How To Build A Dividend House: Which Stocks Go Where?

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Includes: AAPL, ABBV, AMGN, BBL, CMCSA, DEO, DIS, ED, GILD, IBM, JNJ, KMB, KMI, KO, LMT, MAIN, MAT, MMP, MO, NKE, OHI, PG, SBUX, T, TUP, WFC, WMT
by: Dividend House
Summary

In response to a question about how I build our Dividend House DGI portfolio, I decided to review our classification of each stock.

As part of this analysis, I updated the Dividend House rating system adding a ninth step – rating a stock’s long-term debt-to-equity ratio.

Each stock’s position in our portfolio reflects the level of confidence I have in its future dividend growth stream.

The result? I am launching “Project: Shore Up the Foundation!” to bolster the dividend income generated by our core stocks, particularly those from defensive sectors.

I hope this discussion helps you think about how you are constructing your own DGI portfolio, including where renovations may be needed!

I was recently asked an architectural design question about building a Dividend House. Specifically, what guidelines do I use to determine if a stock belongs in our Dividend House's foundation, walls, or roof?

To classify each stock in our portfolio, we ask the following questions:

  • What role should this stock play in our portfolio?
  • Should this stock be a core, supporting, or auxiliary position?
  • Is this stock underperforming our objectives for it? Should it be placed in our doghouse?
  • Are we expecting significant growth from this dividend stock? Should it be classified as speculative and placed in our garden to grow?

This article discusses how we classify each stock that we own (or have already decided to purchase) in our portfolio. Each stock is assigned one of five categories in our Dividend House portfolio: core, supporting, auxiliary, "in the doghouse," or speculative. How confident we are about the growth of a stock's future dividend stream determines the role we assign it to play in our DGI portfolio.

Dividend House -- Architectural Guidelines

Before I launch into how I classify each of our holdings, you should be aware of the key dimensions of our Dividend House. Below I've included our architectural planning guidelines.

  • For each new purchase, the minimum dividend yield should be >2.7%.
  • No one individual holding should be weighted >5% of the portfolio's total market value or weighted >5% of the portfolio's total dividend income.
  • No individual defensive sector (i.e., utilities, healthcare, consumer staples, or telco) should generate >20% of the portfolio's total dividend income.
  • Defensive sectors in aggregate should generate >50% of the portfolio's total dividend income.
  • No individual non-defensive/cyclical sector (i.e., industrials, REITs, consumer discretionary, financials, energy, materials, and technology) should generate >15% of the portfolio's total dividend income.
  • Investment grade holdings >BBB+ should generate >90% of the portfolio's dividend income.
  • Investment grade holdings >BBB- should generate 100% of the portfolio's dividend income. (In other words, do not invest in junk bond rated stocks!)
  • In aggregate, core, supporting and auxiliary holdings should generate >90% of our portfolio's dividend income.

All of the above architectural guidelines are easily quantifiable -- except the last one. How do we decide which stocks are core, supporting and auxiliary holdings? In other words, which stocks belong in our house's foundation, which in the walls, and which on the roof?

Classifying Stocks in the Dividend House Portfolio

Keeping in mind that I am presenting guidelines (not laws set in stone!), here's how I classify the stocks in our portfolio. I'll also discuss notable exceptions I've made to these guidelines. I'm using this opportunity to reposition the stocks in our Dividend House portfolio. Here's a preview -- BHP Billiton (NYSE:BBL) is falling off the roof and landing in our doghouse!

Core Positions (the Foundation). Since it is easier to replace a shingle on a roof than to fix a cracked foundation, our core stocks are our rock solid choices. We look for dividend champions that weathered both the Great Recession and the 2001 market pullback while growing their dividends. Core stocks are our buy-and-hold forever stocks.

While some of our core holdings deviate from the guidelines below, ideally every foundational stock fulfills the following criteria:

  • Dividend Champion - consistent dividend growth history of >25 years
  • Investment grade credit rating of A- or better
  • Dividend payout ratio <100% and less than its industry average
  • Long-term debt-to-equity ratio <1.0 and less than its industry average
  • Market beta of <1.0
  • Portfolio Objectives.
    • Core holdings in aggregate (i.e., the stocks in the Dividend House foundation) should generate >50% of our portfolio's dividend income
    • Given a portfolio of between 50 and 75 stocks, a full position in an individual core stock should generate between 2.5% and 4% of our portfolio's total income.

Due to the greater stability they generally represent, defensive sectors (such as utilities, consumer staples, healthcare and telecoms) should be over-represented in our foundation. Natural building blocks for a Dividend House portfolio foundation include Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Kimberly Clark (NYSE:KMB), Coca-Cola (NYSE:KO), Altria (NYSE:MO), AT&T (NYSE:T), and Consolidated Edison (NYSE:ED).

Supporting Stocks (the Walls). Built atop our solid foundation, our walls should be comprised of strong Dividend Champions and Contenders whose dividend growth records include successfully weathering the Great Recession.

While some of our supporting positions deviate from the guidelines below, ideally every supporting stock fulfills the following criteria:

  • Dividend Contender - consistent dividend growth history of 10-24 years, or Dividend Champion - consistent dividend growth history of >25 years
  • Investment grade credit rating of BBB+ or better
  • Dividend payout ratio is <100%
  • Long-term debt-to-equity ratio <1.0
  • Market beta of <1.2
  • Portfolio Objectives:
    • In aggregate, supporting holdings (i.e., stocks in the Dividend House walls) should generate ~25% of our portfolio's dividend income
    • Given a portfolio of between 50 and 75 stocks, a full position in an individual supporting stock should generate between 1.5% and 2.5% of our portfolio's total income.

Contender/Champion industrial cyclicals, like Lockheed Martin (NYSE:LMT); our only technology holding, International Business Machines (NYSE:IBM); and REIT, Omega Healthcare Investors (NYSE:OHI), are good examples of supporting stocks that help us build strong walls.

Auxiliary Stocks (Shingles on the Roof). Our auxiliary stocks are holdings in which we have confidence, but they generally have shorter dividend growth track records than either our core or supporting positions. Some of them may have stumbled during the last recession, may be more volatile than average (with high market betas), and/or may be facing vigorous currency headwinds (particularly foreign stocks). Often the market-leaders of less stable sectors are represented here.

  • Dividend Challenger - consistent dividend growth history of 5-9 years, Dividend Contender - consistent dividend growth history of 10-24 years, or Dividend Champion - consistent dividend growth history of >25 years
  • Investment grade credit rating of BBB or better
  • Dividend payout ratio <100%
  • Long-term debt-to-equity ratio <1.0
  • Portfolio Objectives:
    • In aggregate, auxiliary holdings (i.e., stocks on the Dividend House roof) should generate ~15% of our portfolio's dividend income
    • Given a portfolio of between 50 and 75 stocks, a full position in an individual auxiliary stock should generate between 0.5% and 1.5% of our portfolio's total income.

Shingles for our roof include Wells Fargo (NYSE:WFC) which cut its dividend due to the Great Recession, Diageo (NYSE:DEO) whose dividend (at least in US dollars) decreased due to currency headwinds in 2015, and master limited partnership Magellan Midstream Partners (NYSE:MMP) in the highly volatile energy space.

Stocks "in the Doghouse." Unfortunately, not all stocks perform as anticipated. Stocks in our doghouse are either

  1. Not performing as expected, e.g., Wal-Mart (NYSE:WMT) with its anemic dividend growth, Mattel (NASDAQ:MAT) with its dividend freeze, and Tupperware (NYSE:TUP) with its emerging market headwinds, or
  2. The dividend is in danger or has undergone a recent cut, like BHP Billiton, whose dividend is in danger, and Kinder Morgan (NYSE:KMI) who recently cut its dividend a whopping 75%. My most recent article entitled, "Which of Your DGI Holdings Could Threaten Your Income?" provides an approach to determining which dividends could be at risk.

If I had to sell a stock, I'd look at my dogs in my doghouse first! But, because I prefer to buy-and-hold, I am waiting out downdrafts to see if these stocks can perform well enough to go back into the Dividend House. For example, if Kinder Morgan doesn't eliminate its dividend, if it doesn't go private, and if the price of oil finally bottoms, then KMI should end up back on the roof one day. (That's a lot of "if's"!) On the other hand, there are some industries, like toys, where I have decided I will sell when I can get out whole. I am still evaluating whether or not Materials is a sector that I want to be in forever.

I like to think that having a few stocks in the doghouse demonstrates that I am continuing to learn about my own risk tolerance and the corresponding sectors and stocks in which I am comfortable investing. It's hard to know when you cross your personal risk tolerance line -- until you cross it. Making some purchase "mistakes" has helped me clarify my personal risk tolerance level as it causes me to think more deeply about my investments. I am glad that I am learning this now -- a few years before I am retired.

Speculative Stocks (Flowers Growing in the Garden). Generally speaking, our speculative positions are meant to be our DGI "growth" stocks. Ideally, stocks in this category have dividend yields below our portfolio minimum of 2.7%. But they have a forecast 4-year dividend compound annual growth rate of 10% or higher to make up for it. We currently have only one example of a growth stock in our garden: Comcast (NASDAQ:CMCSA). When (or if!) our portfolio generates more income than we need in retirement, we plan to consider adding to our speculative holdings with lower-yielding, higher growth DGI stocks, such as Disney (NYSE:DIS), Apple (NASDAQ:AAPL), Nike (NYSE:NKE), or Starbucks (NASDAQ:SBUX).

In addition, we consider BDCs and Biotechs to be speculative holdings. Since BDCs loan money to fledgling companies that banks won't touch, I consider all BDCs to be speculative. Our only BDC holding, Main Street Capital (NYSE:MAIN), belongs here as does our only Biotech, AbbVie (NYSE:ABBV). Lower-yielders Gilead (NASDAQ:GILD) and Amgen (NASDAQ:AMGN) are on our watch list.

How to Build a Dividend House

As in building an actual house, we believe that it is best to initiate building a Dividend House portfolio from the ground up. That is, first, you purchase your foundational or core stocks. Then, you add the walls (supporting positions). Finally, you put your roof on (with auxiliary stocks). As noted above, if you are close to retirement, you might consider holding off on investing in speculative holdings until your portfolio exceeds your income objective.

This approach has the following advantages:

  • Your portfolio produces a stable, growing dividend stream immediately.
  • You can build your confidence in dividend growth investing by starting with the most conservative choices first.
  • By comparing all potential stock purchases to the most conservative choices already in your portfolio, hopefully, you can curb any appetite to chase sucker yields!

Every so often, you should review your Dividend House to see if it needs any renovations. I don't mean that you need to think about buying or selling stocks. (I agree with those who think churn is a bad idea for a portfolio. As a result, I am loathe to sell even underperformers. They may have to underperform for several years while their sector is doing well, before I am ready to let them go!)

What I mean by renovations is reviewing your Dividend House to confirm that your stocks are indeed playing the roles that you expected. Unfortunately, some of your positions may be disappointing you, earning a downgrade to the doghouse. Others may have proven themselves more reliable than you first thought, achieving an upgrade to a supporting or core position. It is important for you to reaffirm how confident you feel about each stock in your portfolio, so that you know which stocks you want to buy more of, when you have the funds!

So, how do I classify which stocks are in which categories? To help classify each stock, I developed a Dividend House rating system. For those of you who are already familiar with my rating system, you will note that I have added a ninth step -- analyzing a stock's long-term debt-to-equity ratio. This bestows higher ratings on stocks that have a more conservative balance sheet -- a must in difficult economic times! I rate each stock in our portfolio against the nine Dividend House Rating System steps and chart it against the number of consecutive years each stock has increased its dividend.

The 9 Steps of the Dividend House Rating System

  1. How many years of continuous dividend increases does the stock have? ½ house for 5-7 years (for making it onto the CCC list), 1 house for 8-9 years (for making it through the Great Recession), 2 houses for 10-24 years (Contenders), and 3 houses for 25 years or more (Champions).
  2. What is the stock's yield? ½ house for 2.7% or above (our portfolio minimum), 1 house for 3% or above, 2 houses for 4% or above, and 3 houses for 5% or above.
  3. What is the stock's payout ratio? 1 house for less than 80%, 2 houses for less than 70%, 3 houses for less than 60%.
  4. What is the stock's historical 5-year dividend growth rate (DGR)? 1 house for 4% or more, 2 houses for 6% or more, 3 houses for 10% or more.
  5. What is the stock's Chowder number?
    • For "regular" stocks with under a 3% dividend yield, 1 house for 15 or more, 2 houses for 18 or more
    • For "regular" stocks with a 3% or more dividend yield, 1 house for 12 or more, 2 houses for 15 or more
    • For REITs, utilities, telecoms, and BDCs, 1 house for 8 or more, 2 houses for 10 or more
  6. What is the stock's anticipated forward 4-year DGR? 1 house for 4% or more, 2 houses for 6% or more, 3 houses for 10% or more.
  7. What is the stock's beta? ½ house for a market beta less than one.
  8. What is the stock's credit rating? 1 house for BBB, 2 houses for BBB+, 3 houses for A- or better.
  9. What is the stock's long-term debt-to-equity ratio? 1 house for a debt-to-equity ratio <100%.

Given the above formula, theoretically, the lowest rating a stock can earn is 0 houses and the highest rating is 21½ houses.

Below are the ratings for the 65 stocks in the Dividend House portfolio, sorted by sector. The sources I used are FastGraphs, Fidelity Research and Yahoo Finance. If a cell is highlighted in orange, it means that the stock earned a zero for that particular criteria.

Dividend House Ratings

Below is a scatter plot that charts each stock's Dividend House rating versus the number of consecutive years each stock has increased its dividend. To help classify our portfolio's stocks, you will note that I have included gray areas (a la FastGraphs) that illustrate the two most recent significant stock market pullbacks: the Great Recession of 2008-2009 and the pullback in 2001.

A stock's initial position in the Dividend House is suggested by its placement on the chart above. However, I also reflect on a business' story within its sector. This can change my confidence level in a stock and, thus, its position in the Dividend House portfolio. Resulting from this due diligence is a picture of our current Dividend House portfolio below.

While the scatter plot suggests a starting position of a stock in our Dividend House, I have made some notable exceptions based on sector preferences (as well as a few individual adjustments on a case-by-case basis).

Utilities. Since people continue to pay their electric bills even after they have lost their jobs, utilities tend to comprise a defensive, stable sector. So, even though most of the utilities in our portfolio are dividend contenders (rather than champions), I have placed all of the utilities in our foundation.

Energy companies. With the exception of Exxon Mobil (NYSE:XOM) in our foundation and Chevron (NYSE:CVX) in our walls, all of the other energy companies in our portfolio are on the roof due to the fierce pressures currently facing the sector. Specifically, all of our MLPs are on our roof, except KMI. KMI's recent dividend cut has placed it in the doghouse.

REITs. I love real estate! In addition to owning several rental properties, I own REITs. But, due to their leveraged operating models and relatively high cash distributions, I am cautious about investing in this sector. As a result, the only REIT that I have placed in our foundation is Realty Income (NYSE:O). This is true even though W.P. Carey (NYSE:WPC) and HCP (NYSE:HCP) chart in foundation territory. WPC and HCP may eventually earn their way into our foundation. But HCP's issues with its Manor Care tenant need to be fully resolved first and WPC's expected reorganization in 2016 will need to be judged as a positive development for the holding.

You will note that most of our REITs play a supporting role in the portfolio (in the walls). The only exceptions are Realty Income (as noted above) and recent Ventas (NYSE:VTR) spin-off, Care Capital Properties (NYSE:CCP), which I've placed on the roof (where it charts).

Conclusion

This analysis has either reaffirmed or repositioned each holding in the Dividend House portfolio, based on the level of confidence we have in the expected future dividend growth stream of each stock.

Unfortunately, our dividend income from stocks in the defensive sectors (i.e., consumer staples + utilities+ telecom + healthcare) amounts to only 48.2% of our portfolio's total dividend income. This is shy of our > 50% target, reminding me to continue to purchase quality foundational stocks from these four sectors as my top priority. I call this "Project: Shore Up the Foundation!" For example, I would love to purchase Alliant Energy (NYSE:LNT), if its price cooperates.

Reinforcing this chief takeaway that strengthening our portfolio's foundation is job #1 is the fact that our core holdings drive only 48.6% of our portfolio's total dividend income. Once again, this is shy of our goal to have > 50% of our portfolio's dividend income generated by our core holdings. This underscores why "Project: Shore Up the Foundation" must be my top priority!

The good news is that, even with KMI and BBL moving into the doghouse, our Dividend House (i.e., core + supporting + auxiliary stocks) is still producing 91.5% of our portfolio's income. This exceeds our goal of at least 90% of our portfolio's income being generated by the stocks making up the house itself.

I hope this analysis helps you think about how you are building your own DGI portfolio.

Where are you focusing your own portfolio's renovations in 2016?

Disclosure: I am/we are long ABBV, ALU, AVA, BBL, BMY, CAT, CBRL, CCP, CLX, CMCSA, COP, CVX, D, DE, DEO, DLR, DUK, ED, EMR, EPD, GAS, GE, GIS, HCP, IBM, JNJ, KHC, KMB, KMI, KO, LMT, MAIN, MAT, MCD, MMM, MMP, MO, NEE, O, OHI, OMI, PEP, PFE, PG, PM, SCG, SEP, SO, SYY, T, TGT, TUP, UL, UPS, VOD, VTR, VZ, WEC, WFC, WMT, WPC, WTR, XEL, XOM, ZMH. 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.