DHIL - 2024 Dividend Growth Portfolio Review And Look Ahead

2024-01-12 12:19:52 ET

Summary

• My dividend growth portfolio has consistently grown income in excess of 10% annually. However, the risks of dividend cuts are building.
• A review of the portfolio's positions and sector weighting and discuss how they have changed over time.
• I discuss the positions that I am targeting to add in 2024 as well as the cash position of the portfolio.

Over the last fourteen years of dividend growth investing, my portfolio, goals, and rules have evolved. Along with the changes, I have made plenty of mistakes along the way. However, through it all, the income has consistently grown at 10% annually. Investing in high-quality dividend growth companies has proven to be a forgiving strategy.

Investing Overview

The goal of the portfolio is simple: Grow the income at 10% annually with dividends reinvested or 7% without reinvesting. This growth rate roughly doubles the income every seven years with reinvestment and ten years without reinvestment.

Generally, I try to meet the goal by buying companies that have an initial yield of 3% and the ability to grow the dividend by 7% annually for decades. Of course, finding companies with these exact attributes is difficult. To meet my requirements, I often create hybrids of lower-yielding, faster-growing companies and higher-yielding, slower-growing ones.

Hybridization requires monitoring dividend growth rates, as meeting the 7% growth without reinvestment will one day be critical. Someday, I expect to withdraw dividends and want the income to continue growing. When using hybrids, it's easy to focus too much on the initial yield and not enough on the dividend growth rate.

It's important to note that this portfolio has been closed to new capital since 2016, so the goals are only met organically. I did this to better judge the overall performance of a dividend growth strategy.

I don't subscribe to hard and fast investment rules. Instead, I use guidelines. My guidelines give the overall direction but provide flexibility to evaluate any situation on its merits. At present, my guidelines are as follows:

• Invest in companies from the Champions and Contenders list with at least 15 years of dividend growth.
• Look for companies with a 3% starting yield and the potential to maintain a 7% dividend growth for decades. The growth is critical as it's impossible to continue growing income at 7% without reinvesting unless companies raise distributions by at least that amount.
• Replace (or sell covered calls against) significantly overvalued positions if the opportunity exists to reduce risk and increase income. In practice, this usually means higher quality at a higher yield.
• I want to see flat to mild payout ratio creep. A payout ratio growing from 30% to 35% over ten years is acceptable. One that has gone from 30% to 60% is not. I want companies to grow the dividend with earnings, not by increasing the payout ratio.
• Unless it is well-diversified across industries, no single sector should account for more than 20% of the income. This burned me in 2016 when several energy companies cut dividends.

Again, these are just guidelines and are flexible to accommodate what makes sense to achieve my overall goals. I follow a few other items but don't see them as integral to my investing. Instead, these tend to be more personal preferences. They include avoiding foreign companies because I don't enjoy accounting for the taxes and FX rates causing fluctuating dividends.

Top Income Producers

I like to look at the portfolio in a variety of ways. The first is watching the largest income producers. The portfolio has been unbalanced from the beginning, as it was very heavy in Altria ( MO ) and Philip Morris ( PM ) at inception. This was mainly due to a position in MO held pre-spinoff and adding heavily in 2009 at double-digit yields. Today, MO and PM still account for 18% of the income, down from nearly 34% in 2010 and 25% in 2011. It's been a slow process watching the percentage of income provided by these two recede, mainly due to Altria's strong dividend growth over the past decade.

Aside from those two companies, the top five income producers have always accounted for a significant portion of the income. Although, this has fallen from over half the total income in 2011 to 36% today. The pie charts below show the top five income producers for a few selected years. Note that two companies from 2011 don't even exist anymore, a caution to chasing high yield. The ConocoPhillips ( COP ), shown in 2011, was a pre-split of ConocoPhillips and Phillips 66 ( PSX ).

The other takeaway from the top 5 is these companies have relatively slow dividend growth. This slow growth becomes a real drag on meeting my goals. Fortunately, some faster dividend growers appear when expanded to look at the top 10 largest income producers (shown below). The top 10 largest income producers currently account for around 55% of the total income.

I had expected Omega Health Care Investors to fall off the list above in 2024, but given the small increase from Medtronic ( MDT ), it looks less likely. A significant increase by Cincinnati Financial ( CINF ) this month will also knock it off. Either way, whether it's this year or next, OHI will fall off the list, showing once again that dividend growth prevails in the long run.

Income by Sector

At one time, I never thought about the sector weightings in this portfolio. Today, I only vaguely use them as a guide, not a rule.

At its inception, this portfolio was loaded with energy-related MLPs. The overweighting was due to dabbling in high yield in 2009 before finding dividend growth investing. It continued to be energy-heavy until 2016, when the sector cratered, and many cuts occurred across a wide swath of energy-related industries.

Entering 2015, the energy sector comprised nearly 25% of the income, but by the end of 2016, energy was down to just 11%. This was primarily due to cuts, although partly due to purchases in other sectors. Today, I generally watch closely if a sector creeps above 20% of income. In 2018 and 2019, real estate exceeded the 20% mark, leading me to reduce my position in Omega Healthcare Investors.

The chart below shows the income from the most significant income-contributing sectors over the years. Note that I consider Altria and Philip Morris their own sector for this portfolio as they contribute so much income. In fact, I define the companies into sectors that make sense to me and fit the needs of the portfolio.

Today, financials are above my 20% target for any individual sector. Mostly, this has occurred because of the massive increase in the Blackstone dividend in 2021 and 2022. Last year, BX had a significant decrease, but it's expected to rebound in 2024. I am using a very conservative number for the BX dividend in 2024, projecting a 10% increase versus the analyst average of a 37% increase.

Even being above 20%, this sector is well diversified, as detailed below. A full breakdown of estimated income by sector for 2024 and the companies comprising each is shown below.

Financials

Aflac ( AFL ), Ameriprise, BlackRock ( BLK ), Blackstone, Cincinnati Financial, CME Group ( CME ), Diamond Hill Investment Group ( DHIL ), Intercontinental Exchange ( ICE ), Prudential Financial ( PRU ), Visa ( V)

A higher portion of the income from financials is warranted for two reasons. While there are several asset managers and insurance companies, most of these are distinctly different business models. Also, financials make up over 40% of the Champions, Contenders, and Challengers list. Notably absent are any banks. For the most part, I have shied away from companies that cut during the Great Financial Crisis ((GFC)), although several banks did continue to raise through that period.

Healthcare

AbbVie, Abbott Labs ( ABT ), CVS ( CVS ), Johnson & Johnson ( JNJ ), Medtronic

This is a relatively straightforward sector, although CVS is a hybrid insurance/staples company. After selling Walgreens ( WBA ) and Cardinal Health ( CAH ) last year, this sector is down to 12% of income from 14%. There is room to add in this sector, but I'm not sure if it would be a new position or adding to existing ones.

While JNJ, MDT, and CVS all look like decent buys, I'm not excited about any of them right now. While I would love to add Eli Lilly ( LLY ), the valuation has become irrelevant as it is all about the story at this point. If I were to start a new position in healthcare, Amgen ( AMGN ) would be at the top of the list.

Technology

Apple ( AAPL ), Automatic Data Processing ( ADP ), Broadcom, Microsoft ( MSFT ), Texas Instruments

ADP has officially been moved to industrials from tech. However, I think it fits here better. Either way, it is a relatively small contributor to the portfolio. I am constantly evaluating companies to add to this sector, but I am being patient. Tech has had a massive multiple expansion over the past decade, and I still believe it's due to rotate out of favor.

I add slowly to ADP whenever it is below $230 and occasionally add a little TXN. While I haven't given much consideration to starting a new position in tech, Amdocs ( DOX ) is interesting.

Real Estate

Ladder Capital ( LADR ), National Retail Properties ( NNN ), Realty Income ( O ), Omega Healthcare Investors, Simon Property Group ( SPG ).

I consider every company in this group as part of my high-yield exposure. While I am looking for opportunities to reduce my OHI position, O, NNN, and SPG are used as hybrid purchases to achieve my 3% yield and 7% dividend growth.

Energy

Enterprise Products Partners, Phillips 66.

EPD is the last MLP standing after purchasing several during the Great Recession. I received the Phillips 66 shares in the split up of the old ConocoPhillips.

Staples

PepsiCo ( PEP ), The J. M. Smucker Company ( SJM ), Unilever ( UL ), Kroger ( KR )

Kroger was added to the portfolio last year, and I am actively building out the position. I would like to own more Pepsi, but I won't overpay, at a minimum I want a 3% yield. Unilever is the only foreign company in the portfolio and has been a holding since 2010. I no longer consider foreign companies for this portfolio.

I recently completed a review of companies as I work to simplify my portfolios, and Hershey ( HSY ) came out highly rated. I may open a position in this portfolio should it reach a 2.7% yield.

Defense

Lockheed Martin

I distinguish defense contractors from other industrial companies, as I see them tied to different drivers.

Consumer Discretionary

Best Buy ( BBY ), Home Depot ( HD ), Starbucks ( SBUX )

Starbucks was the only consumer discretionary company in the portfolio for a long time. Home Depot and Best Buy are more recent additions. Consumer discretionary has a small representation in the dividend champions, and specialty retailers even less so, with Lowe's ( LOW ) being the lone representative.

While I am not looking to create any new positions in this sector, I would like to add to my Home Depot position.

Industrials

A. O. Smith ( AOS ), Fortune Brands Innovations ( FBIN ), Honeywell ( HON ), MSA Safety ( MSA ), Snap-on ( SNA ), MasterBrand ( MBC )

Six positions are a lot for such a small representation in the portfolio. It seems like industrials have been chronically overvalued forever. MSA Safety is a long-time holding and was trimmed significantly due to overvaluation in 2021. FBIN and MBC were created when Fortune Brands Home and Security (FBHS) split up at the end of 2022. Both have appreciated nicely, and both have disappointed from a dividend growth perspective. Consider FBIN and MBC on notice.

I want to add to Snap-On and Honeywell if the yield becomes attractive.

Utilities

Duke Energy ( DUK )

The only utility in this portfolio is Duke Energy, which I held long before I became a dividend growth investor. Last year's increase in interest rates brought utilities to attractive valuations for the first time in a long time. However, I didn't take advantage of the opportunity as I expected rates to stay higher for much longer and missed the chance.

All in all, I'm not particularly looking to add more utilities. The only one I have up for consideration is NextEra Energy ( NEE ).

The chart below shows the full breakdown of income by sector for 2023.

2024 Target Income

The goal of this portfolio is to grow the income by 10% annually, with dividends reinvested and 7% without reinvesting. Since I am currently putting distributions back into the market, the simple target for 2023 is $18,914. This is a straight-line 10% increase over 2023's income.

The chart below shows the percent growth in income every year. Note that in 2017 and 2018, no dividends were reinvested, hence the lower growth. Additionally, no new capital has been added to the portfolio since 2016.

The last few years have beaten my 10% goal by a decent margin. One of the things I track is the projected income from every year. The table below shows the projected income, updated yearly. I have found that these projections are highly accurate over the long run and that dividend cuts are possible when the current year begins to deviate significantly.

Note that the average projection for 2023 is $17,783. The straight-line $18,914 is 14.5% above this, a significant deviation from the long-term forecasts; last year's deviation was only 5.5%. Much of the variation comes from trimming the very low-yielding companies MSA in 2021 and Apple in 2022. These were replaced with higher-yielding companies.

Last year, I observed that the chance for a dividend cut was building based on the deviation. I did experience a cut from Intel ( INTC ), which I have since sold. Walgreens Boots ( WBA ) also cut after I sold the company. Finally, Blackstone had a 33% dividend reduction in 2023. While BX is expected to rebound this year, there is still the potential for cuts from other holdings.

The obvious candidates for a cut are Omega Healthcare Investors and Ladder Capital, as high-yield positions. Investors have speculated on a collapse of the OHI dividend since at least 2017. Of course, there could be another surprise cut like Intel was last year. Texas Instruments will be cash flow negative as they have significant capital outlays, and retailers like Best Buy are always suspect. But I highly doubt either of these two will cut in 2024.

The forecast projection, where I project each dividend increase, stands at $18,212, or an increase of only 5.9%. This is typical as I am conservative with my beginning of the year projections and don't account for reinvested dividends. However, this year is interesting as I am entering the year with record cash, and cash is yielding around 5%. Hopefully, some enticing opportunities will come along to put all the money to work!

Companies I'm targeting in 2024

I have focused on faster dividend growth over the last few years, sacrificing initial yield to do so. There were a couple of reasons for making this decision. Firstly, some of the largest income producers in the portfolio have low, slowing, or inconsistent income growth. The second reason is the strong overall income growth performance of the past few years. The extra income was placed to work in faster-growing dividends.

Finding companies with a 3% initial yield and 7% consistent growth has been challenging in recent years. While 2022 brought a reprieve, I kept expecting even better opportunities in 2023 that never materialized. At present, I am primarily looking to add to existing positions, but there are three companies that I am considering new positions in if the value appears.

The first company I am looking at is Cummins ( CMI ). Even though they were just hit with a massive penalty, I still believe they are a fantastic dividend growth company. I will be looking to start a position above a 3.1% yield but have a preferred buying point at a 3.6% yield.

I have watched the second company, Air Products and Chemicals ( APD ), for a long time. I think there is a strong chance that the company will get beaten up this year or next due to its significant capital outlays and (probably) going cash flow negative as a result. I would consider adding a position at a 2.75% yield but prefer to see it at 3.4%.

The final company that I am considering is Hershey. This company makes a lot of sense for the portfolio as I am very light in consumer staples. I would consider opening a position above a 2.7% yield, although today's 2.5% is an attractive entry point.

While I will reinvest some dividends every month this year, I will hold many of the dividends as cash, waiting for better opportunities. The positions I am most interested in adding to and the three buy points are shown in the table below. The third buy points are rarely touched and usually only in a recession or other crisis with the company.

Of course, I am constantly evaluating the overall market and bargains relative to one another, so at times, I may be reaching for one of the above companies or adding to something else entirely.

Final Notes

Having a down market in an election year would be unusual, but who knows? Everyone is convinced we are in a goldilocks situation for investors and the economy. This market has little room for error; everything predicted needs to happen or the market could drop steeply.

As long as cash keeps yielding 5%, I expect to save most of my dividends and look for better bargains ahead. While I will be buying more this year than last, cash still looks like the most attractive investment. I know I can only do this for a while, eventually I will be losing out to dividend growth opportunities. But, by my calculations, another year or so won't hurt.

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