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In a seeming contradiction to the article: How Not to Re-Balance Your Stock Portfolio, I will explain how regular re-balancing, when done right, can lead to excess gains in a dividend growth strategy.

Dividend Growth Investing

Dividend growth investing has been gaining popularity of late. The stock selection method is simple and the rationale behind it is fairly obvious. Choose dividend stocks with a track record of increasing dividends. This provides an income stream that can be continually re-invested for a compound growth-like effect. This stalwart dividend policy will encourage income-oriented shareholders to stay invested during difficult times, which should lead to a more stable share price, at least in theory.

Are dividend growth stocks really that superior? I have some 'survivorship bias free' back-tested results that I will be releasing in a following article, but suffice to say that dividend growth stocks do perform better on average, but a lot depends fundamental valuation. More on that later.

Value vs. Growth Stocks

Growth stock investors are willing to pay a premium for stocks that are rapidly increasing their earnings, revenue, asset value and dividends. This premium comes in the form of higher valuations, which is a common method of separating growth or glamor stocks from value stocks.

Value stock investors may argue that larger initial income streams are more important than a higher (and unsustainable) dividend growth rate of glamor stocks. As well, you sometimes get the unexpected surprise of having valuations increase as the stock comes back into favor.

Here is one notable finding in the Rebalancing and the Value Effect paper:

  • While growth stocks enjoy faster dividend growth than value stocks, value portfolios that are regularly re-balanced enjoy faster dividend growth than growth portfolios.

Are they contradicting themselves? How can a portfolio of growth stocks be worse for dividend growth than a single stock? The answer lies in re-balancing.

Value vs. Growth Portfolios

If you were stuck on a desert island and could only bring one dividend stock to hold forever and your goal was to make the most money from dividend growth, your best bet would be a growth stock. But if you had to re-balance your portfolio regularly and were only allowed one broad category of dividend stock, your winning portfolio would be value stocks. Why?

Growth stocks have faster growing dividends when held long-term. But what happens at re-balancing time when your growth stock has increased total dividend income (and usually yield - this is important) and now has deeper value than before? You dump it for another low-yielding growth stock with a rapidly increasing dividend. This works against your goal of gaining a large pot of cash from dividend growth.

Consider how this works:

  1. Value stock ABC has a yield of 3% and a dividend growth rate of 3%. Share price is $100. After 20 years, a total of $83.03 of dividends is collected. $60 of that could be attributed to the original yield and a remaining $23.03 comes from dividend growth.
  2. Growth stock XYX has a yield of 1% and a dividend growth rate of 15%. Share price is $100. After 20 years a total of $117.81 of dividends is collected. $20 of that could be attributed to the original yield and a remaining $97.81 comes from dividend growth vs. $23.03 of the value portfolio.
  3. At year 10, they are making almost exactly the same annual income from dividends ($4.03 - $4.04 per share).

Now assume we only re-balance once during the entire 20 years. At year 10, the growth portfolio has $4.04 in current annual income where the average yield has increased up to 2%. We sell our stocks and buy another portfolio of dividend growth stocks with high metrics and we are reset back to a 1% yield. Our income is cut in half. By the end of the 20 years, we have lowered our dividend growth portion of the gain to $53/share.

The stocks in the value portfolio are replaced with stocks that have deeper value at year 10. If these were replaced with stocks which had 50% larger yields (e.g. yields had fallen to 2% and you replaced them with 3% yields again), the re-balance would have a compounding effect on dividend growth. $44.20 per share could be contributed to dividend growth.

While the value portfolio still has not yet captured the growth portfolio, it would quickly surpass it with more frequent re-balancing instead of once a decade. As well, our initial 20 years of 'buy and holding' assumed a constant 15% dividend growth rate for growth stocks, which is unlikely.

Putting It Into Practice

To illustrate how this works, we will use the Dogs of the Dividend Aristocrats Portfolio. How has the S&P 500 Dividend Aristocrat Index performed over the past five years (50 companies with a history of at least 25 annual dividend increases in the S&P 500 index)?

Click to enlarge

  • 1 year total return 10.3%
  • 3 year total return 21.05%
  • 5 year total return 5.21%

I create a simple strategy of targeting stocks with higher total yields (thus deeper value), higher yield compared to its own 5-year average and some other valuation ranking mechanisms to ensure I am not buying a sick horse. Below are the stats using various re-balancing periods. The effects of compounding dividend growth is included in the total returns and not separated at this time. There may also be positive capital gain effects to our re-balancing strategy.

No Re-balancing

  • 1 year total return 10.45%
  • 3 year total return 62.65%
  • 5 year total return 37.86%

Annual Re-balancing

  • 1 year total return 10.45%
  • 3 year total return 68.85%
  • 5 year total return 38.99%

Semi-Annual Re-balancing

  • 1 year total return 4.53%
  • 3 year total return 71.39%
  • 5 year total return 38.99%

While the short-term effects of such a strategy are less obvious, we can see an increasing return over longer periods of time. But why limit ourselves to a rigid re-balancing interval that does little to maximize valuation? Would it not be more prudent to have individual selling triggers once valuations rise and replace with the deeper value counterparts then? We adopt a strategy where we sell if the total yield falls in the bottom half of the index, or when yield relative to 5-year average falls into the bottom half of the index. Also, if our other valuation ranking plummets we have a mechanical sell rule.

Dynamic Re-balancing

  • 1 year total return 8.64%
  • 3 year total return 92.7%
  • 5 year total return 152.61%

In addition to this, our portfolio turnover is only about 200%, which is similar to our semi-annual re-balancing even though we monitor our stocks weekly for a more timely transaction. The chart below shows how $100 invested using this strategy (red line) would have fared since 1999 next to the S&P 500 (blue line).

Chart compliments of Portfolio123:

Dogs of the Dividend Aristocrats in 2012

What were/are some of the stocks in this portfolio? Let's walk through a few examples this year:

On January 1, 2012, the portfolio consisted of the following stocks:

Symbol

Name

(ABT)

Abbott Laboratories

(AFL)

Aflac Inc.

(CLX)

The Clorox Company

(EMR)

Emerson Electric Co.

(ITW)

Illinois Tool Works Inc.

(JNJ)

Johnson & Johnson

(PEP)

Pepsico Inc.

(PG)

Procter & Gamble Co.

(SYY)

Sysco Corp.

On February 6, the stock ITW was sold after the dividend yield fell as prices jumped up 22% after six months of holding.

Due to fundamental ranking restrictions, it wasn't until March 12 that Pitney Bowes Inc. (PBI) was added and Wal-Mart Stores, Inc. (WMT) on April 30.

  • Pitney Bowes proved to be a disappointment despite deep value and was dropped due to a nose-dive in fundamental quality on July 16. This resulted in a loss of over 23% once you account for the dividend payout.

  • Wal-Mart was only held for 21 days when relative yields (compared to 5-year averages) fell into the bottom half of the Dividend Aristocrat index. This was a quick 6.7% gain if you include the dividend payment, as the stock was held on the ex-dividend date. Prices have since risen another $10 per share, but those profits are not realized under this strategy.
  • Walgreen Co. (WAG) was purchased on June 4, 2012 and is sitting on a 14% profit position.
  • Abbott was sold after being held for 7.5 months for a total return of 18%.
  • Proctor & Gamble was picked up July 9 and has returned over 6% in that short period of time.

Stay tuned for future articles where I will highlight how this approach works with a much higher alpha group of dividend growth stocks and some hard numbers for how much real money dividend growth stocks have returned on average with data that is free of survivorship bias. But today, we have made the case for re-balancing your dividend growth portfolio provided you are buying deep-value stocks or hanging on to your high-growth (glamor) dividend stocks for a long-time without re-balancing to let compound gains work in your favor.

Source: How To Maximize Gains In A Dividend Growth Portfolio