If I were to start a portfolio today, it would be a simple and beautiful DGI portfolio that can fund my retirement with ever-growing dividends. But how to accomplish this goal in a market where the S&P average yield is only 1.9%? In this article, I will discuss a dream team of high yielders I have assembled whose average return is 5.3%. Not only these companies can reward shareholders with an oversized paycheck, but I believe these firms will also grow their distributions at a sustained rate of at least 5% over the long term. This combination of high yield and moderate growth is a perfect formula for high total returns. But wait, there's more! The portfolio constituents are, for the most part, moaty businesses led by experienced management teams. The icing on the cake? Valuation: At equal weight, the portfolio could deliver a 40% upside to fair value. Interested to know more? Read on.
The basics of total return
The Gordon Growth model is a simple mathematical method that prices a stock based on its forward payment (the dividend) which grows at a constant rate. The formula is straightforward:
P is the current stock price, D the forward dividend amount, g the constant growth rate expected in the distributions and r the (required or desired) rate of return. However, the exciting thing is that by solving this equation for r, we can find out the rate of return we can obtain from a dividend-paying stock. This return is equal to forward payout D/P plus the yield's growth. Such simple but powerful concept can, therefore, be used to determine the expected return on a portfolio of dividend-paying equities at a price P. Growth is the most difficult (read: subjective) part of the equation, because past performance is not indicative of future results. However, past dividend CAGR is often used by dividend growth investors to confirm the management's commitment to continue returning value to shareholders. Sustainability of the dividend's growth is kept in check by monitoring the payout ratio.
The "dream team portfolio," June 2019 edition:
The stocks that made my final cut to this selection are biotech giants AbbVie (ABBV) and Amgen (AMGN), the safe utility Dominion Energy (D), energy behemoth Exxon Mobil (XOM), refiner Marathon Petroleum (MPC) and plastic specialist LyondellBasell (LYB), English tobacco Imperial Brands (OTCQX:IMBBY), financial advisory and asset manager Lazard (LAZ), mall REIT Simon Property Group (SPG), and WestRock (WRK). The portfolio is reasonably diversified by sector and constituted by four cyclical, four defensive and two interest-sensitive holdings. Most of these companies were selected because I believe they can provide a stable 10% return through a "5%+5%" combination of yield and growth (the exceptions being high-growth AMGN and high-yield IMBBY). While I believe the current dividend is safe, many of these companies have a track record of being able to grow their distributions at a much faster rate than what I assumed. This margin of safety could potentially secure a better return to investors, but I think it just more conservatively assumes a full-cycle economic performance. Another embedded margin of safety of this portfolio is that the payout ratio is (on average) well below the 60% threshold.
The $10,000 retirement challenge
Morningstar portfolio tracking at June 13th market open
I created a virtual $10,000 model portfolio in Morningstar to show the strategy in action because I plan to track the portfolio performance over the next few quarters. The portfolio P/E is well below market average at just 10.5x earnings, and all holdings have a Morningstar rating of four or five stars, implying they are currently undervalued. But let's not think about valuation just yet. As shown above, I believe the portfolio can generate long-term total return according to the Gordon Growth Model equal to 10.7%. Now let's take two fictitious roommates: Joey, a mediocre actor, and Chandler, an office worker. Both are aged 25, and Chandler invests his $10K in a total market passive ETF which will likely generate a 9% long-term return over the next 40 years. Joey invests all his savings in this portfolio. Both go to sleep for 40 years (which I do not recommend you to do) and only come back to get their retirement paycheck. If you think the 1.7% extra return earned by Joey over the years is not that significant, watch below results (assumes no further contributions and no withdrawings, all dividends reinvested):
Ladies and gentlemen, compounding wins big again. With a frugal lifestyle (and some social security benefits) Joey can peacefully retire and receive over $30K per year, just because he invested $10K at a young age. Even better, he can now start withdrawing the dividends and yet the sum would continue to grow by 5%! (likely exceeding inflation). The little DGI portfolio beats the market.
The active investor's edge
Joey can enjoy his retirement with a simple buy and hold strategy: he lets his DGI portfolio work for him. However, for those of you who believe valuation still matters, here comes the icing on the cake: this particular portfolio was carefully assembled considering fundamentals as well.
A rational investor who can keep his cool during stressful times and use valuation to his advantage has a high possibility to enhance his returns further. Here is the situation of the dream team portfolio with regards to fair value: the portfolio is 30% undervalued!
The simulation above considers a 10-year time frame for reaping valuation benefits. Still, a wise active investor could theoretically capture an additional 3.2% (for a total compounded return of almost 14%). To sustain the portfolio total return level over the long-term; however, a new holding should always replace a sale, and the new equity should also have a Gordon total return of at least 10.7%. Please note that above valuation assessments are from Morningstar, and I have a slightly lower price for Marathon ($87 vs. $89). a higher target for both ABBV ($118 vs. $102) and LyondellBasell ($104 vs. $99). LyondellBasell is the only holding not directly covered by a "real" analyst. Fortunately, you can read my report on LYB here on SA. For the remaining positions in the portfolio, I did not come up with an independent or have similar targets to those provided.
Some final words and how to "future-proof" the portfolio
Lastly, a few words on the safety of this portfolio. As of today, all the companies are rated investment grade by both S&P (which I prefer) and Moody's.
However, a word of caution is needed. A portfolio with only 10 holdings carries a high concentration risk, and although buy and hold could theoretically work out fine, there is a long-term probability of distress of the constituents which could affect returns. Such a threat is significant when it comes to stock picking vs. passive ETF investing. Therefore, some due diligence and portfolio maintenance are always recommended to investors. In particular, I would like to pinpoint three holdings (XOM, IMBBY, and LAZ) that are said to face secular headwinds. Exxon's risk is a shift from fossil fuels to renewables; Imperial faces a decline of smoking rates and a harsher regulatory environment; and Lazard as an asset manager the ever-increasing popularity of passive investing. However, an alternative to XOM could be renewable yieldcos such as Atlantica Yield (AY) or NextEra Energy Partners (NEP). In the case of Lazard, BlackRock (BLK) offers a wide moat and a decent starting yield. For Imperial Brands, investors could switch to Molson Coors (TAP) or another defensive play.
For every stock narrative, there are always both long and short cases. A wise investor dispassionately manages risk either through replacing the holding he no longer feels comfortable about or by building new positions reinvesting dividends. There is no speculation involved, and I am not talking about swing trades: through the highs and lows of the markets, there will be times to sell at a profit over the next couple of decades. Let the time be your friend and work for you, not against you!
Disclosure: I am/we are long ABBV, IMBBY, LAZ, LYB, MPC, SPG, AY. 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.