A Dividend Growth Portfolio For Total Return Investors

Summary

• Research has shown that dividend growth stocks have historically outperformed the S&P 500 with less volatility, making them an excellent long-term vehicle for total return investors.
• Applying filters to financial metrics can narrow the dividend growth stock universe to higher-quality companies with high dividend growth rates, two factors shown to contribute to strong total return.
• Portfolio selections are also influenced by macro-economic trends including population, technology, and interest rates.
• I share my Dividend Growth Total Return model portfolio, which has gained 11.5% versus 7.2% for the S&P 500 TR through April 30, 2017.

Background

It's been about four years since my last Seeking Alpha article. From July 2011 to June 2013, I wrote many articles focused on dividend growth stocks, highlighting research that demonstrated the outperformance of dividend growth stocks compared to the S&P 500 and subgroups of the dividend growth universe that drove this performance. This work led to the creation of four model portfolios that I maintained and tracked, such as the High-Dividend-Growth/Low-Payout-Ratio portfolio. In 2013, I had the opportunity to join an RIA and manage a dividend growth portfolio for its clients, which is why I stopped writing for SA. Overall, that portfolio had a slight growth stock bias (e.g. underweighted utilities and higher-yield) yet performed very well, especially considering the declines in interest rates that favored value stocks and the energy price collapse. Over 3 years, the portfolio had annualized returns of 9.46% vs. 8.87% for the S&P 500, and it nearly matched the S&P 500 over 5 years (2 years were based on my SA income model portfolio), 14.40% vs 14.65%, with 0.85 beta.

Having left finance and returned to healthcare analytics, I look forward to engaging more with the Seeking Alpha community and sharing my experience. From my observations, I've noticed that there are many DG portfolios being tracked online now, but not many focus on total return investors or provide some higher-level narrative and research to explain the portfolio decisions. I hope to address both areas. Looking at my holdings and the portfolio I managed, I own a mix of higher-yield core and lower-yield higher-growth stocks. I thought it would be interesting and informative to create a portfolio representing the latter half for those interested more in total return. The following sections will outline the Dividend Growth Total Return (DGTR) portfolio's rationale, construction, and year-to-date results and statistics. The portfolio inception date was January 1, 2017.

Why Focus on Higher Dividend Growth vs Yield?

In the research I've previously reviewed, both high dividend growth and high dividend yield were cited as factors leading to above average total return. So why am I more focused on dividend growth? Ultimately, higher stock prices and higher dividends come from higher earnings, so I'm interested in earnings growth potential. Strong dividend growth, regardless of yield, can serve as a proxy for stronger earnings and management's commitment to shareholders.

This doesn't mean a high-yielding dividend stock can't meet a total return goal. However, with interest rates near historic lows, I believe higher-yield, slower-growth stocks are generally overvalued. Familiar core companies, such as Procter & Gamble (NYSE:PG) and Coca-Cola (NYSE:KO), trade at high PE ratios with mid-single-digit earnings growth expectations. There are other stocks trading at PE ratios over 23 (or even better, below 23) with higher growth prospects. The graph below from Santa Barbara Asset Management confirms that dividend yield is more expensive than dividend growth.

In addition to overvaluation, interest rates are expected to continue rising, assuming continued economic growth. As rates normalize, I expect the premium being paid for higher-yield core stocks to be reduced. While income-focused investors may not be concerned with this price reduction - they may even be glad, as they can acquire more shares at a lower price - it spells underperformance for a total return investor. Stocks with higher dividend growth, which generally means stronger earnings growth, tend to fare better in a rising rate environment, as shown in this chart from Goldman Sachs.

Screening the Dividend Growth Universe

This section outlines my screening process for the DGTR portfolio, which relies on David Fish's CCC list so as always, a BIG thank you to him for putting it together each month! This process narrowed the list of nearly 800 dividend growth stocks with at least 5 years of dividend increases to under 200. Final selections included consideration of macro-economic trends, a focus on industry leaders, and other factors; I also made a couple of "overrides."

• Dividend Growth: I started with the December 31, 2016 CCC list and removed stocks with dividend growth rates ((DGRs)) that did not meet the following thresholds: 1-yr (7%), 3-yr and 5-yr (7.5%). While I expected the final portfolio to have a dividend growth rate over 10%, I didn't want to be too restrictive with my initial list of prospects.

• Beta: Based on research indicating outperformance of low volatility stocks, I removed stocks with a beta over 1.7. Given that I am constructing a growth-focused portfolio, I expected the portfolio beta to be closer to 1.0 than the 0.80 of my balanced DG portfolio models and planned to include few stocks with betas over 1.5. However, I didn't want to be too restrictive as owning a couple of high beta stocks would not have a large impact on the portfolio beta.
• Earnings: I sought out companies with next-year earnings growth expectations of at least 4% and 5-year earnings growth projections of 5%. These values are above GDP expectations for the U.S. and the latter, when combined with a 2% yield, delivers a 7% return. 7% is the midpoint of Vanguard's 10-year forecast for US Equity returns, though I aim to exceed this target. I used a lower cutoff for next year's growth as the U.S. economy is still recovering and the government has yet to pass significant pro-business legislation (e.g. lower taxes).
• Yield: While I am focused on total return, there is research suggesting that the lowest yielders underperform. I set a floor of 0.75% to remove lower yielders with the expectation that the final portfolio would yield around 2%, so I don't plan to own too many very low yielders. I also reviewed the payout ratio when making selections, as lower payout ratios provide more room to support higher dividend growth.
• PEG: To screen for valuation, I use the PEG ratio, which combines the Price/Earnings or PE ratio with the company's expected Earnings Growth rate. A PEG of 1.0 indicates that the PE ratio equals its growth rate. With the post-election run-up, it was harder to find stocks in the 1.0-1.5 PEG range. My goal was for the portfolio to have a PEG under 2.0. I removed stocks with a PEG greater than 2.75. I ignored PEG for REITs, as this metric becomes skewed due to the impact of depreciation on earnings.

In addition to these metrics, I favored leading companies (Top 5, often #1 or #2 in their industry) with diversified revenue streams, strong cash flows, and complementary business units. For example, Marathon Petroleum (NYSE:MPC) has midstream and downstream assets, and Disney's (NYSE:DIS) businesses monetize their character library through multiple channels. Research from Northern Trust showed higher excess returns from higher quality companies, hence the bias toward companies like Nike (NYSE:NKE), Visa (NYSE:V), and Home Depot (NYSE:HD).

Macro-Economic Themes

I find value in having a story behind the portfolio's tactics. There are many potential themes you could focus on. What's important is having a rationale for your decisions. Your thesis may be challenged in the future by changing events; these become opportunities to review your thinking and potentially change course. I focused on the following themes.

Population Trends

• The US population continues to grow slowly, but the larger story is the sharp growth in senior citizens as the Baby Boomers retire. Seniors utilize more healthcare than younger adults, hence a focus on healthcare companies across numerous categories: Stryker (NYSE:SYK), UnitedHealth (NYSE:UNH), and Amgen (NASDAQ:AMGN).
• Recent census estimates indicate that millennials are now the largest living generation and about one-third of millennials live at home with their parents. With unemployment at new lows and wages rising, I expect this group to start moving out into apartments or homes of their own. Housing inventory is at lows and prices rising, which should lead to an increase in new construction. Building material supplier Home Depot and title insurer Fidelity National Financial (NYSE:FNF) are two potential beneficiaries of these trends
• In 2016, there were about 3.2 billion people globally in the middle class, and the rate of increase is about 140 million per year and rising. While increased consumer spending may lift all sectors to some degree, consumer discretionary, air travel, storage, and financial stocks are the areas of interest for the portfolio. The portfolio includes Hasbro (NASDAQ:HAS), Boeing (NYSE:BA), Principal Financial Group (NYSE:PFG), and Extra Space Storage (NYSE:EXR).

Technology

• Utilization of Internet-based services and applications continues to grow. Cisco's 2015 Global Cloud Index whitepaper projects 47% growth in hyperscale data centers and total data center traffic tripling over the next five years. Infrastructure will be needed to meet this demand. While familiar high-growth Internet stocks are excluded from the portfolio due to a lack of dividends, data center REITs such as CoreSite (NYSE:COR) are eligible. Internet security and consulting firms also benefit from the continued growth in Internet-of-Things, cloud services, security, and mobile applications. I focused on Accenture (NYSE:ACN), Texas Instruments (NYSE:TXN), and FLIR Systems (NASDAQ:FLIR).

• Analytics is another growing area of technology and it is not restricted to tech companies. Businesses that effectively align strategy and operations with analytics that leverage customer, business, and market data have an advantage. Examples: Walgreens (NASDAQ:WBA) and Starbucks (NASDAQ:SBUX) are masters of choosing store locations. UnitedHealth's Optum business unit helps providers, employers, and health plans to improve care and operations.

Rising Interest Rate Environment

• With interest rates expected to continue rising as US and global economies improve, financial companies are potential beneficiaries, particularly insurance companies.
• Higher-yield, lower-growth sectors, such as utilities and consumer staples, may underperform as interest rates become more competitive with stock yields.
• The following chart from Santa Barbara Asset Management provides historical excess return by sector in rising rate months over the last decade. The DGTR portfolio underweights consumer staples and utilities, overweights info tech and consumer discretionary, and makes tactical selections in financials, industrials, and telecom.

The DGTR Portfolio

Based on the fundamental screening and macro-economic trends, I created a portfolio of 20 dividend growth stocks. I personally own all of these stocks and over half were also part of the portfolio I previously managed. To keep things simple, the stocks were equally weighted. Dividends will be reinvested every six months; I will decide which stocks to invest the funds into at that time. In previous models, I performed annual rebalancing. Research suggested rebalancing benefited value-oriented portfolios. With this model being growth-focused, I am not planning to perform any full portfolio rebalances at this point. Instead I'll trim positions to reallocate funds as opportunities arise. The portfolio will always be fully invested except for the accruing dividends. In my portfolio tracker, I factor in a $4.95 commission for each trade. I also assume funds are in an IRA and do not track capital gains or dividend tax implications.

The portfolio was initiated on January 1, 2017. You will see connections to the macro themes as you review the list. There were three "overrides" included:

• Marathon Petroleum had a beta of 1.80, causing it to fail the screen. I like that it owns midstream and downstream assets with growth opportunities in both areas. MPC has also been exploring ways to enhance shareholder value and its dividend increases have consistently been strong.
• Extra Space Storage did not pass the earnings growth thresholds, but REITs are more accurately assessed by funds from operations. In Q1, EXR increased FFO by 19.8%. Brad Thomas wrote a detailed write-up on EXR last year that highlights many reasons I like it. EXR also has a low beta, which balances out a couple other holdings. Growth in population, employment, and wages means more stuff, which should help storage firms.
• Walgreens Boots Alliance only boosted its dividend by 5.4% last year, falling short of the cutoff. However, its growth forecasts remain strong and while a consumer staple stock, WBA also includes a healthcare component through its pharmacy and retail clinic services. I would like to see a stronger dividend increase this year though.

Here is the full portfolio. I will discuss the holdings in more detail in future updates. Two of the REITs are classified under their specialty sector as I view them as proxies for those sectors.

Company	Ticker	Sector
Disney	DIS	Cons Disc
Hasbro	HAS	Cons Disc
Home Depot	HD	Cons Disc
Nike	NKE	Cons Disc
Walgreens	WBA	Cons Staples
Marathon Petroleum	MPC	Energy
Fidelity National Financial	FNF	Financial
Principal Financial Group	PFG	Financial
Visa	V	Financial
Amgen	AMGN	Healthcare
Stryker	SYK	Healthcare
UnitedHealth	UNH	Healthcare
Boeing	BA	Industrial
Accenture	ACN	Info Tech
CoreSite Realty	COR	Info Tech (REIT)
FLIR Systems	FLIR	Info Tech
Texas Instruments	TXN	Info Tech
Dow Chemical	DOW	Materials
Extra Space Storage	EXR	Real Estate
American Tower	AMT	Telecom (REIT)

Click to enlarge

Portfolio Statistics

At inception, the DGTR portfolio had an average yield of 2.4%, a beta of 0.98, expected 5-yr earnings growth of 13.0%, and 1-, 3-, and 5-yr DGRs of 15.8%, 19.1%, and 25.2% respectively. Definitely a portfolio geared toward growth, but if the dividend growth rates stay above 10%, the yield may approach 3% in the not-to-distant future. The portfolio valuation was reasonable considering the growth focus with a PE of 21, a PEG of 1.87, and a payout ratio of 45%; the 3 REITs were excluded from these calculations.

Through April 30, 2017, the DGTR returned 11.5% compared to 7.2% for the S&P 500 Total Return Index. The current yield is around 2.3%, so dividend growth has matched price gains well. With 17 of 20 companies reporting Q1 earnings, 88.2% beat earnings estimates (the other two were in-line), with average year-over-year adjusted EPS growth of 18.2%. Seven companies delivered dividend increases in Q1, raising their payouts an average of 23.2%. This followed nine companies posting an average dividend raise of 20.9% in Q4, which factored in no increase for DOW. Given these figures, I expect to see double-digit dividend growth over the next year.

Next Steps

Going forward, I plan to provide one or two updates per quarter discussing performance, earnings reports, dividend increases, and any portfolio changes. I will also provide more commentary on the portfolio selections. I anticipate low turnover for this portfolio, as I take a long-term approach. However, repositioning may occur based on company-specific concerns or opportunities, and sector allocations may change with macro-economic conditions.

I welcome your thoughts on this portfolio and its construction process, as I continue to refine it based on research, review, and feedback. If you found this article insightful or useful, please comment and/or follow me.

Disclosure: I am/we are long NKE, DIS, HD, HAS, WBA, MPC, FNF, PFG, SYK, UNH, AMGN, FLIR, BA V, ACN, TXN, DOW, AMT, COR, AND EXR. 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.