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One year ago, I created the first of four dividend growth model portfolios, the Dividend Aristocrats+ model. So began a year of researching dividend growth stock strategies, the creation of three additional models, monthly performance tracking, and the development of rebalancing and stop-loss strategies. I thought this would be a good time to reflect on my learning from these efforts and the future of these models.

Background

My original goal was to create an income-oriented portfolio with lower price volatility that was easy to create and maintain; a portfolio that my parents or others with limited investment experience could understand and feel comfortable with. The Dividend Aristocrats were an easy place to start. The response to this article was amazing and motivated me to continue researching dividend stock strategies. I was also introduced to David Fish's CCC stock list, which has become an invaluable resource.

I found a UK research paper that showed sub-groups of dividend growth stocks outperformed the overall market, including stocks with longer dividend growth histories, smaller market capitalization, higher yields, and not the highest dividend growth rates. A more detailed summary can be found here. From this research, I developed Income Growth and Small Cap dividend growth portfolios.

The final portfolio was started in January of this year, after reading some research on the outperformance of high-yield, low-payout stocks. This research made so much sense! Income investors want a good yield and to know that the dividend is well covered by earnings and cash flow. In addition, because of the relationship between dividend, price, and earnings, stocks with high yield and low payout will have a low PE, indicating a value stock.

Performance

Going into this venture, my expectations were that the models would have lower volatility than the overall market and hopefully, would outperform the market as the research suggested. Honestly, I would have been happy if they outperformed on a volatility-adjusted basis. The first year results did not disappoint. All of the models, except the high-yield, low-payout portfolio, which didn't start until January 2012, had higher total returns than the S&P 500 (SPY) in both absolute and volatility-adjusted terms. All of the models also had lower betas and their yields were 3.5% or higher when created.

I wasn't surprised to see dividend growth stocks with lower volatility than the SPY. I was surprised that all of them outperformed the SPY on an absolute total return basis. I'd love to credit the performance to choosing from the dividend-growth universe; the screens of yield, dividend growth rates, earnings growth, and payout ratio; and the sector weightings and equally weighted holdings. If we start with a solid group and then select the cream of that crop, we should get good results, right? The time frame was just one year though, so we'll see if these positive results continue in the future.

I was also surprised by some of the strongest performers. Who would have thought that some of the top performing dividend stocks would be utilities, mature large-caps, and a REIT with a low dividend growth rate? The table below highlights the total return of these stocks since inception; the August 2011 prices are adjusted for dividends. While I like each of these companies, and have owned two of them in the past, left to my own devices, I may not have chosen them. There are others with higher yields, or higher dividend growth rates. This shows that the "boring stocks" can surprise you, so don't ignore core-holding stocks.

Stock

Ticker

Aug 16, 2011

Aug 23, 2012

% Chg

Sempra Energy

(SRE)

$47.43

$66.95

+41.2%

Plains All-American

(PAA)

$57.75

$86.48

+49.7%

Realty Income

(O)

$31.12

$41.84

+34.4%

AT&T

(T)

$27.21

$36.56

+34.4%

Wal-Mart

(WMT)

$50.64

$71.56

+41.3%

Portfolio Monitoring

The UK research created passive baskets of stocks, though stocks that cut their dividend were dropped, and rebalanced annually. While my models were meant as benchmarks and sources for stock ideas that readers could pick and choose from, I had reservations about having them be completely passive. By the time a dividend is cut, the price has already declined. While the models are appropriate for income investors, my personal goal is to outperform in total return, so I wanted to avoid losing capital.

Fortunately, my MBA capstone project involved research on dividend cutters and the beginnings of a model for predicting the cuts in advance. However, the model was only 65% accurate and involved some calculations. I wanted something simpler, so I examined price changes relative to the SPY and found that many dividend cuts were preceded by a -20 basis point gap between the stock's performance and the SPY's. Further active research found that this rule didn't always hold as a dividend cut predictor, but it was rather good at avoiding additional price declines. This led to the implementation of a stop-loss rule for the portfolios.

Since inception, four stocks have been replaced because they triggered the stop-loss rule. So far as a group, the replacement stocks have dramatically outperformed the original holdings, reinforcing my confidence in using this rule:

  • Natural Resource Partners (NRP) is a coal MLP. Since it triggered the -20% stop-loss on January 3, 2012, the stock is down 18%. It was replaced with Magellan Midstream Partners (MMP), a pipeline MLP, which has increased 24%.
  • Atlantic Tele-Network (ATNI) provides wireless voice and data services. The stop-loss occurred on March 23, 2012. ATNI is down 0.1% since then. It was replaced by Verizon (VZ), which is up 9.8%.
  • Alliance Resource Partners (ARLP) is another coal MLP. Its decline was due in part to perceived concerns regarding proposed legislation that would halt new construction of coal-fired plants, as well as general economic recovery concerns. It has since recovered from its lows, but as it triggered the stop-loss on March 9, 2012, it was sold. ARLP is down 3.3% since then. It was replaced with MMP in one portfolio and Sunoco Logistics Partners (SXL) in another. They are up 16.0% and 16.6% respectively.
  • NTT DoCoMo (DCM) is a telecom provider in Japan. It also triggered the stop-loss on March 9, 2012. It is the one exception, delivering a gain of 1.2% since being sold. DCM was replaced by China Mobile (CHL), which up until a week ago was outperforming it. Due to lackluster earnings growth in its latest quarterly report, CHL is now down 1.6% since being added to the portfolio.

Portfolio Rebalancing

More recently, I have been thinking about the frequency for rebalancing the portfolios. Initially, I was going to just rebalance them annually, as the research study did. However, I had concerns about being too passive with these portfolios, as recent years have been volatile and I didn't want to miss opportunities to improve the income stream or capture gains from overvalued holdings and reinvest them in higher-yielding, undervalued alternatives. This seemed particularly important for the high-yield, low-payout portfolio, as a run-up in price could reduce the current yield enough that the stock would really be "high-yield" anymore. With the CCC list, I was confident in finding alternative stocks that would meet my screening criteria and offer higher current yields; there's always an option! Therefore, I chose to rebalance the high-yield, low-payout portfolio after six months.

Earlier this month, I was sent a research paper that discussed how rebalancing value portfolios enhanced returns. I analyzed the performance of my rebalanced portfolio versus the original holdings and found that just one month later, the rebalanced portfolio was outperforming by 1.4%. Based on these initial results, I have decided to rebalance the Income Growth model at the end of this month (seven months since last rebalance). Since the Small Cap model has a rebalance scheduled in three months, I will wait until then for that portfolio. I will adjust the screening criteria slightly to more formally include payout ratio, PE, and/or earnings growth to ensure that the models maintain a value focus while pursuing high yields and dividend growth rates. The Dividend Aristocrats+ fund has such a limited universe that I'm not sure rebalancing will be worthwhile and it was meant to be simple. This model has a scheduled rebalance in four months, so again, no action at this time.

Summary

I have learned a lot from the research articles, the practical application of that research via these four dividend-growth models, and the discussions with SA community members. While the research articles strengthened my confidence in dividend-growth investing, nothing beats practical application and seeing the results. I'm very pleased with the first-year results, and believe that the stop-loss and rebalancing schedule will be beneficial to the portfolios. I hope that readers have found value in the models' screening processes and in the portfolio stock lists. I look forward to the second year and hope to see continued outperformance by these dividend growth investment strategies.

Source: One Year Anniversary Reflections For Dividend Growth Model Portfolios