FERG - 4 Factor Dividend Growth Portfolio - Cruising Towards A 20% Return

2023-07-10 02:48:58 ET

Summary

• The 4-factor dividend growth portfolio is a strategy that leverages the stock selection process of Schwab U.S. Dividend Equity ETF™, with a few minor twists.
• The portfolio gained 5.00% in June, underperforming the S&P 500 by 1.60%. Year-to-date, the portfolio is up 11.99% and trailing the S&P 500 by 4.90%.
• Since inception, the portfolio is generating 3.56% of alpha over the S&P 500.

4-Factor Dividend Growth Portfolio

I started the 4-factor dividend growth portfolio on November 1st, 2022. You can read about the strategy, stock selection process and portfolio construction in this article . In a nutshell, the strategy leverages the stock selection process of Schwab U.S. Dividend Equity ETF™ ( SCHD ), or rather its underlying index, the Dow Jones 100 Dividend Index, with a few minor twists. The first major differentiation is the starting universe of stocks, I opted to create my own shortlist of 100+ dividend growth stocks with a history of stable growth and economic moats.

The second major difference is the replacement of the return on equity with the return on capital as one of the ranking criteria. I personally believe the return on capital is superior to the return on equity, you can read more of my thoughts on this in the original article referenced earlier.

Here is a snapshot of the actual portfolio as of July 7th, 2023, including each position, the number of shares, current market value, estimated annual dividend, current allocation and target allocation.

June 2023 Results

The portfolio is not faring as well as the S&P 500 (SP500) in 2023, and it underperformed the index once again in June. This portfolio was launched in November of 2022, and hence the annual return is measured on a fiscal year between 11/1/22 and 10/31/23. Since inception, the portfolio continues to outpace the S&P 500 and is achieving a very respectable return.

The portfolio gained 5.00% in June, trailing the S&P 500 by 1.60%. Year-to-date the portfolio is up 11.99% and trailing the S&P 500 by 4.90%. Since inception, the portfolio is up 19.88% and outperforming the S&P 500 by 3.56%.

In July the portfolio thus far has a negative return, and one that is worse than the S&P 500. Through July 7th, the portfolio is down 1.78% compared to a loss of 1.11% for the S&P. With 3.5 months to go in the first year, I am optimistic the portfolio can deliver a great return and one that is better than the S&P.

The portfolio is top heavy, with the 7 largest holdings making up 46.69% of the target allocation. These 7 positions posted a below average return in June of +4.39% and were the primary drivers of underperformance. The 10 largest holdings make up 64.82% of the target allocation and had an average gain of 3.93% last month. The smallest positions in the portfolio performed the best in June with the smallest 10 stocks seeing an average gain of 9.22%.

The average gain in June for all 30 holdings was 6.58%, and the strategic asset allocation led to a negative outcome since the portfolio finished the month with a gain of just 5.00%.

Since inception the actual allocation has drifted away from the target allocation, at the moment the absolute drift is 9.41%. This is the first time the drift has shrunk compared to the prior month when the absolute drift was 9.74%. The minimal dividend stream this portfolio generates will be used to help minimize long term drift.

Individual Returns and Variations

Here are the individual returns from June for each holding. In the table below you can see the ticker symbol for each holding, the target allocation weight, the total return for June and the respective allocation return in the portfolio.

You will notice that only three of the top seven holdings enjoyed a strong return last month when compared to the S&P 500. Home Depot ( HD ) posted a solid gain of 9.59%, Mastercard ( MA ) posted a gain of 7.75% and Visa ( V ) finished the month up 7.44%. Notable gains also came from Snap-on ( SNA ) +15.80%, Best Buy ( BBY ) +14.12%, Lowe's ( LOW ) +12.22% and Monolithic Power Systems ( MPWR ) +10.48%.

Only 1 out of the 30 stocks in this portfolio saw a negative return last month, AbbVie . The stock has now posted 3 consecutive negative monthly returns and is one of the worst components of this portfolio since it was launched in November.

Here is a breakdown of the portfolio by top "X" number of stocks, their weight in the portfolio, average return, contribution to the portfolio return and impact on the total portfolio return.

This data is based on the target weight and not the actual portfolio weights, however, the margin of difference is not significant. As you can see, the top 7 holdings accounted for about 40.31% of the gain in June, which is below par since they make up 47% of the portfolio. It was stocks 16-30 that picked up some of the slack for the largest positions and helped push the portfolio to the 5% return it posted.

Here are the combined returns for each holding since November 2022.

With many stocks seeing strong gains in June we now have 19 out of the 30 stocks in this portfolio seeing double digit total returns. That's 4 more than a month ago. This is better than I expected and I hope to see this run continue in the final 4 months of the first fiscal year. Here are the best performers:

1. TSM +66.47%
2. AMAT +64.93%
3. LRCX +60.40%
4. MPWR +60.08%
5. KLAC +54.85%

The average return of the top 7 holdings is 24.84% compared to an average return of 22.58% for all 30 positions in the portfolio.

5 holdings have thus far generated an overall loss for the portfolio, this is two less than a month ago. The losers are:

1. INFY -13.04%
2. ADP -7.56%
3. ABBV -6.23%
4. LMT -3.56%
5. PAYX -3.37%

The target allocation for these 5 positions is 17.90%, and the inclusion of these 5 positions is costing the portfolio approximately 1.19% in total return.

Long-Term Performance

The portfolio trailed the S&P 500 by 0.19% in Quarter 1 (7.31% to 7.50%). Quarter 2 was even worse; the portfolio finished the quarter 4.38% behind the S&P 500 (+4.36% to 8.74%).

Through July 7th my portfolio has a loss of 1.78% compared to a loss of 1.11% for the S&P 500. Quarter 3 is not off to a great start but I am still satisfied with the long term return this strategy has generated thus far. I'm not too concerned with losing months or quarters because it's really the long term return that is important. It may be tough to watch your portfolio trail its benchmark for months on end, this is where an investor's patience is tested. If this portfolio loses to the S&P 500 for 11 out of 12 months, but makes up the entire loss and generates alpha during month 12, to me that is a win, nevertheless.

Since inception, the portfolio has been generating alpha over the S&P 500. After June the alpha shrunk to 3.56% from 5.06% a month ago. If I include the partial return for June the alpha drops to 2.72%. I think that is still a comfortable cushion going into the final 3.5 months of fiscal year number 1. Since inception the portfolio is up 17.74% which for me is an excellent return.

My hypothesis for the 4 factor stock selection strategy is that it can produce long term alpha over the S&P 500 and generate a growing passive dividend stream along the way.

Future Outlook

Currently, the portfolio has a forward dividend yield of 2.16%, which is down from the 2.19% dividend yield a month ago. This is a direct result of the gains we saw in June, offset by some dividend growth. The portfolio generated $3.62 in dividend income during the month of June, these dividends were reinvested in a way to reduce the allocation drift. The total dividend income generated in 2022 was $6.08, and $21.41 in 2023 through month end June.

The projected dividend income for the next 12 months is $46.18; this figure has increased from $46.06 a month ago as a result of dividend increases and dividend reinvestment. That is a 0.26% increase month over month. Since I am not adding any new money to the portfolio, I will have a unique opportunity to track how the dividend income grows over time directly through these two factors.

16 out of the 30 stocks have already announced a dividend increase since November. The average dividend increase has been 15.08%, or 8.23% at the portfolio level factoring in individual stock weights and 0% increases for the 14 stocks that have not raised their dividend yet. This figure is highly likely to increase over the next 3.5 months and should climb above 10%.

First Insight - Update

I updated my long term return figures for all 30 chosen stocks through June, extending the amount of data to 8 months. The base case for adopting an equal weight allocation opposed to using a capped float adjusted market cap allocation still stands, and the margin of difference has improved from 0.62% to 2.52%.

If you happened to read my update three months ago, you may recall that the first insight I made about this strategy was that stocks that ranked better in the 4 factor test have been generating higher returns compared to lower ranked stocks. And perhaps adopting the allocation methodology of SCHD was not the optimal route to take.

Between November 2022 and June 2023 the average total return for the 15 highest ranked stocks using the 4 factor stock selection process was 27.48%. Whereas the next 15 stocks (positions 16-30) had an average return of just 17.68%. If we break these average returns down further, the top 5 ranked stocks had an average gain of 25.59%, the stocks ranked 6 through 10 had an average gain of 12.87% and the stocks ranked 10 through 15 had an average gain of 41.87%. Given that this is based on just 8 months of rather volatile market activity this could simply be a coincidence, but nevertheless I will continue monitoring this going forward.

With 3.5 months to go before the first rebalancing in this portfolio I am strongly considering making the following changes. I will likely trim the number of holdings to just the top 20 stocks. I will likely adopt an equal weight allocation and I may rebalance the portfolio more frequently. Each of these 3 changes would have yielded positive improvements to the portfolio during the past 8 months.

As I accumulate more data about this portfolio and strategy I hope to build on the initial insights and share them with you by documenting the evolution of my actual portfolio in this series.

New 4 Factor List

I had a few requests to share an updated list of stocks that rank the best using the 4 factor stock selection process and I have decided to run this list every month and include it with this analysis. Compiling the list is a 2 step process; the first part is generating a shortlist of dividend growth stocks; the second step is ranking them based on the 4 factors.

Here are the criteria for the initial stock screener:

1. Payout Ratio of 80% or less
2. 3 & 5 year Dividend Growth Rate of at least 5%
3. 5 Year Revenue and EPS Growth Rate of at least 5%
4. Stock must trade on the NYSE or NASDAQ
5. Wide or Narrow Economic Moat
6. Exemplary or Standard Stewardship Rating.

I ran this screener on June 30th and 134 unique dividend growth stocks were selected for further analysis. I then applied the 4 factor stock selection process and narrowed the list down to just the top 30 ideas. The list is presented below with data shown as of June 30, 2023.

For further details see: