Seeking Alpha

How To Eat An Elephant: Building A Dividend Growth Portfolio One Bite At A Time

by: Elephant Dividends
Elephant Dividends
Dividend Investing, portfolio strategy, large-cap, Long Only
Summary

A well-constructed dividend growth portfolio can be built "out" and "up" over time.

Relative sector representation within popular dividend growth indexes like the Dividend Aristocrats and Dividend Achievers provides a useful starting point for creating sector-weighting targets in individual portfolios.

Portfolio visuals are useful for tracking progress toward achieving target allocations and monitoring self-imposed risk metrics during the portfolio construction phase.

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"Behold, from my humble earnings I had begotten a hoard of golden slaves, each laboring and earning more gold. As they labored for me, so their children also labored and their children's children until great was the income from their combined efforts." - George S. Clason, The Richest Man in Babylon

This ancient truism is both the philosophical and mathematical underpinning of dividend growth investing, and it goes to the heart of this portfolio's objective: generating a safe, sustainable, and growing passive income stream. The portfolio's name was intentionally chosen to reflect the incremental approach of building wealth over time through patient and disciplined investments in dividend-paying equities.

As a personal introduction, I am a working professional in my early thirties whose day job focuses on the development and use of bioeconomic models to make procurement and marketing decisions in the physical ag commodity space. In my spare time, I am working to develop multiple passive income streams to eventually achieve total financial independence. While I have great respect for those participating in the FIRE (financial independence/retire early) movement, that is not my personal investing objective. My job is interesting, flexible, and supports the lifestyle we desire for our family, so I can happily say I look forward to working for a few more decades. That said, I desire the peace of mind that will come with knowing our financial future is fully secure without requiring dramatic changes to our lifestyle. To that end, my interest is in pursuing what I have come to call a "Hi-FI" investment objective, meaning that by pairing consistent savings and budgeting with prudent investments, we should have the option (but not the obligation) to retire in our mid- to late-fifties with no meaningful change to our ability to travel, support our children's education, or drink the occasional glass of fine wine.

Portfolio Goals

Goal #1: Approximate the returns of the broader market (benchmarked against the S&P 500) with lower volatility.

Goal #2: Derive a significantly greater proportion of overall returns from dividends than the portfolio benchmark. (Reduce reliance on capital gains as a source of portfolio returns.)

Goal #3: Grow the portfolio's dividend income at a rate that exceeds inflation.

It is important to note that this portfolio does not constitute my core retirement savings. (In fact, I am planning for my retirement as if this portfolio did not even exist.) Rather, it is meant to serve as a source of supplemental income in retirement. As such, at this time I am comfortable not having specific goals related to portfolio income and/or value. When it comes to supplemental income, the more the merrier. Eventually this portfolio's holdings and income stream may be used to secure financing for selected investments in single family rental properties.

Portfolio Construction Methodology

The Elephant Dividends portfolio has been constructed using a top-down strategy, meaning that the initial focus was placed on selecting the specific sectors and subsectors to be represented in the portfolio (and their weights) with a secondary focus on the specific issues used to achieve this overall design. Investors employing the bottom-up approach reverse this order, placing primary emphasis on the selection of promising individual assets or issues before considering how those assets are distributed across asset classes, sectors, and subsectors. While each approach has its own merits, the investor who elects to construct a portfolio based on a published index (as in the Dividend Aristocrats) or indices (as is proposed here) is effectively committing to a top-down approach.

The portfolio has and will at all times hold positions representing all 11 GICS sectors. The weighting of individual sectors is based on a weighted average of each sector's representation on the Dividend Aristocrats (75%) and Dividend Achievers (25%) lists. When the portfolio is complete, no single sector should represent greater than 20% of the portfolio's holdings.

Once the initial portfolio construction phase is completed, the portfolio will hold a minimum of 30 and maximum of 40 equities at any given time. This implies that each sector should be represented by a minimum of one and up to eight (40 total positions * 20% = 8) positions. All positions are equally weighted. Profits are allowed to run on a given position until it is 120% of the average portfolio position size, which is defined as a "unit." Proceeds from trimmed positions may be used to either add to underweight positions or initiate a new position as circumstances may dictate. If no compelling investment opportunity is available, cash may be allowed to accumulate for deployment at a later date.

For the sake of income diversification, the portfolio should not hold any positions that contribute greater than 10% of the portfolio's projected annual dividend income (PADI) with a very strong preference that no single position contribute greater than 5% of the PADI. In the event that a holding exceeds the 10% threshold, that position will be held intentionally underweight in order to reduce single-stock income exposure until its PADI contribution is diluted by other holdings in the portfolio. All dividends are collected in cash (no DRiPs). This facilitates the addition of capital to underweight positions or initiation of new positions as described previously. Zero-commission trading has made small odd lot (or even single share) purchases a viable and relatively inexpensive method for building positions. While it comes with the drawback of forgoing DRiP discounts on some equities, the naturally value-oriented approach of adding to blue chip positions that are temporarily out of favor seems like a reasonable tradeoff.

Outside funds are contributed to the Elephant Dividends portfolio as they come available. This portfolio is ultimately intended to provide supplementary income in retirement but not serve as our sole nest egg, meaning that other retirement accounts and living expenses (like the home mortgage) take priority before funds are diverted to the Elephant Dividends portfolio. In keeping with the foregoing, the portfolio will generally hold a minimal amount of cash. If compelling opportunities arise that require fresh capital, outside funds may be contributed on a case-by-case basis.

Selection Criteria for Portfolio Positions

I look for a minimum starting yield that is greater than the current yield of the S&P 500 (1.69% as of this writing; S&P 500 Dividend Yield). While this is the minimum yield threshold for consideration, it is hard for me to get excited about any company yielding less than 2.00%.

When it comes to dividend growth investing, past is often pretense. Therefore, I invest only in companies with a proven track record of maintaining and growing dividend payments over time. Strong preference is given to companies that have grown their dividends each and every year, although some special circumstances are allowed. (TD Bank and Home Depot, which held their dividends steady but did not raise them during the Great Financial Crisis, are prime examples.) All things being equal, preference is given to companies with longer dividend track records.

With rare exception, companies included in the Elephant Dividends portfolio have a minimum dividend growth streak of 10 years. Based on that, most portfolio constituents are members of the myriad indices and lists familiar to dividend growth investors: the Dividend Aristocrats, Dividend Achievers, Dividend Champions, and Dividend Contenders). If a company isn't already a Dividend Aristocrat, there must be a compelling case that it is on track to achieve that status at some point in the foreseeable future. Any issue that doesn't pass this "sniff test" will not receive further consideration.

In addition to each company's dividend track record, candidates for inclusion in the portfolio are assessed on the basis of payout ratio (generally <60% with some exceptions for sectors like REITs, MLPs, and utilities). I consider debt levels and relevant accounting ratios relative to industry peers on a case-by-case basis.

Finally, I give some consideration to outside assessments of quality and dividend safety (analyst opinions and blogger commentary). Greater weight is given to the opinions of those whom I regard as rigorous DGI practitioners, but all sources of ideas are considered. Keeping with this theme, I require my holdings to have investment-grade credit ratings as determined by S&P.

The Elephant Dividends Portfolio Today

Image created by author.

Current holdings and relevant basic data are summarized in the table above. Position sizes are monitored relative to the average position size across the entire portfolio. By definition, a "unit" is equal to the total value of all holdings in the portfolio (ex-cash) divided by the number of holdings. The goal is for all positions to fall in a range of 0.8x to 1.2x the standard unit size at any given time. Presently, all positions are within acceptable limits except EPD, which has been intentionally left underweight because it currently accounts for just under 10% of the portfolio's PADI.

Image created by author.

The relative contribution of individual positions to the overall portfolio PADI is important because it speaks to the diversity (or lack thereof) of income streams generated by the portfolio holdings. Based on the principles laid out above, no single position should account for more than 10% of the portfolio PADI (and preferably no more than 5%). EPD and T are in compliance with the hard-and-fast 10% rule, but only by a slim margin. ED, O, and TD are not concerning at this time, because as additional positions are added to the portfolio their PADI contribution should be diluted down to under the preferred 5% threshold.

Image created by author.

Actual dividend income by month since portfolio inception is summarized in the chart below.

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In order to smooth out some of the "lumpiness" associated with which month within the quarter different companies choose to pay their dividends, a trailing three-month average dividend income is also calculated.

Image created by author.

To track longer-term progress, year-over-year monthly dividend income is monitored.

Image created by author.

A simple sensitivity analysis shows projected PADI at various points in the future based on current PADI and varying dividend growth rates. A critical assumption here is that no dividends are re-invested and no new capital is added to the portfolio. Of course, neither of those assumptions is true for this portfolio, but it simplifies the math and gives a very conservative baseline for expected future income growth. The greyed cells indicate what I think are reasonable dividend growth expectations over time, which I have centered on 9%. The five-year average dividend growth rate for the holdings in this portfolio weighted by PADI contribution is 8.91% (calculations not shown).

Image created by author.

Finally, consistent with the principle that this portfolio should have sector representation equal to a weighted average of the Dividend Aristocrats (75%) and Dividend Achievers (25%), the following table and chart track the portfolio's progress toward that objective. The rationale behind this weighting system is crude, but it does have a basis in logic. By virtue of their status as Dividend Aristocrats, companies included in that index have proven they have business models and revenue streams that have not only allowed them to grow into some of the largest companies in the United States, but they also have boards that have made a consistent effort to return value to shareholders in the form of dividends (for 25 years or more). The Dividend Achievers (which includes some of the Dividend Aristocrats) includes many companies that are well on their way to achieving Aristocrat status (minimum 10-year dividend growth steak) but have shorter dividend growth records or smaller market caps. As the Achievers mature and join the Dividend Aristocrats, it is reasonable to expect that the sector representation of the Dividend Aristocrats will change as well. (Think about what will happen to relative sector representation as many of the large dividend payers within the Technology sector come of age!)

Image created by author with data downloaded from Simply Safe Dividends and the author's own calculations.

Image created by author with data downloaded from Simply Safe Dividends and the author's own calculations.

Conclusion

The Elephant Dividends portfolio is still in its infancy. Immediate plans are to continue to grow the portfolio "out" by adding positions that help achieve the overall goal of sector diversification as indicated by sectors' relative representation within the Dividend Aristocrats and Dividend Achievers indices. While this objective could be accomplished immediately with the addition of fresh capital to the portfolio, for now I am focused on funding new positions with a combination of accumulated dividends and strategically harvested capital gains.

Once the portfolio has grown out to the point that it holds a minimum of 30 positions, the next step will be growing it "up" by adding to existing positions with fresh capital, rebalancing, and reinvestment of dividends. A very distant goal is to have all holdings consist of at least one round lot (100 shares) so I can write covered calls against positions I believe to be overvalued. Just like eating an elephant, these goals will have to be accomplished one bite at a time!

Disclosure: I am/we are long ADM, APD, CAT, ED, EMN, EPD, GD, HD, ITW, JNJ, LMT, MDT, MSFT, O, PEP, PG, SJM, T, TD, TROW, TRV, TSN, UNP, UPS. 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: All opinions expressed are my own and should not be construed as trade recommendations. Caveat emptor.