Bunker Dividend Growth Portfolio: Our Newest Dividend Aristocrat

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Includes: ABBV, AOS, CAH, CL, FRT, GD, HRL, KO, MMM, WBA
by: Dividend Sensei
Summary

Dividend aristocrats and kings have proven themselves a great way to enjoy safe and growing dividends, even in recession, plus market-beating returns over time.

However, any portfolio that's overly concentrated into such a few stocks and sectors risks underperforming in the short term if what you own is unpopular.

The Bunker Dividend Growth Portfolio started out owning the 10 most undervalued aristocrats and kings, which has weighed on results so far.

Last week we were able to add General Dynamics, our 12th company, as part of the long-term plan to diversify opportunistically into all sectors and dozens of blue-chip companies.

While new, the portfolio's results during infrequent market declines (it falls 25% to 33% as much during such times) gives me confidence in the long-term potential of the portfolio. When the next correction/bear market comes BDGP will likely shine.

(Source: imgflip)

Note that to avoid reader confusion I've shifted to a rotating portfolio update schedule. I'll now be providing just one update per week, alternating between:

Introduction To The Bunker Dividend Growth Portfolio

I'm a huge fan of dividend growth stocks and dream of eventually becoming financially independent as defined by being able to live on 50% of my post-tax annual dividends alone. Being able to live 100% off passive income from a quality dividend growth portfolio is a dream shared by many of my readers.

And it's not hard to see why. Historically, S&P 500 dividends have been 16 times more stable than stock prices, even during recessions and bear markets.

Thus, a well-built dividend growth portfolio can be trusted to provide you safe and even growing passive income no matter what the stock market or economy is doing. That makes it perfect for achieving your dreams of a comfortable retirement.

But wait, it gets better. Dividend growth portfolios aren't just a boring way to earn income at the expense of great total returns.

Historically, dividend growth stocks have outperformed the S&P 500 and non-dividend payers, and all while experiencing 13% less volatility to boot. But as great as dividend growth investing is, it's far from the only proven market-beating or alpha factor strategy.

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

I personally like to stack alpha factor strategies (like dividend growth, value, and low beta) so as to essentially rig the game so much in my favor that getting rich becomes purely an issue of time, patience, and discipline (to stick to time-tested strategies). After all, Warren Buffett, the greatest investor in history (53 years of 20+% CAGR total returns), famously summarized the two biggest reasons for his success thusly:

"We don't have to be smarter than the rest. We have to be more disciplined than the rest." - Warren Buffett

"The Stock Market is designed to transfer money from the active to the patient." - Warren Buffett

Thus, my model Deep Value Dividend Growth Portfolio or DVDGP (beating the market by 5.8% after 12 weeks) combines the power of dividend growth stocks and valuation, and the focus on mostly low-risk blue-chips is why we also tend to be less volatile during market downturns while keeping up with the market during rallies.

That's a commonality that portfolio shares with the legendary dividend aristocrats, S&P 500 companies that have raised their dividends for 25+ consecutive years.

(Source: Ploutos Research)

The aristocrats have managed to beat the market by 25% annually since 1990 not because they are necessarily super fast-growing companies that soar high and fast, but steadily growing blue-chips that merely keep up during bull markets and fall a lot less during bear markets.

I've had a lot of readers ask me two questions about that portfolio. First, why do I own so many companies (76), and second, why I don't just buy a dividend aristocrat ETF like the ProShares S&P 500 Dividend Aristocrats ETF (NOBL).

The answer to the first question is that I'm testing out several investing strategies simultaneously and thus need a lot of data points (I need to know the system itself is market-beating and reproducible since I plan to use it for all future savings).

As to why I don't just buy an ETF and be done with it, the answer is mostly about valuation. ETFs buy stocks blindly and ignore valuation, which is something I can't personally stomach.

A Yale study found that starting valuation can affect your future returns out to 30 years. In other words, overpaying for a company, no matter how great, is not something that patience and time can necessarily overcome.

However, in order to help ultra conservative income investors, like retirees or those close to retirement, harness the proven power of the aristocrats and kings and value investing, I've decided to build a model ultra-low risk portfolio called the Bunker Dividend Growth Portfolio.

It's 100% composed of nothing but aristocrats and kings and built on two modified watchlists from my "best dividend stocks to buy this week" series. As for my valuation approach, I use dividend yield theory or DYT.

(Source: Investment Quality Trends)

That's 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. According to Hulbert Financial Digest IQT's risk-adjusted 30-year total returns are the best of any investing newsletter in the country.

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.

(Source: S&P Global)

DYT merely compares a stock's yield to its historical yield. If a company is mature and the business model relatively stable, yield will mean revert and return to a long-term average that approximates fair value.

For example, if a dividend aristocrat normally yields 2% and grows cash flow and dividends 10% per year, then buying it at fair value (2%) can get you about 12% long-term total returns (2% yielding + 10% long-term cash flow growth).

That's because stock prices are, in the long term, always a function of cash flow (from which dividends are paid). If that same company is now yielding 3%, yet the fundamentals are intact, then it's 33% undervalued (3% -2%/3%) and has 50% upside back to fair value (3%/2%).

My valuation-adjusted total return model (based on the one Brookfield Asset Management has been using for decades) is based on a return to fair value over five to 10 years.

Our example, aristocrat returning to fair value over 5 years would deliver total returns of 3% yield + 10% cash flow (stock price) growth + 8.5% valuation boost (return to fair value yield over 5 years) = 21.5%.

Over 10 years, it would be 3% yield + 10% cash flow growth + 4.1% valuation boost = 17.1%.

Historically, the margin of error on this valuation model (the best I've ever come across so far) is 20%. The point is that using dividend yield theory you cannot just invest in ultra-low-risk aristocrats and kings but you can also know which are the very best ones to buy at any given time.

So, now that you know the theory behind the Bunker Dividend Growth Portfolio (capable of surviving any economic or market storm), let's take a look at the rules of how I run it.

Rules For The Bunker Dividend Growth Portfolio

The BDGP is very different than my DVDGP. That portfolio is very diversified because it serves as a kind of master watchlist of low-risk dividend growth stocks I consider worth owning with long-term 13+% total return potential.

BDGP is going to be:

  • far more concentrated (with no sector caps)
  • higher quality (the bluest of blue-chips)
  • has no long-term total return target (though it should deliver double-digit returns over time)

Here are the rules for this portfolio:

  • I start out buying $1,000 of each (rounded up to the nearest share) of the 5 most undervalued aristocrats and kings.
  • Any week where a new one makes the list (companies roll on and off naturally over time), I make a $1,000 starter position buy.
  • Once per month, I make a $1,000 cost average buy into any active recommendations (that week's top 5 aristocrats and kings).
  • Only sell if the thesis breaks (dividend becomes unsafe, or a company loses its aristocrat or king status, a very rare occurrence).
  • Or if a company becomes 25%+ more overvalued (sell 50%) or 50+% overvalued (sell the other half) - also very rare outside of crazy bubbles like 2000.
  • Dividends are reinvested via DRIP.

As with DVDGP, should some opportunistic buying opportunity appear (like during earnings season or unexpected bad news), I will move up the next month's buy to that day, using the next month's DCA funds.

This recreates the limited capital constraints most investors have and also helps maintain a more balanced portfolio (avoids buying too many dips and becoming severely overweight in one company). I'll provide a portfolio update any week there is new buying (which means at least once per month).

So, now that you understand why this new model portfolio is so potentially useful and the rules behind it, here are the top 10 most undervalued aristocrats and kings you can buy today.

The Best Dividend Aristocrats And Kings To Buy Right Now

These are the most undervalued dividend aristocrats and kings you can buy right now. I've curated this list myself to exclude companies that I think have a high risk of the thesis breaking (thus, the exclusion of certain companies like BEN). The companies are sorted by most to lease undervalued according to DYT.

Top 5 Dividend Aristocrats To Buy Today

Company Ticker Sector Yield Fair Value Yield Historical Yield Range Discount To Fair Value Expected 5-Year Annualized Cash flow Growth

Valuation Adjusted Total Return Potential

Cardinal Health (CAH) Healthcare 4.0% 2.3% 1.2% to 4.3% 42% 4.8% 14.1%
Walgreens Boots Alliance (WBA) Consumer Staples 2.8% 1.9% 1.0% to 3.1% 33% 9.5% 16.0%
AbbVie (ABBV) Healthcare 5.3% 3.6% 0.9% to 5.5% 32% 8.5% 17.2%
A.O Smith (AOS) Industrials 1.6% 1.1% 0.8% to 3.4% 29% 8.9% 14.4%
General Dynamics (GD) Industrials 2.4% 1.9% 1.0% to 4.9% 19% 9.8% 13.9%

(Sources: Management guidance, GuruFocus, F.A.S.T. Graphs, Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model) Note: Margin of error on total return potential is 20%.

Top 5 Dividend Kings To Buy Today

Company Ticker Sector Yield Fair Value Yield Historical Yield Range Discount To Fair Value Expected 5-Year Annualized Cash flow Growth

Valuation Adjusted Total Return Potential

Colgate-Palmolive (CL) Consumer Staples 2.5% 2.2% 1.8% to 2.9% 12% 5.9% 9.8%
Hormel Foods (HRL) Consumer Staples 2.0% 1.8% 1.2% to 2.8% 10% 8.5% 11.0%
Coca-Cola (KO) Consumer Staples 3.4% 3.2% 2.3% to 4.0% 7% 7.2% 11.2%
3M (MMM) Industrials 2.7% 2.5% 1.8% to 4.8% 6% 10.0% 13.7%
Federal Realty Investment Trust (FRT) REIT 2.9% 2.8% 2.2% to 6.4% 5% 7.0% 10.7%

(Sources: Management guidance, GuruFocus, F.A.S.T. Graphs, Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model) Note: Margin of error on total return potential is 20%.

Note that the dividend kings trade at such high (but well-earned) premiums that even the most undervalued one in America is only 12% undervalued. Buying these elite dividend growers is an example of Buffett's famous rule that:

"It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price."

New Buys Last Week

  • 9 shares of Walgreens at $55.83
  • 6 shares of General Dynamics at $171.26

Walgreens was bought on Tuesday, April 2nd, the day of its 13% earnings crash. I used the overreaction (management is confident it can deliver about 7% long-term EPS and dividend growth after 2020 and analysts agree) to move up next month's dollar cost average buy to that day.

General Dynamics was the new addition to the portfolio and BDGP's 12th company overall. It managed to break into the top 5 aristocrats list, which per our rules, means we take a starter position of $1,000.

While that doesn't help much with the diversification problem faced by a highly concentrated new portfolio focused on buying the least popular blue-chips at any given moment, I'm very happy to own GD in the portfolio now. As you'll see in the performance section, Lowe's (LOW) is the BDGP's biggest winner and was also opportunistically purchased upon a brief break into the top 5 kings list.

In the current market environment, economically sensitive stocks (like industrials and consumer discretionary) are red hot, and thus it's good to own them, and not purely defensive names that are currently unloved by investors.

Because of how BDGP is structured, specifically only able to buy companies of a combined watchlist of 10 stocks in any given week, it's going to take a long time before we can achieve the 15 to 25 company diversification that is generally optimal for most investors.

Thankfully, while the short-term total returns might be lackluster, the quality of the portfolio (as seen by above-average profitability and a majority of companies with "exemplary" Morningstar management quality grades) means that anyone who is mirroring this ultra-low risk portfolio is still likely to do well over time.

The Bunker Dividend Growth Portfolio Today - 12 Holdings

(Source: Morningstar) - data as of April 5th

Starting out the portfolio is going to be heavily concentrated because we're working off a watchlist of just 10 companies, with minimal weekly turnover.

Due to the small investing universe we're dealing with, the BDGP will likely top out at 60 holdings after many years of steadily adding aristocrats and kings.

Our Highest Yielding Positions

(Source: Morningstar) -data as of April 5th

Note that stewardship is Morningstar's rating of the quality of management. S = standard (fair to good) and E = exemplary (very good to great). P = poor, but our policy is to avoid such companies (thus why we're not buying AT&T (NYSE:T) anytime soon).

The portfolio isn't "high-yield" by some definitions but is paying about 50% more than the S&P 500. And given the ultra-low risk nature of its income stream and double-digit dividend growth rate, I consider a yield roughly equal to the 30-year US Treasury to be very good.

(Source: Morningstar)

Due to only owning aristocrats and kings, the portfolio is 100% US stocks. But in reality, we have very strong exposure to foreign markets because almost all our holdings are multi-national blue-chips.

Of course, that is likely to hurt us at times, such as periods when a stronger dollar and trade conflicts hurt multi-national earnings. However, that just creates more buying opportunities that will eventually result in superior returns when those temporary headwinds subside.

(Source: Morningstar)

Due to the 100% focus on the safest blue-chips, we're mostly in slower growing companies.

Sector Concentration

(Source: Simply Safe Dividends)

Since we're starting out very concentrated into the most undervalued kings and aristocrats, there is going to naturally be a lot of sector concentration. Over time, this will smooth out, but given the rock-solid dividend safety of every company we own, I'm not worried about being overweight by sector (there are no sector caps).

Income Concentration

(Source: Simply Safe Dividends)

As with any equal weighted and concentrated portfolio, the highest yielding stocks will dominate the income stream. This will balance out in the future as we diversify into more companies.

Annual Dividends

(Source: Simply Safe Dividends)

Any concentrated portfolio is going to have a lot of month-to-month variation in dividend payments. Eventually, this will spread out as we diversify into a few dozen companies.

The small annual income is due to this portfolio being about $26K in size. Over time adding fresh savings and steady dividend growth will generate impressive and very safe income.

(Source: Simply Safe Dividends)

I'm pleasantly surprised at how fast this portfolio would have grown its dividends in the past one to 10 years. The S&P 500's 20-year median dividend growth rate is 6.5% and these dividend legends have delivered close to double-digits this decade and even better in recent years.

If we could maintain the five-year average rate then in 20 years even this $10,000 portfolio would be generating impressive amounts of super safe income, generating a yield on cost of about 25% (about 13% adjusted for 2% long-term inflation).

(Source: Simply Safe Dividends)

It might not be easy to maintain such growth rates but currently, analysts are estimating earnings growth (and thus likely dividend growth) of 10.3% over the next five years.

(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). In addition, Morningstar rates many of our companies' management as "exemplary" in terms of long-term capital allocation decisions.

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

  • Yield On Cost: 2.9%
  • Yield: 2.9%
  • Expected 5-Year Dividend Growth: 10.3%
  • Expected 5-Year Total Return (No Valuation Changes): 13.2%
  • Portfolio Valuation (Morningstar's DCF models): 9% undervalued
  • 5-Year Expected Valuation Boost: 1.9% CAGR (20% margin of error)
  • 10-Year Expected Valuation Boost: 1.9% CAGR (20% margin of error)
  • Valuation-Adjusted Total Return Potential: 14.2% to 15.1% (market's historical return 9.1%) - note margin of error 20%
  • Margin of error adjusted total returns expected: 11.4% to 18.1%
  • Portfolio Beta: 0.84 (16% less volatile than S&P 500)

Portfolio Performance

  • CAGR Total Return Since Inception (February 25th, 2018): -1.7%
  • CAGR Total Return S&P 500: 3.7%
  • Market Outperformance: -5.4%
  • Long-Term Outperformance goal: 1+%

Due to the highly concentrated nature of the portfolio and the timing of when the portfolio is starting (deep into a strong rally), it's not surprising that the initial results after a week are not that impressive. I expect the alpha to improve immensely once the market becomes overheated and goes through a pullback/corrections.

(Source: CNN)

In terms of valuations the S&P 500 is now 3% overvalued, and investor sentiment, as measured by the CNN Fear & Greed index (based on 7 technical indicators) is approaching extreme greed levels. Historically, within one to three months of such levels, stocks suffer a decline that will allow BDGP to diversify further plus benefit from the low effective downturn volatility baked into such an ultra high-quality portfolio.

(Source: Morningstar)

Starting out our heavy concentration in healthcare is badly hurting short-term returns. However, monthly dollar cost averaging buys will reduce the cost bases of our biggest losers helping to boost returns over time when these blue-chip SWANs recover.

Bottom Line: Diversification Is Crucially Important, Even When You Only Buy Ultra-Low Risk Dividend Blue-Chips

Both historical studies, as well as my own experience with various portfolios over the years, shows the importance of diversification. While you don't want to go overboard and own more companies than you can track (or "de-worsify" just to hit an arbitrary number) there is indeed safety in numbers.

If you own just a handful of companies then your early returns will be at the mercy of short-term market sentiment about those overweight positions. While BDGP is 100% composed of the bluest of blue-chip companies, and about as low-risk as an equity portfolio can get, the early results have been disappointing due to its focus on only buying the least popular aristocrats and kings at any given time.

I remain confident that this highly conservative dividend growth strategy will ultimately prove successful. However, as with all long-term investing approaches, patience and discipline are essential.

The probability of Alpha Strategy Underperforming Over Rolling Time Periods

(Source: Advisor Perspectives)

Even the best time tested investing strategies will underperform, and sometimes for long stretches of time. BDGP is based on the principle that "offense wins ball games, defensive wins championships." While launching on February 25th means we haven't experienced many periods of market weakness, those few that have occurred have generally seen this portfolio fall 25% to 33% as much as the S&P 500.

This indicates that, while the overall beta is 0.84, the effective beta during a market downturn is far less. This bodes well for the future, given that current economic/market conditions indicate we may be approaching the end of the bull market (for example, a massive rush of non-profitable IPOs are historically a sign that venture capital investors are racing for the exits before a bear market starts).

I'll continue patiently buying great companies at good to great prices per the portfolio's rules as I test this highly conservative "widows and orphans" approach to dividend growth investing. Just remember that even low-risk collections of blue-chips like this are only meant to be part of the equity portion of your portfolio.

NO DIVIDEND STOCK IS A TRUE BOND ALTERNATIVE. During the Great Recession, almost all aristocrats and kings declined, just far less than the 57% crash experienced by the S&P 500.

Top Performing Dividend Aristocrats During Great Recession

(Source: Simply Safe Dividends)

Just Walmart (WMT) and People's United Financial (PBCT) were able to post positive total returns during the Great Recession, and their 7% and 2%, respective returns, were far below what long-term bonds returned.

Note that the negative return for 10-year bonds during 2009 was due to the stock market roaring higher beginning March 2009 (creating a "risk on" environment that ended the flight to safety seen in 2007 and 2009).

Best Performing Dividend Kings During the Great Recession

(Source: Simply Safe Dividends)

Among the dividend kings, Lancaster Colony (LANC) was the best performer, posting a flat total return of zero. But note that California Water (CWT), as close to a recession-proof defensive stock as you can get, still fell 7%.

The point is that aristocrats and kings will help you sleep well at night in terms of smaller declines and safe and growing dividends. But if you need stable/appreciating assets to sell in order to meet expenses during a bear market (like retirees on 4% rule) you need to actually own the appropriate amount of cash/bonds.

Disclosure: I am/we are long ABBV, AOS, WBA, ITW. 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.