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Evaluating The Safety Of Our Portfolio

I've been an avid reader on SA and I continue to learn with each article and comment. Some of the stock selections I made as recently as a month or two ago, I wouldn't have made today, as I have continued to learn how to evaluate and select potential businesses to invest in.

A recent article that was very educational and the inspiration for this article is Bob Wells' "A Current Review Of Dividend Safety Superstars" Parts 1 and 2, found here and here. In these articles, Bob detailed his quest to find the safest dividend growth stocks, and identified the safest group and his Level 2 group. Since I own a number of stocks that are not mentioned, I back tested my portfolio to evaluate which stocks I should deem safe and which ones I should watch carefully (or consider selling). I'm posting this article in case my analysis provides benefit to other "novice" investors like me.

Background

I've always been a little afraid of investing. In the past few years, I've worked to educate myself but I was only applying my knowledge to try to pick mutual funds and ETFs. I was interested in dividend paying stocks and had looked at a number of companies for several years but was too afraid to buy (thinking it was somehow more "risky" than being in ETFs/funds). About 6 months ago, I found SA and the many articles and authors describing the DGI approach. With that discovery, I had finally found an investing approach that I could believe in. I initiated my (and my spouse's) journey into DGI in January.

Needless to say, in this somewhat "bumpy" year and in the 6th year of a bull market, it's been a little unnerving. Right after starting our DGI journey, there was a broad market correction in the last week of January into early February (although it was fairly minor and short lived). Those couple of weeks were a bit scary to me; however, I bought some stocks during the dip. I figured that if I picked stable blue chips, I wouldn't likely lose any more than the funds I was currently invested in, so I may as well buy some stocks "on sale." I bought some T, MCD, IBM, MSFT, WAG, MMM, MO, KO, JNJ, and K during those two weeks. Those were probably all good picks, but I was basically selecting high quality blue chips. Prior to and after that 2-week period, I made some choices that were less safe, as you'll see below.

My Safety Evaluation

I currently categorize the stocks I hold into three "baskets," my core holdings (which I consider the safest and intend to have a larger dollar amount invested in), satellite stocks (the backup team to add more diversity and higher potential growth or income), and my speculative stocks (those I consider unproven). I analyzed each basket, starting with the results Bob Wells reported in his articles, and emulating his analysis on the stocks that weren't mentioned. My analysis wasn't exactly the same as his, for example, I "eyeballed" the comparison of the price dip compared to the S&P in 2008, and only back tested the number of down years since 2004, which was readily available. A summary of Bob's criteria for "safest" and Level 2 are shown below, with differences in my analysis shown in parentheses.

In addition to the analysis Bob performed, I also attempted to find the Value Line Safety Ratings. Since I don't have a Value Line account, I went with a historic (2011) list that I found on the internet. One of the things on my "to-do" list is to go to the library and look up my list on a more recent version, but I thought the Safety Ratings probably didn't change very fast and an older list was better than nothing.

The results were very enlightening - a couple of the companies that I thought are relatively safe aren't as much as I expected. On the other hand, I'm a little more comfortable with some of my "speculative" stocks. As a result of this exercise, I have re-categorized a few of my stocks. Here are the results:

Core Basket: The following table shows the analysis for my core basket of stocks. Safety Analysis results shown in bold were companies mentioned in Bob's article, the remaining (not bold) were my analysis.

As I had anticipated (and hoped), my core holdings are relatively safe. I did have a couple of surprises:

  1. AWR has a Value Line safety rating of 3 (average), which indicates some potential risk. It is possible that the Value Line rating has improved since the 2011 document I found; that merits further investigation. Nevertheless, the back testing (and 60-year dividend growth history) makes me believe AWR is safe.
  2. HCP, despite a 29-year record of dividend growth, has shown 4 down years for earnings, although in 2 of those years earnings were down by only a very small amount. The 2008 price dip was about the same as the S&P. Value Line gives it a 3 safety rating. Maybe it doesn't deserve to be a "core" holding? It's one to monitor.
  3. O has a Morningstar financial quality rating of C and a Value Line safety rating of 3 (per the 2011 table). Bob's analysis ranked it as a Level 2 safety star, and my evaluation concurred with his rating. As with HCP, I plan to monitor performance.
  4. MSFT failed the safety test, which surprised me. MSFT had an earnings dip in 4 of the past 10 years and the price dip approximately mirrored the S&P in 2008. However, it has a wide moat and a Value Line Safety Rating of 1. This is another one to monitor.
  5. TGT also surprised me. TGT almost qualified as Level 2, but not quite because the price dip in 2008 was about the same as the S&P (although TGT did recover more quickly than the overall S&P). Also, with the recent earnings miss and price dip, I'll be watching for the next dividend increase; if it is meager, I may change TGT from core to satellite status.

Satellite Basket: The following table shows the analysis for my satellite stocks. Safety Analysis results shown in bold were companies mentioned in Bob's article, the remaining were my own analysis.

This basket of stocks includes three that failed the safety back test (COH, DE, and MDP) for the same reason: their price dipped MORE than the S&P in 2008. Additionally, they are more volatile stocks (as indicated by their beta scores). Two of these stocks (COH and MDP) have Value Line Safety Ratings of 3, which causes me some concern, so I'm moving them to speculative status and considering selling them in the near future. I have better confidence in DE due to the Value Line safety rating, so it remains a satellite stock for now. I know DE is cyclical, but want some industrial stocks for diversity, and it has had better growth than CAT in the last several years.

Speculative Basket: The following table shows the analysis for my speculative stocks.

None of my speculative stocks are on the CCC List maintained by David Fish; thus, all of them have an unproven record of dividend increases. In addition, most of them have a high beta. Four of my speculative stocks have Value Line Safety ratings of 3. Nevertheless, back testing revealed that BKE qualified as "safest" (except for being on the CCC List) because the stock price barely dipped in 2008. A note about BKE and why I bought it: BKE has a different method of paying dividends than many companies. The company has a normal dividend yield of about 2% ($0.22/share), but it pays a "special" dividend most years, which can be quite high. For example, the Q1 2014 special dividend was $1.20 and the Q4 2012 special dividend was $4.50! So, I bought it for its "bonus" potential (its good financial rating and performance history was a prerequisite). At the current price of around $45/share, that $4.50 special payout two years ago was about a 10% dividend! Where else can you get a bonus like that?

Three stocks (ESV, MRK, and WIN) qualified as "level 2" (Except for being on the CCC list). As a result of my back testing, I'm promoting BKE, ESV, and MRK to satellite status. Although WIN also back tested as level 2, I'm keeping it on my speculative list because of the C financial quality rating and 3 Value Line safety rating. I pay close attention to whether they have adequate cash flow to pay the dividend.

Lessons Learned and Actionable Takeaways

As a result of the back testing I performed, I plan to do the following:

Monitor and evaluate my core basket of stocks: I only want the best of the best in this basket. I expect to reevaluate my "core" list at least annually, and may drop HCP to satellite status if it seems prudent. I wanted at least one and preferably two REITs as core holdings for diversification, so I'll need to weigh the pros and cons.

The situation with MSFT is similar: I wanted a technology stock in my core basket for diversification. I also hold QCOM (tested as safest), so I am considering swapping QCOM with MSFT as core and satellite holdings. QCOM was a recent purchase (after I constructed my list of core stocks - it wasn't even on my radar screen at the time I created my core list.)

Conduct more robust due diligence in selecting stocks: As a result of my safety back testing exercise, I'm moving COH and MDP to my "speculative" basket, and I'll likely sell them. These are two stocks that I probably wouldn't have purchased had I performed safety back testing as a part of my selection process. CA is another one that I may sell. It's one of the first stocks I bought, and I didn't have a robust selection process when I bought it.

Continue to monitor my speculative stocks: I never want to have more than a handful of stocks that I consider speculative. This small basket of stocks is monitored fairly closely.

Perform the same back testing on my watch list: I intend to perform this analysis on my watch list to help cull down the list (there are nearly 40 companies on the list) and prioritize the companies on the list that should be considered the most safe.