Dividend Growth Portfolio Update

by: The Hedged Economist


There are multiple ways to evaluate a portfolio.

Total return and volatility matter: return over the long-run, and volatility ongoing.

Dividend yield and dividend growth are easily estimated.

A portfolio update explained.

Portfolio Update

A previous posting, "Buying Stocks For A Dividend Growth Portfolio: Postscript A" SeekingAlpha, Sep. 21, 2017 (Buying Stocks For A Dividend Growth Portfolio: Postscript A), presented the portfolio as of the beginning of September. It then went on to discuss a number of portfolio adjustments designed to simplify the portfolio and increase the dividend flow. The adjustments discussed in that posting occurred much faster than was anticipated.

Ignoring one covered call that is still outstanding and will expire on October 20, the portfolio has been simplified by reducing the total number of stocks from 40 to 36. A number of small positions were eliminated, and industry composition was changed slightly. More importantly, the dollar dividend flow was increased. That was done by using the proceeds from the sale of the positions that were eliminated and some of the dividend flow from the portfolio to expand some of the positions in higher-yielding stocks. The current portfolio composition is shown below. As was done in the previous postings addressing the total portfolio, both the portion of the portfolio value and the portion of the dividend flow generated by the portfolio are shown.

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Perspective on the Update

Although the dollar value of the dividend flow increased, the dividend yield as a percent of the portfolio did not increase; it actually fell slightly. That phenomenon illustrates the impact of the current bull market. The price appreciation raised the value of the portfolio more than the trades raised the value of the dividends. It also illustrates the risk that can arise in a dividend-oriented portfolio where the yield as a percent of the portfolio is monitored and managed too closely. The fall in the percentage yield creates a temptation to shift into higher-yielding stocks, a phenomenon often referred to as yield chasing.

That temptation is particularly acute since it is the run-up in a number of dividend-growth stocks that has created the lower percentage yield. Consequently, the yield on stocks like Boeing, 3M, McDonald's, Microsoft, Procter & Gamble and even Johnson & Johnson are low by historical standards. The temptation would be to sell those highly reliable, dividend growth stocks in pursuit of higher-yielding, and perhaps lower-quality, holdings.

Most of the stocks just mentioned are overpriced. Thus, the temptation to sell them in order to chase yield is compounded by the temptation to try to manage the capital appreciation. Those opportunities to increase yield and try to increase capital appreciation have to be viewed from the perspective of the portfolio objectives. They are:

1-Generates a reliable dividend stream that will grow over time

2-Displays less volatility than the market in general

3-Provides returns that do not lag the overall market over a full market cycle

4-Contains core stock holdings in a diversified portfolio of assets

5-Requires very few changes over a long period of time

One objective of this portfolio is to produce an increasing dividend flow. It is, after all, a dividend growth portfolio, not a dividend portfolio exclusively, and not a capital appreciation or growth portfolio. Consequently, it's important to look at the potential rate of growth of dividends as well as their current yield. While the stocks mentioned above are overpriced, and maybe they will not appreciate in value, their dividends will grow, and that growth is highly reliable. However, for some of these stocks, the rate of growth in the dividend may not be as rapid as it was in the past.

Further, in order to achieve the objective of lower volatility than the market while achieving returns that do not lag the overall market over a full market cycle, the portfolio has been constructed with the objective of having stocks that display different price-performance at various stages over the economic market cycle. Thus, having stocks that are overpriced at any given point in time is a portfolio phenomenon rather than a problem. At different points in market cycle, other firms will become overpriced.

That philosophy was discussed at length in previous postings, and, interestingly, the unique nature of the cycle of Boeing's stock was pointed out. Boeing is probably the most overpriced stock in a portfolio, but that is exactly what one would anticipate under current market conditions. However, it is a company that will return a substantial portion of its cash flow to shareholders at this point in its market cycle. Further, the stock's performance will probably remain uncorrelated with some of the other stocks in the portfolio; it will continue to raise its dividend, and, through the cycle, it will continue to appreciate although the rate of appreciation will vary substantially depending upon the point in the economic and market cycle. Therefore, although overpriced, the appropriate portfolio strategy is to hold the stock and let it run. Eventually, the run will be over and other stocks will be appreciating at a faster rate. However, the overall portfolio effect, when held in combination with other companies, will be consistent with the portfolio objectives.

Normally, some of the stocks mentioned above (Boeing, McDonald's, 3M, Microsoft, Procter & Gamble, and Johnson & Johnson) would be candidates for covered calls. However, as discussed in previous postings, each of the stocks has a potential for an upward blip in value that would defeat the purpose of collecting covered call premiums. Also, the risk associated with writing covered calls is heightened going into earnings announcements. So, if the strategy is of interest, the appropriate time would be after earnings announcements.

The Dividend Growth Objective

There are a number of different ways to monitor the dividend growth objective. One can actually track dividend payments over time, and use the data to compare year-over-year or current month over the same month in the previous year. While interesting, that approach has a number of drawbacks. First, it can be very time-consuming to record and maintain a database. Second, it only provides historical information. Further, it doesn't reflect any changes in the portfolio. Finally, at year-end most brokers will provide information that allows a year-over-year comparison. However, because of changes in the portfolio, even as minor as dividend reinvestment on some of the stocks, the comparison involves comparing return on different portfolios at different points in time.

An alternate approach that overcomes some of the deficiencies of actually tracking returns is to do a comparison of the previous year's dividend payment on the current portfolio to an estimated forward return. The advantage of the approach is that it requires no record-keeping, and it can be done from readily available data sources. Further, it allows the construction of multiple scenarios based on different assumptions.

For example, one can take the trailing 12 month dividend payments and compare them to four times the current quarter dividend. In many respects, it is like taking a snapshot at a point in time: this is what my portfolio yielded over the previous year, and this is what it is currently yielding. Essentially, that is a "no-dividend-cut scenario." It is important to keep in mind, however, that it is an estimate of no dividend cuts in aggregate. It allows for the potential that some individual stocks will cut their dividend, but it assumes the dividend increases in other stocks will compensate for the cuts, thus leaving the entire portfolio dividend estimate as a no-cut scenario. It is worth noting that this calculation held up during the recent financial crisis. The portfolio I held at the time experienced some stocks that cut dividends, but the increases in the dividends of the other stocks more than offset them.

Alternatively, one can take the trailing 12 month dividend payments and compare them to different sources for estimates of the forward year's dividend payments. In some respects, this approach is more dynamic than the snapshot that results from the no-dividend-cut scenario. While the forward dividend estimates may be wrong on any individual stock, taken across the entire portfolio they represent a reasonable expectation if based on a reliable source of estimates. The result is an "estimate-of-growth scenario."

Neither of these alternatives, the no-cut scenario and the estimate-of-growth scenario, takes a tremendous amount of time to construct. Some readers have probably automated the entire process. It can be done manually with a spreadsheet and Yahoo finance in a matter of an hour or so. It could also be done using most brokerage companies' websites. The only advantage of most brokerage websites is that they will provide multiple estimates of forward-year dividend flows while Yahoo finance provides only one, but it presents it in a particularly convenient format.

The result is a range of potential returns that one can use to subjectively arrive at an estimate of the dividend growth of the portfolio. When this approach is used on the portfolio presented above, it results in an estimate that the portfolio will experience growth in the dividend flow in the range of 6% to 7% based just on the dividends. While not spectacular, an increase in income of between 6% and 7% without any capital gains is acceptable. Further, the likelihood of growth below 4% is very small. It would require dividend cut frequencies and magnitudes that would be greater than those experienced during the financial crisis. Keep in mind, the construction the portfolio includes a large number of companies that continued to raise their dividends right through the recent financial crisis.

Putting Yield and Dividend Growth in Perspective

Investing is always a very personal matter that is dependent upon an individual's unique objectives and requirements. Just like data on total return and volatility, measuring yield and dividend growth can inform one's decision. However, they cannot determine what is appropriate for an individual investor. Anyone who says that the data determine what the correct investment is, consciously or unconsciously, is assuming that the investor has an objective that may or may not be made explicit.

Using just the two portfolio characteristics (yield and dividend growth) one can easily envision the young investor placing much more emphasis on dividend growth than an older, retired investor. A previous posting entitled "Dividend Growth Portfolios And Retirement," on Seeking Alpha, Oct. 1, 2017 (Dividend Growth Portfolios And Retirement) described how a 3% yield could be tucked into a retirement plan very efficiently. However, the 3% current yield may be totally inappropriate for young investor if it involves sacrificing dividend growth. Similarly, eventually some investors who are retired will prefer a greater cash flow than 3% even if it means sacrificing dividend growth.

Portfolio Composition

The desire to hold a number of overpriced stocks in cyclical industries like Boeing in aerospace and 3M an industrial, as well as some noncyclical overpriced stocks, has required a different kind of monitoring. The focus has been on portfolio composition. To offset those overpriced stocks, especially the cyclical stocks, has made adding some noncyclical stocks that were depressed in price appropriate. That theme could continue as long as the bull market continues.

In pursuit of that offset of the overpriced cyclicals, the previous posting on portfolio composition ("Buying Stocks For A Dividend Growth Portfolio: Postscript A" SeekingAlpha, Sep. 21, 2017, Buying Stocks For A Dividend Growth Portfolio: Postscript A) did not just talk about potential portfolio adjustments. It also mentioned that the position in National Retail Properties (NNN), a REIT, had been expanded as had the position in Verizon (VZ). Both were purchased because the prices of the stocks seem depressed and the firms operated in industries subject to totally different cyclical influences from the overpriced industrials.

However, both REITs and telecommunications tend to be interest-rate sensitive. Banks also can be interest-rate sensitive, but in the opposite direction. Consequently, the posting also mentioned that the position in Toronto Dominion (TD) had been expanded. REITs and telecommunications tend to be heavy borrowers, and, thus, they are adversely affected by rising interest rates. They are also viewed as bond substitutes, and, consequently, become less desirable holdings as interest rates on bonds rise. Banks, on the other hand, are assumed to benefit from interest-rate spreads as long rates rise faster than their short-term financing costs. Consequently, the price of banking stocks can increase as interest rates rise.

General Mills (GIS) was mentioned as a position that had been expanded and as a potential "go to" for additional purchases. As a more reasonably-priced consumer staple, it was purchased to offset some of the effect of other overpriced consumer staples. However, as was mentioned, other consumer staples are on the watch list for exactly the same reason.

A comparison of the current portfolio to the one presented in the previous posting shows that the positions in pipelines, Enbridge Inc. (ENB) and TransCanada Corporation (TRP), have been expanded. They, too, can be interest-rate sensitive in the same way as REITs and telecommunications. At the same time, positions in the financial service industry, MetLife (MET) and Brighthouse Financial (BHF), have been eliminated. Consequently, the portfolio might benefit from the addition of a financial service firm that doesn't embody the risks that lead to exiting the positions in MetLife and Brighthouse Financial. J.P. Morgan Chase (JPM) is currently reasonably priced and could be added to the watch list after earnings season. BB&T also looks interesting, and it could be put on a watch list.

It would be nice to have a less overpriced pharmaceutical than Johnson & Johnson (JNJ) in a portfolio. That may be accomplished simply by turning on the dividend reinvestment on one or both of the other pharmaceuticals in the portfolio. Finally, McDonald's (MCD) is the only retail representation in the portfolio. As a potential candidate that is less overpriced, Wal-Mart (WMT) is interesting but a little bit overpriced. To some extent, National Retail Properties (NNN) provides some alternative retail exposure. However, it comes with the risks associated with any REIT. Nevertheless, the position in National Retail Properties reduces the urgency associated with the retail space.


While yield and dividend growth are important, the overriding objectives are return through the cycle and low volatility. It's easy to measure yielded and dividend growth, but the more overriding objectives involve considerable uncertainty. Thus, trying to achieve them involves some subjective judgments about what constitutes an appropriate portfolio. For example, there is no easy way to quantify whether the expanded position in TD is adequate to offset interest-rate risk of the other adjustments to the portfolio that have been made. Consequently, there is always a danger of managing to that which is measurable and concrete at the expense of what is uncertain and important. However, the current portfolio of 21 core positions and 15 supplemental positions should hold high potential for achieving the most important objectives.

Achieving the important objectives is always an aspiration. Thus, it may be necessary to add positions, and there is always the possibility that one or more companies in the portfolio may fail to perform in a way consistent with the portfolio objectives. Yet, it is very unlikely that the current portfolio will fail to provide the foundation for achieving the portfolio objectives.

Disclosure: I am/we are long THE PORTFOLIO.

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.

Additional disclosure: Disclosure: I am long all positions identified in the portfolio. I may acquire some of the stocks mentioned as on a watch list. This posting is intended only to share my experience and opinions, and it is not intended as advice. Each investor should do his or her own due diligence regarding the valuation of individual stocks and their appropriateness for that individual investor.