Deep Value Dividend Growth Portfolio: Our First Sale

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Includes: ABBV, ABCB, CWEN, EQM, HOMB, NBLX, OMP, SU, SYF
by: Dividend Sensei
Summary

Per reader requests, I'm splitting my "best dividend stocks to buy this week" series into the watchlist article and a DVDGP update.

DVDGP represents the culmination of 23 years of investing experience and is what I plan to use for all future savings for the rest of my life.

It's focused purely on low-risk dividend growth stocks bought at fair value or better (usually at steep discounts) off my five watchlists.

Last week, we had our first sales when CWEN's dividend became high-risk and I sold it a day before it was cut by 40%. That money went into undervalued blue-chip ABBV.

So far DVDGP is beating the S&P 500 by 10.6% since inception and across all-time frames and in all market conditions (crashes, strong rallies, and flat conditions).

(Source: imgflip)

Note that due to reader requests, I've decided to break up my weekly "Best Dividend Stocks To Buy This Week" series into two parts.

One will be the weekly watchlist article (The Best Dividend Stocks For New Money Today). The other will be the update on the Deep Value Dividend Growth Portfolio (which is beating the market by 10.5% so far and across all time frames).

To also make those more digestible, I'm breaking out the intro for the weekly series into a revised introduction and reference article on the 3 rules for using margin safely and profitably (which will no longer be included in those future articles).

Introduction To The Deep Value Dividend Growth Portfolio

I've spent 23 years trying to find an investing strategy that can consistently achieve great returns that will enable me to achieve my dream of financial independence.

While there are many good investment strategies to choose from after five years as a professional analyst/investment writer I've determined that for me (and many of my readers) three approaches work best.

First, I'm focusing on dividend growth stocks because historically these have tended to significantly outperform the market, both on an absolute and risk-adjusted basis (total returns/volatility).

Second, I'm adding a value focus ("be greedy when others are fearful"), because, like dividend growth, value is a proven alpha factor that generally beats the market over the long-term.

(Source: Ploutos Research) - note data through January 2019

Finally, I'm targeting low-risk dividend stocks, primarily sleep well at night or SWAN blue-chips (such as dividend aristocrats and kings) because they have shown a remarkable ability to generate safe and steadily rising income, as well as market-beating total returns over the long-term.

(Source: Ploutos Research)

That's thanks to usually keeping up with stocks during a bull market, but falling less during bear markets. In other words, low-risk dividend growth stocks manage to outperform not by "hitting grand slams" but by "avoiding striking out".

What evidence do I have that such a value-focused low-risk dividend growth approach actually can beat the market over time?

(Source: Investment Quality Trends)

Because asset manager/newsletter publisher Investment Quality Trends has been using a pure valuation approach on nothing but blue-chip dividend stocks (based on six quality criteria) since 1966 and has managed to consistently beat the market by about 10% with 10% lower volatility.

1% annual outperformance for 30 years doesn't sound like much but just 7% of mutual fund managers can even match the S&P 500 over 15 years. Beating the market by 1% over 30 years puts IQT in the elite of professional money managers/analysts.

I'm applying the same system to things like younger companies, as well as REITs, YieldCos and MLPs, which due to the 25 years of uninterrupted dividends requirement IQT has, excludes these kinds of investments from their recommendations.

Basically, my investing strategy can be summarized like this:

  • Only buy deeply undervalued blue chips (off my watchlists) during a market decline.
  • Save up 50% to 100% of weekly cash (invested in the form of T-bills or long-term Treasury bond ETFs) and wait for pullbacks/corrections/bear markets.
  • During a pullback (average one every six months since WWII), deploy 50% of cash (sell the bonds) in stages.
  • If the pullback becomes a correction, deploy 50% of remaining cash (in stages).
  • If the correction becomes a bear market, deploy the remaining 50%.

This approach ensures that I'll be able to avoid hoarding cash for years on end (because market declines are frequent are frequent) and will always be able to buy some quality undervalued dividend growth stocks at highly attractive valuations.

I'm also considering deploying 50% of my real savings into the best-undervalued dividend growth opportunities on a monthly basis with the other 50% building up liquidity for market pullbacks (more on this in a second).

I use the same valuation-adjusted total return model that Brookfield Asset Management (BAM) uses, and they have a great track record of delivering 12-15% CAGR total returns (in fact, it's their official goal as a company, and they usually exceed that target).

There are four carefully curated lists designed to focus on:

  • Quality companies
  • Safe dividends (they are all low-risk stocks)
  • Good long-term growth potential
  • Good margin of safety (attractive valuations)

The portfolio also uses size caps for risk management purposes (in case a thesis breaks)

  • sector cap: 25%
  • industry cap (like tobacco): 15%
  • individual holding cap: 5%

This is currently a paper portfolio I'm maintaining on Morningstar and Simply Safe Dividends to not just provide in-depth portfolio stats but also the total returns over time. The rules for the portfolio are:

  • Each month, I buy $500 worth (rounded up to the nearest whole share) of any existing portfolio positions that remain on the active buy list (fair value or better).
  • Each week, I buy $500 worth of any new stocks that make it onto the "top 5 high-yield blue-chips/fast growers, aristocrats/kings" watchlists (stocks rotate on and off). But that's only if the long-term total return potential is 13+%, which is the official portfolio hurdle rate.
  • If opportunistic buying opportunities appear (like a 5+% one day crash due to an earnings freakout), then I can move up the next month's buy to that day.
  • Dividends are reinvested.
  • Stocks are only sold if the thesis breaks or a stock becomes 25% overvalued (then sell half) or 50% overvalued (sell all of it), and the capital is reinvested into new active recommendations.

Again, this is purely a tracking (paper) portfolio. I'm not yet putting real money into it until the late 2019 or early 2020, once I've eliminated all margin from my portfolio and started saving up cash (in the form of either ultra-short-term bonds or long-term bonds, depending on the state of the economy).

The reason I'm tracking this portfolio is to determine if the best use of my savings in the future is a combination of 50% dollar cost averaging and 50% opportunistic buying during downturns, or a 100% focus on downturns only.

Late 2018 (worst correction in 10 years) was an ideal time to buy quality dividend growth stocks at steep discounts. DVDGP's early returns have been sensational (small profit in December and 10% gain in January vs S&P 500's 8% January rally) mainly due to starting the portfolio when valuations were at their lowest levels in years. But many investors want to also deploy cash on a consistent basis. The monthly DCA buys of all active buy recs is our way of simulating that and testing how much alpha this investing system generates in a rising market (beating S&P 500 by 0.7% in February so far).

Ultimately DVDGP represents the culmination of my 23 years of experience and is designed to be a safe income growth portfolio that almost anyone can use. Or to put another way, if I were managing a pension/endowment fund, this is what the equity portion of that portfolio would look like. Thus it's also safe for most readers, as most of its holdings are "widows and orphans" stocks including plenty of dividend aristocrats and kings.

How can you use DVDGP? Mainly for investing ideas, and not necessarily tracking it move for move (it owns 73 companies and most people prefer a more concentrated portfolio). Since I'm an analyst for Simply Safe Dividends (researching over 200 companies per year) I am basically building out a smart beta ETF with DVDGP. One that yields double the S&P 500, has faster dividend growth and that should be able to outperform it by a wide margin over time (or so my total return model says which is why I'm testing it).

If the strategy works as well as expected I may partner with Brad Thomas and Chuck Carnevale to turn it into a closed-end fund. That would allow investors to profit from the portfolio but avoid the problems money managers have with redemptions forcing them to sell during market declines when they should be buying instead.

Essentially you can look at what DVDGP owns as a quality screening tool to help you build your own watchlists and then buy those companies when they hit fair value or better.

Last Week's Buys/Sells

Our first sale

  • Sold all of Clearway Energy (CWEN) on Wednesday, Feb 13th (at $13.78 for a 3.4% loss)

New Positions this week ($500 starter positions)

  • Home BancShares (HOMB)
  • Synchrony Financial (SYF)
  • Oasis Midstream Partners (OMP) - uses a K1
  • Noble Midstream Partners (NBLX) - uses a K1
  • EQT Midstream Partners (EQM) - uses a k1
  • Suncor Energy (SU)

Clearway Energy (CWEN) I sold because it became high-risk when Guggenheim warned that, after talking with management about the PG&E (PCG) bankruptcy fallout, the analyst firm believed a major dividend cut was imminent.

I've been closely following the PCG Ch 11 sage closely since CWEN has 23% of revenue under long-term contracts with PG&E. The analyst warning was enough to boost my estimate of a dividend cut to over 50% and thus trigger my sale a day before the yieldCO slashed its payout by 40%.

Basically, the fundamentals had deteriorated and the thesis was broken. I'm not a "buy and hold forever investor" but a "buy and hold as long as the thesis is intact" one.

No portfolio can avoid making any mistakes (stocks are "risk assets" after all) but the goal is always to limit risk and permanent losses through good risk management. In this case, I was able to sell CWEN before the dividend cut which is the goal of most income growth investors.

Note that CWEN relatively riskier holding and a 1% position for us (thus an insignificant 0.034% total loss). For context that $34 realized loss will take just three days of average portfolio dividends to recoup. I rolled that money into AbbVie (ABBV) which was our biggest loser at the time (to lower the cost basis).

HOMB and SYF were quality recommendations from the Motley Fool (where I used to be an analyst) that they put on my radar and that meet DVDGP investing criteria.

EQM, NBLX, and OMP are three of my real money holdings that I consider extremely promising long-term income growth opportunities. I added them to the bear market watchlist and portfolio after doing a review of my portfolio and selling high-risk stocks, including CWEN, OHI, and UNIT on Wednesday, February 13th. I thus avoided CWEN's dividend cut and UNIT's 30% AH plunge after the disastrous trial results came out on Friday.

Suncor Energy was brought to my attention by both Berkshire buying it last quarter and the company's 17% recent dividend hike. Further analysis indicated it was a strong long-term buy (23% undervalued).

I also made the monthly dollar cost average $500 buy into all active recommendations. Again this simulates a popular and time tested strategy that many investors follow and will help me finalize my future investing strategy.

Plan For The Next Week

I'll be researching Ameris Bancorp (ABCB) which the Motley Fool has been very bullish on for the last few months. If I like what I see, and it has an attractive long-term total return potential (and a good valuation), I'll take a starter position in the fast-growing regional bank.

The Deep Value Dividend Growth Portfolio - 73 Total Holdings

(Source: Morningstar) - data as of February 15th close, the S&P 500 closed up 1.09% that day.

Our Highest Yielding Positions

(Source: Morningstar)

(Source: Morningstar)

We're mainly focused on large-cap US dividend stocks because the goal of this portfolio is to only own low-risk SWAN stocks. Low-risk is defined as low-risk of a dividend cut during a recession.

(Source: Morningstar)

Due to the preference for undervalued stocks we're overweight high-yield, hard asset and cyclical companies.

Sector Concentration (25% Sector Caps, 15% Industry Caps, And 5% Company Caps In Place)

(Source: Simply Safe Dividends)

I'm imposing firm sector caps to ensure good risk management. No matter how good the bargains may be, it's never a smart idea to let your portfolio get too risky.

Income Concentration

(Source: Simply Safe Dividends)

The portfolio's income is likely to be concentrated into the highest-yielding names, at least until it becomes more diversified over time. A good rule of thumb is you want to limit income from any one position to 5% or less. We've now achieved that goal in DVDGP.

Annual Dividends

(Source: Simply Safe Dividends)

While we may never fully get to the dream of daily dividend payments, we're currently getting paid every week. And the monthly income flow will smooth out nicely over time.

(Source: Simply Safe Dividends)

Note that the 10-year dividend growth figures are artificially low because my tracking software doesn't average in anything that hasn't existed for those time periods. Some of these stocks have IPO-ed in the last five years, and so, the 1-year and 5-year growth rates are the most accurate. These figures are purely organic growth rates and assume no dividend reinvestment.

The dividend declines during the Financial Crisis were due to REITs (such as Kimco and Simon) which cut their dividend (as 78 REITs did during the Great Recession) as well as our large exposure to mega-banks. Fortunately, since then, the REIT sector has deleveraged and enjoys the strongest sector balance sheet in history.

(Source: Hoya Capital Real Estate)

This means that during the next recession, most REITs will not cut their payouts, especially Kimco, which has a BBB+ credit rating and will be getting an upgrade to A- in 2019 or 2020. Simon is one of just 2 REITs with an "A" credit rating.

Top REIT Credit Ratings (S&P)

(Source: F.A.S.T.Graphs)

Similarly, I am confident that every bank we own (C, JPM, BAC, GS, HOMB) will maintain its dividends through future recessions (though they are likely to be frozen).

There is no official dividend growth target, though I'd like to at least maintain long-term dividend growth (either 1-year or 10-year) which is above the market's historical 6.4% payout growth rate. The huge jump in the 1-year dividend growth rate is courtesy of some of our semiconductor stocks, several which raised their dividends by over 100% in the past 12 months.

(Source: Simply Safe Dividends)

While maintaining 11.5% long-term dividend growth is likely beyond our portfolio's ability, according to Morningstar, the projected EPS (and thus dividend) growth rate is about 10.9%.

Fundamental Portfolio Stats: (Total Return Potentials Are From Current Levels)

  • Yield On Cost: 4.3%
  • Yield: 4.0%
  • Expected 5-Year Dividend Growth: 10.9%
  • Expected 5-Year Total Return (No Valuation Changes): 14.9%
  • Portfolio Valuation (Morningstar's DCF models): 10% undervalued
  • 5-Year Expected Valuation Boost: 2.1% CAGR (20% margin of error)
  • 10-Year Expected Valuation Boost: 1.1% CAGR (20% margin of error)
  • Valuation-Adjusted Total Return Potential: 16% to 17% (market's historical return 9.1%) - note margin of error 20%
  • Margin of error adjusted total returns expected: 12.8% to 20.4%
  • Portfolio Beta: 1.03 (3% more volatile than S&P 500) - note we tend to actually fall less in downturns (due to heavy blue-chip dividend focus) but slight outperform in a rising market

(Source: Morningstar)

The quality of these stocks can be seen in the far-above-average returns on assets and equity of this portfolio (good proxies for quality long-term management and good corporate cultures).

What's DVDGP is also far more undervalued, offers a much higher yield and should achieve far superior dividend growth compared to the broader market. While our EPS growth may match the S&P 500 (based on analyst expectations), the S&P 500's dividend growth rate is about half that of its earnings due to non-dividend stocks as well as corporate America's bigger focus on buybacks vs. dividend hikes.

As an added benefit, the average market cap is smaller, providing yet another alpha factor (smaller stocks tend to outperform). Note that the overall focus is on blue chips, which means that the average market cap is likely to rise over time (but remain far below the market's $100 billion average).

Portfolio Performance

  • CAGR Total Return Since Inception (December 12, 2018): 17.7%
  • CAGR Total Return S&P 500: 7.1%
  • Market Outperformance: 10.6%
  • Long-Term Outperformance goal: 2+%
  • YTD: 13.9% vs S&P 500 11.0%

(Source: American Enterprise Institute)

Beating one's target benchmark is extremely difficult, even for professional money managers. That's because "hot funds" see lots of new money flows which makes it harder to recreate that success the next year.

(Source: S&P)

In addition, during market declines retail investors pull money out causing professional money managers to be forced sellers instead of buying at fantastic valuations. Thus, just 0.45% of mutual funds remain in the top quartile of performers for five consecutive years.

This is why DVDGP is a margin-free portfolio, using steady cash inflows (simulating steady and high savings) to buy opportunistically. There is no guarantee that the strategy can beat the market over time, but avoiding the biggest pitfalls of active money managers means I believe we have a very good chance.

Worst Performers

(Source: Morningstar) - note Clearway Energy is no longer owned in the portfolio

The good news is that due to our monthly additions to all stocks that remain active buy recommendations, the more any stock falls in the short term, the lower our cost basis will become.

Best Performers

(Source: Morningstar)

The downside of our dollar cost averaging approach is that we also raise our cost basis for early winners. This is why I'm testing the DCA approach to see if it can continue to generate alpha outside of steep market declines.

However, since we only buy great companies at good to great valuations, ultimately, we should be able to deliver very strong returns. That's because winners tend to keep on winning, and thus adding to winners even at a higher cost basis should help keep the portfolio well balanced and avoid getting too top-heavy with out of favor companies that could cause very long stretches of underperformance.

Bottom Line: Investment Losses Are Inevitable But With Proper Risk Management You Can Still Reach Your Long-Term Financial Goals

Since no one knows the future no investor can be right 100% of the time. Even the greatest investors in history (like Buffett, Lynch, Graham, and Dodd) are right just 60% to 80% of the time. The key is good risk management and minimizing permanent losses while letting your winners run as long as the thesis remains intact.

In the case of CWEN we ended up with a 0.034% permanent loss, that is a drop in the bucket compared to the massive gains our other companies have generated (and represents three days worth of average dividends).

This is why I'm so fanatical about risk management and include a risk section in every company focused article I write. Everyone's risk profile is different of course, but anyone mirroring DVDGP needs to remember that.

I've structured the portfolio to be safe for almost anyone to use BUT only if the risk management rules are appropriate for you:

  • sector caps: 25%
  • industry caps: 15%
  • individual holding caps: 5%

The largest position we have right now is ABBV, a high-yield dividend aristocrat and that's just 2.8% of the portfolio. With such diversification (that has yet to hinder our market-beating power) even if one of our companies suffers a worst case scenario, the loss will be minimal, and quickly overcome by the portfolio's large and fast-growing dividend stream.

Ultimately DVDGP is not about making a fortune via getting lucky with one or two "rock star" stocks. It uses several time tested investing approaches, with common sense rules, tight risk management, and then letting the incredible power of long-term value investing and safe and exponentially growing dividends to deliver great income and great total returns.

The key is to have the right watchlists of quality stocks you can trust to provide safe and growing dividends in any economic cycle. Then just wait patiently for the market to throw you "fat pitches" and put your savings to work and let the exponentially growing dividends roll in.

Or to paraphrase a famous Latin quote (Fortuna Eruditis Favet "fortune favors the prepared mind")

"Fortune favors the prepared investor, and so disciplined investors prepared with quality watchlists and high savings will eventually make a fortune."

Disclosure: I am/we are long ENB, KIM, BPY, BLK, ITW, TXN, AOS, AAPL, ABBV, BEP, MMM, LEG, WBA, EPD, MMP, ET, GS, XOM, MPLX, V, MA, BIP, TERP, IRM, HD, SWKS, PM, OKE, C, AMT, BAM, LRCX, JPM, BAC, AMGP, LYB, BTI, TU, SPG, AMTD, BA, CONE, LOW, BMY, AMP, QTS, AY, EQIX, SWK, EPRT, GD, D., LAZ, QCOM, CVS, VOD, APD, AMP, HOMB, SYF, OMP, NBLX, EQM, SU. 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.