Dividend Growth Models Weathering The Correction Better Than The S&P 500

Includes: BBL, CB, COP, LMT, MCD, MSFT
by: Jeff Paul

This is the May 2012 update on my four research-based Dividend Growth Model Portfolios. The Dividend Aristocrat+ portfolio focuses mostly on stocks with 25-year+ histories of dividend increases and uses equally weighted sectors. The DG-SmallCap portfolio concentrates on medium and smaller-cap firms with strong dividend growth, with preference to higher yielders. The DG-IncomeGrowth model is similar, but pursues non-small caps with high yields and high dividend growth rates. The newest model, DG-HYLP, screens for high-yield, low-payout ratio stocks as value plays with safe and growing dividends. The first three models were initiated on August 16, 2011, whereas the DG-HYLP was started on January 1, 2012, so there is less data history for that portfolio. Note: the performance figures are total return as of June 2, 2012.

Performance Summaries (3mo, YTD, and Since Inception)

Performance 3 mo

Over the last three months, the S&P 500 Index (NYSEARCA:SPY) experienced a decline. All of the DG models and the S&P Dividend ETF (NYSEARCA:SDY) had better performance with lower volatility and beta. This is what we would expect from dividend stocks. With the exception of the DG-HYLP model, the others all had less than half of the SPY's decline. The DG-HYLP model's mining and industrial stocks took a hit as concerns about the global economy rose again, which contributed to the portfolio's decline.

Performance YTD

Year-to-Date, the dividend models and SDY are trailing the SPY by around two percentage points, though again, with much lower volatility and beta. Since we generally expect dividend stocks to appreciate at a slower pace than the SPY in up markets, which was the case until the last month or so, there is nothing to be alarmed about in these results. The lower portfolio volatility has made for a smoother ride for DG investors, which is a plus.

Performance since Inception

Since inception, the original three Dividend Growth models have delivered total returns higher than the SPY and with less volatility. The DG-HYLP model has a later inception date, so the YTD results are more appropriate for this model. All of the DG models, excluding DG-HYLP, have higher volatility-adjusted (Sharpe) and beta-adjusted (Treynor) return ratios than the SPY. In simpler terms, these portfolios produced higher returns for each unit of risk, as measured by volatility or beta.

Stocks of Interest

Rather than focus on a particular model this month, I am highlighting stocks from all of the models that have had some major corrections or other developments. These DG stocks may be of interest to DG investors who have been waiting for valuations to improve before initiating or adding to a position. Price information is as of June 2, 2012.

  1. McDonald's (NYSE:MCD), which has been near $100 for the better part of the last three months, has experienced a 15% correction and is now closer to $86. A couple research analysts downgraded the stock this spring and margins are always a concern in this economy, but earnings growth is still projected at around 8-10%. With a payout ratio around 50%, MCD has room to continue raising its dividend later this year. I bought in a little early, buying it for my own portfolio near $92, but it's a long-term holding for me.
  2. BHP Billiton PLC (NYSE:BBL) is a natural resources company, including gas, oil, and mining. Its recent price decline to $52 brings it close to its 52-week low and raises its current yield to 4.2%. With a low payout ratio, the dividend is safe, and it has consistently raised its dividend for the last 9 years. The stock will likely lag until economic signs improve, but it will rise quicker once we turn that corner. This may be a good opportunity for those willing to wait, as you get a nice dividend in the meantime.
  3. Conoco Phillips (NYSE:COP) completed the spin-off of Phillips66 (NYSE:PSX), its refining and chemical businesses. The dividend payment for COP remains the same though, so COP now yields 5.2%. With earnings estimates of $6.45/share, COP trades at a forward P/E of 8 and a low payout ratio of 41%, making it attractive for income-oriented investors.
  4. Lockheed Martin (NYSE:LMT) has had a 12% decline from its 12-month high of $92. Despite the on-going threats of lower defense spending, LMT reported that 2012Q1 profits rose 26%. It is one of just a handful of major defense firms, with specialization in aircraft and missile technologies. LMT's 4.9% yield is attractive, and with a payout ratio around 50%, the dividend appears quite safe and could still grow, even if earnings are flat for a few years. I did a more complete write-up on LMT last year, which discusses growth and pension concerns.
  5. Microsoft (NASDAQ:MSFT) is down about 15% from its 52-week high and now yields 2.8%. With its very low payout ratio of 29%, MSFT's dividend is quite safe and it has a lot of room to continue growing. The next dividend increase would be expected in November 2012. While MSFT has not experienced the stellar growth of Apple Computer (NASDAQ:AAPL) over the last decade, its Windows, Office, Xbox, and Business software divisions continue to do well, leading to increased revenues and profits. Windows 8 is scheduled for release later this year, potentially leading to more presence in the tablet space. It is also worth noting that in addition to the $4.5B to $5.2B in dividends paid each of the last three years, MSFT has also repurchased approximately $9B in stock EACH of those years. While dividend investors probably prefer to get that money in cash, stock buybacks do help to increase earnings per share and support the stock price, which currently trades at a low PE of 10. Bottom line, MSFT has a lot of cash ($50B in cash, in addition to cash flows), solid core product lines, and room to grow its dividend, making it an attractive income play with growth potential.
  6. Chubb Corp (NYSE:CB) provides property and casualty insurance to businesses and individuals. The stock is flat YTD, but it has outperformed the SPY and Aflac (NYSE:AFL) on a beta-adjusted basis during that time frame. CB's long-term chart is appealing, a slow, steady riser. As with MSFT, CB also repurchases a significant amount of stock each year, generally close to 3x to 4x the amount paid out as a dividend. I currently own both AFL and CB, but have been wanting to sell my AFL, as it is much more volatile and the price always seems to trade at a much lower PE. CB's yield is only 2.3%, but with a 28% payout ratio and lots of free cash flow, its dividend is quite safe and continues to grow. I wish CB would pay out more in dividends and reduce the buybacks slightly, but taken together, the firm is returning a lot of money to shareholders.

Portfolio Changes

There are no changes to the DG model portfolios this month. A couple of stocks are near my -20% performance gap rule, which my data have shown often signals either a dividend cut or a larger future decline in price. If a stock in this portfolio is 20 or more percentage points below the S&P's performance for 4 consecutive weeks (using end-of-week data), then it will be replaced. However, none has triggered the rule yet.

Next month, I plan to rebalance the DG-HYLP portfolio. This portfolio is not subject to the -20% rule, as the low payout ratios generally insulate it against dividend cuts. Instead, I have elected to rebalance it semi-annually, whereas the other portfolios are rebalanced annually. My thinking is that high-yield, low-payout stocks indicate undervalued firms. If the market has since increased their valuation (i.e. price increase), then it makes sense from a total return standpoint to redeploy those funds into stocks with lower valuations. For income-oriented investors, such rebalancing may not be of interest, unless a stock falls out of the HYLP category. I expect the new portfolio list to be similar to the current one, but funds will be rebalanced as well, locking in some profits from rising stocks and shifting money to the stocks that have declined in price.


Overall, the DG models continue to perform well versus the SPY and do so with much less volatility, which was a primary objective. I will continue to monitor and report on these funds, and welcome any feedback and suggestions for improving them.

Disclosure: I am long MCD, BBL, COP, CB, AFL, AAPL.

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