Deep Value Dividend Growth Portfolio: 3 Great New Blue Chips

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Includes: CVS, MO, MSM, UNH, UPS, WBA
by: Dividend Sensei
Summary

The DVDGP is a model portfolio I'm tracking to determine a highly diversified portfolio of quality companies bought at fair value or better, can consistently beat the market.

It's inspired by Peter Lynch's Magellan Fund, which delivered 29% CAGR total returns from 1977 to 1990 and at times held 700 companies.

Last week, based on recommendation's from Simply Safe Dividends, I added UPS, MSM, and UNH to the portfolio. All three are high-quality blue-chips and SWAN stocks.

Also based on the recommendation of Simply Safe, I'm revising down our sector caps to 20% while individual position caps remain at 5%. Risk management is critical to long-term investing success.

After 17 weeks, this 83 value-focused dividend stock portfolio has beaten the market in four of the last five months and outperformed the S&P 500 by 6.3% overall. All while delivering twice the yield and double-digit dividend growth.

(Source: imgflip)

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 (with the best ideas for new money at any given time). The other will be the portfolio update.

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).

To minimize reader confusion, I will be providing portfolio updates on a rotating three-week schedule. This means an update every three weeks on

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. In fact, according to Hulbert Financial Digest, IQT's DYT focused approach to pure blue-chip investing has resulted in the best 30-year risk-adjusted returns of any investing newsletter in America.

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 dividend requirement IQT has, excludes these kinds of investments from its recommendations.

Basically, my investing strategy is focused 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: 20%
  • Industry cap (like tobacco): 15%
  • Individual holding cap: 5%

These are the recommendations that Simply Safe Dividends gives our subscribers, and are based on founder Brian Bollinger's time as a mutual fund manager. His three model portfolios have all beaten the market by 1% to 2% CAGR since 2015, indicating that this level of diversification/risk management is likely a good strategy for most people.

This is 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" watch lists (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.

This is purely a tracking (model) portfolio, which, combined with two other model portfolio's, is helping me to refine how I manage my retirement portfolio.

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 83 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 one day. 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.

Think of DVDGP as a quality screening tool and master watch list of dividend stocks I consider worth owning for most investors. Then use it to help build your own watch lists and then buy those companies when they hit fair value or better.

3 Great New Buys Plus Opportunistic Additions To Existing Positions

In the past two weeks DVDGP bought

  • 9 shares of Walgreens (WBA) at $55.83
  • 10 shares of CVS Health (CVS) at $51.91
  • 10 shares of Altria (MO) at $53.90

These were all opportunistic buys taking advantage of 5+% daily declines created by non-thesis breaking news (earnings disappointment at WBA, a sympathy crash at CVS, and FDA vaping scare with MO).

In addition, last week I added three new companies to the portfolio (and my overall watchlists)

  • 21 shares of MSC Industrial (MSM) at $81.12
  • 10 shares of UPS (UPS) at $114.46
  • 6 shares of United Health Group (UNH) at $223.22

MSC and UPS were recent Simply Safe "timely recommendations" and after analyzing them I concluded that each was a level 9 quality SWAN stock (based on my new Sensei Quality Scoring system).

United Health is a level 11 SWAN (a perfect score), courtesy of a very safe dividend, a wide moat, and industry-leading quality management team. I picked it up off SSD's list of dividend stocks near 52-week lows, screened by dividend safety score. Morningstar's conservative discounted cash flow fair value estimate says it's 26% undervalued, and while DYT estimates just a 5% margin of safety, I'm thrilled to not just add this blue-chip to my watchlists, but also my retirement portfolio as well (it qualifies as a Buffett style deep value "fat pitch").

MSM is 5.6% away from my target price, has also received a limit buy order in my retirement portfolio. But UNH is already beneath the target price, ensuring I'll buy it this week (and set a limit to buy more if it declines further).

All three companies are capable of delivering at least 13% CAGR total returns over the next five years. The reason for the double buy was that last week was DVDGP's monthly dollar cost averaging buy when I add $500 worth of shares to all active watchlist recommendations.

Is this portfolio getting large and more diversified than most investors might prefer? You bet. But the entire point is to show that great returns can be derived not from a handful of smash hits, but rather a time tested and methodical approach to quality dividend growth companies bought at good to great prices.

After all, Peter Lynch, one of the greatest investors of all time, managed to deliver 29% CAGR total returns at the Magellan fund while at times owning 700 stocks. DVDGP is capping the holding size at 150 or less (my retirement portfolio at 100) purely for issues of time management.

The trick is to buy quality companies, at fair value or less, and not be in a rush to diversify for its own sake.

The Deep Value Dividend Growth Portfolio - 83 Total Holdings

(Source: Morningstar) - Data as of April 12th close, (CWEN) is no longer owned by the portfolio because I sold it before it cut its dividend by 40%.

Our Highest Yielding Stocks

(Source: Morningstar) - Data as of April 12th, Clearway Energy is no longer owned in the portfolio

(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. Note that in reality many of our large-cap blue-chips have significant overseas sales, so we have plenty of exposure to global growth markets.

(Source: Morningstar)

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

Sector Concentration (20% 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.

That's so that some of the riskier positions (like level 7 quality dirty values) don't cause a significant hit to the dividend stream should their thesis break.

Annual Dividends

(Source: Simply Safe Dividends)

While we may never fully get to the dream of daily dividend payments, the portfolio might get close. And the monthly income flow will smooth out nicely over time and should continue growing rapidly (double digits is the goal).

(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 one-year and five-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 (NYSE:KIM) and Simon (NYSE:SPG)) which cut their dividend (as 87% of 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 a handful of 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, ABCB) 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 11.8% dividend growth for 20 years is likely beyond the portfolio's ability, according to Morningstar, the projected EPS (and thus likely dividend) growth rate is about 10% over the next five years.

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

  • Yield On Cost: 4.1%
  • Yield: 3.8%
  • Expected Five-Year Dividend Growth: 11.1%
  • Expected Five-Year Total Return (No Valuation Changes): 13.7%
  • Portfolio Valuation (Morningstar's DCF models): 7% undervalued
  • Five-Year Expected Valuation Boost: 1.6% CAGR (20% margin of error)
  • 10-Year Expected Valuation Boost: 0.8% CAGR (20% margin of error)
  • Valuation-Adjusted Total Return Potential: 14.5% to 15.3% (market's historical return 9.1%) - Note margin of error 20%
  • Margin of Error Adjusted Total Returns Expected: 11.6% to 18.4%
  • Portfolio Beta: 1.05 (5% more volatile than S&P 500)

(Source: Morningstar)

The quality of these companies can be seen in the above-average returns on assets and equity of this portfolio (good proxies for quality, long-term management, and good corporate cultures) as well as faster projected earnings growth rates.

DVDGP is also far more undervalued, offers a much higher yield and should achieve far superior dividend growth compared to the broader market. That's due to corporate America's bigger focus on buybacks vs. dividend hikes for most non-dividend-focused companies.

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): 18.9%
  • CAGR Total Return S&P 500: 12.6%
  • Market Outperformance: 6.3%
  • Long-Term Outperformance Goal: 2+%
  • YTD: 16.4% vs. S&P 500 16.7%

(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) Data as of April 12th, Clearway is no longer owned, and thus shows up as a 0% gain.

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, boosting long-term gains. That's assuming the thesis doesn't break, which is where the high diversification comes in to lower the risk of a permanent loss of capital.

Best Performers

(Source: Morningstar) Data as of April 12th

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.

This is why the monthly DCA buys are mostly based on target yields from the DVDGP Bear Market Buy List, to help keep the portfolio well balanced. The sector caps are also in place to avoid becoming too top heavy in any one sector.

Bottom Line: So Far DVDGP Is Proving Simply Safe And Peter Lynch Right

Don't get me wrong, by no means am I saying that you need to own anywhere close to this many companies to do well with a dividend portfolio. 20 to 30 companies work well for most people (Simply Safe's model portfolios hold 20, in all sectors, using strict sector and position size caps).

But what I've noticed about the performance of this portfolio compared to my other model (and real money retirement) portfolios is that always being diversified is highly advisable. If you start out with a pure deep value focus you'll likely start out with a heavy concentration in a few companies and sectors. This can lead to many months, if not years of underperformance and frustration that makes it hard to remain disciplined. And as Buffett famously explained, the key to successful investing is discipline and patience, "We don't have to be smarter than the rest. We have to be more disciplined than the rest."

While 17 weeks is far from definitive proof that this approach works, thus far the outperformance is remaining relatively constant, despite quadrupling the number of holdings since this portfolio's inception.

This is a big reason why I've reduced my own retirement portfolio's holding caps to 5% and sector caps to 20%. Not just is that what Simply Safe's Brian Bollinger recommends, but it's been what DVDGP has been running thus far, and to some pretty impressive initial results.

Disclosure: I am/we are long WBA, SKT, BPY, ABBV, ET, BIP, NEP, EPR, MPLX, IRM, AM, ENB, SPG, BLK, AOS, AAPL, CVS, BMY. 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.