Dividend Strategy: My Grandfather's Dividend Growth Portfolio

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Includes: ABT, ADM, AMZN, BF.B, CE, DEO, DIS, GE, HON, IFF, ING, INTC, MO, NKE, O, PFE, RBGPF, RDS.A, RE, T, TGT, TXN, UN, VCIT, VCLT, VCSH, XOM
by: Gold Finder

Summary

My grandfather finally left his expensive portfolio account with his local bank - the weak strategy is discussed.

A alternative dividend growth portfolio is presented and explained.

Risks and actionable ideas are giving during downturns in the financial markets.

For years, my grandfather had his money managed by a local Dutch bank, which was not to my liking. Although he made annual profits, every year he underperformed all major indices, because of high fees. This article will discuss a new portfolio for him and will serve as a handle of anyone in an equal situation.

Management by the local bank: what was wrong

The portfolio that was held by the local bank was very simple. It consisted of four categories/funds: a real estate fund, an equity fund, a bond fund and a liquidities fund. Of course, all funds were owned by the bank. The ratio between those funds was 1:1:1:1, and whenever one fund rose in value or lost value, the portfolio would be rearranged at a quarterly basis to maintain the ratio. For this very intelligent and hard-to-carry-out job, the bank charged alone 1.5% in annual fees. Moreover, looking into detail at the total costs, it was very hard to find the costs of the individual funds. Transparency at its best.

I quickly came to the conclusion that my grandfather was just the "dumb money" and a cash cow for the local bank. The fees were way too high for the service delivered, as even a child can just hit the rebalance button. Moreover, I fundamentally disagree with the need to rebalance a portfolio. This is primarily based on the saying: "Cut your losses and let your winners run." Here is a small example of why rebalancing is not ideal:

Chart

TGT data by YChartsChart AMZN data by YCharts

Imagine a situation where an investor bought shares in Amazon (AMZN) and Target (TGT). If the investor put $1000 into each stock, he would be looking at an amazing return. Target fell in price, but he received dividends, while Amazon more than doubled in price. If this investor would have rebalanced every quarter, he would have sold his winner, Amazon, to buy more of his loser, Target.

Finally my grandfather decided to leave the local bank and asked me how I could invest it for him. I proposed to follow a buy-and-hold dividend growth strategy with a mix of bonds and cash.

The goal of this portfolio

The goal of this portfolio is to generate stable and safe income, which will be transferred annually to my grandfather to cover taxes and household expenses. It is important that the income stream grows with inflation and if possible grows more than this.

This goal will be achieved through a portfolio that contains 28.6% in corporation bonds held through Vanguard ETFs. The portfolio will contain 20 different stocks being 57.1% of the total value. Also, a cash position of 14.3% will be established within the portfolio to take advantage of weaknesses in the general market or the portfolio.

The strategy

As said, 28.6% of the money will be put in American investment-grade bonds. The term "investment-grade" means that the investments are only being done in credible corporations. Investing in investment-grade bonds is safer but yields a lower interest than "junk bonds." However, since the goal of this portfolio is to generate safe income, such junk bonds are not acceptable. To generate enough diversified exposure to the bond market, ETFs will be purchased. The Vanguard ETFs are known of their low costs, and for example the Vanguard Long-Term Corporate Bond ETF (VCLT) has an expense ratio of as little as 0.07%!

With bonds it is important to realize the interest risk that is taken. The longer the date-to-maturity, the more a bond reacts negatively to rising interest. To take account for this risk, three bond ETFs of Vanguard have been selected to be held in equal amounts. A fund each with short-, intermediate- and long-term maturities, of 3.1, 7.5 and 23.7 years, respectively. To compensate for the increasing interest-risk with the long-term fund, the monthly distribution is almost double that of the short-term fund.

This bond block will provide very safe income, which will be received on a monthly base and will provide stability in case of a market correction. Bonds are more safe than equity.

The rest of the money, 57.1%, will be invested in high-quality dividend growth stocks. "High quality" is defined by strong balance sheets, competitive advantages and a reliable dividend. Returns are expected to be lower than more speculative equity, but the chance for lasting losses is also lower. Not every stock is the same. Royal Dutch Shell (RDS.A) has a high yield but a lower dividend growth; in contrast, Texas Instruments (TXN) has a dividend half that of Shell but recently increased the dividend by 31.5%. An opposing correlation can be made between yield and dividend growth. This can be explained by the payout ratio; the lower the payout ratio is, the more room there is left for investments.

The 20 stocks, the bond ETFs and the cash weights are shown below:

Stock Sector Weight (%) Yield
Abbott Labs (ABT) Medical 2.86 2.16%
Archer Daniel Midland (ADM) Farming 2.86 2.81%
AT&T (T) Telekom 2.86 5.05%
Brown-Forman Corp (BF.B) Alcohol 2.86 1.53%
Celanese Corp (CE) Industry 2.86 1.74%
Diageo (DEO) Alcohol 2.86 2.71%
Disney (DIS) Consumers goods 2.86 1.42%
Everest Re Group (RE) Finance 2.86 1.95%
General Electric (GE) Industry 2.86 3.78%
Honeywell (HON) Industry 2.86 1.99%
Ing (ING) Finance 2.86 4.43%
Intel (INTC) Technology 2.86 3.04%
International Flavours & Fragrances (IFF) Industry 2.86 1.94%
Nike (NKE) Consumers goods 2.86 1.33%
Pfizer (PFE) Medical 2.86 3.87%
Realty income (O) Real Estate 2.86 4.43%
Reckitt Benckiser (OTCPK:RBGPF) Consumers goods 2.86 2.28%
Royal Dutch Shell (RDS.A) Energy 2.86 6.58%
Texas instruments (TXN) Technology 2.86 2.49%
Unilever (UN) Consumers goods 2.86 2.88%
Vanguard Intermediate-Term Corp Bond (VCIT) Bonds 9.52 3.15%
Vanguard Long-Term Corp Bond (VCLT) Bonds 9.52 4.19%
Vanguard Short-Term Corp Bond (VCSH) Bonds 9.52 2.18%
Cash Cash 14.29 1.00%

The distribution of all sectors is shown here:

After bonds and cash, the consumer goods and industry sectors are the biggest allocations in the portfolio. The industry sector will provide growth with names such as Honeywell and Celanese Corp. The consumer goods sector will provide safety as this sector can be regarded as less cyclical than the industry. Another important aspect of this portfolio is "alcohol," and through the holdings of Diageo and Brown-Forman, this portfolio has good exposure to this sector. I am not a fan of the cigarettes business because I am fearful of regulation within this sector, accompanied with falling sales in terms of volume. In my opinion, alcohol has the same benefits as cigarettes, such as high margins, inelastic demand and brand loyalty, without the fear of the regulation that hangs over stocks like Altria (MO). Those fears can be quite justified, as recent price action has shown upon the news of regulations with nicotine content.

Chart MO data by YCharts

Other names in the portfolio are dividend aristocrats suchs as mighty AT&T or entertainment giant Disney. Finance is divided into a Dutch bank with a strong yield and Everest Re, an insurance company. Technology in the strong names of Intel and TXN.

It must be striking to see that this portfolio has very little exposure to the energy sector. This decision is made on the fact that oil trades very low and in my opinion the oil sector is in serious long-term problems. I simply do not see a future where oil prices will be high, this subject alone could require an entire article to explain. Gas is still the cleaner alternative to oil and I like Shells dedication to expand into this area, and therefore I allocated this small amount of money into Shell. Moreover, I find the small exposure to oil through General Electric also still acceptable. But again, I prefer to do my money into Nike rather than Shell or a company like Exxon Mobil (XOM), since I feel more comfortable with this name for the next 50 years.

Risk management

The risks of the portfolio are plenty and will be discussed here. First of all, the bonds. As discussed earlier, the portfolio will have "interest risk." Once interest rises, the value of the funds will go down. By spreading the investment over long term, intermediate and short term maturities, this risk is reduced. Moreover, since we live in Europe, it can be expected that the dollar will gain strength over the euro once interest rates rise in America. This effect will reduce the loss of value. Another risk is default, reducing the principle and interest paid. However, this effect is deemed small because the ETF is strongly diversified.

Furthermore, one of the 20 stocks can cut their dividends, leading to a lower income. This risk is reduced by investing in quality companies. A more imminent risk is the loss of value through imploding valuations during a market fall down. As long as no equity is sold and the companies maintain the fundaments, this is not considered a dangerous risk. Moreover, the following strategy is designed to take advantage of such a situation.

What to do during a market correction?

Firstly, the portfolio has 14.29% cash. This cash can be employed to purchase new positions or expand in existing ones. This way the portfolio can take advantage of a cheaper market. Secondly, the short-term and intermediate corporation bond ETFs can be sold to release funds to purchase more equity. It is expected that those two ETFs will hardly lose any value, as the funds also have one of the highest safety ratings on the Vanguard website. As a last resort, it can be decided that the portfolio will no longer pay out a dividend to my grandfather, and the funds are used to buy more equity. This last option is, however, a very last possible option.

Conclusion

I have discussed what this new portfolio strategy will look like for my grandfather and anyone in an equal situation. Through bonds, equity and cash, a portfolio will be established that will provide stable and safe income. Moreover, I have discussed risks and how they are limited. Furthermore, I have discussed how the portfolio can react and act to a falling stock market.

My question to the readers: If you could swap one stock in the portfolio for another, which one would that be and what is the alternative? Please give the accommodating arguments! Thank you in advance.

Disclosure: I am/we are long GE, RBGPF, ABT, VCLT, RE.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.