out and researched to make sure they accomplish what I am trying to do, namely having a portfolio of dividend-paying stocks to fund retirement. I feel that these changes will help to focus our investments going forward. Thoughts on this updated strategy?

Disclosure: I am/we are long AFL, V, MA, MO, JNJ, T, GE, PG, SBUX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.