TXN - 4 Factor Dividend Growth Portfolio - Passively Outpacing The Market

2023-06-09 17:39:31 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 1.84% in May, outperforming the S&P 500 by 1.40%. Year-to-date the portfolio is up 6.66% and trailing the S&P 500 by 2.99%.
• Since inception, the portfolio is generating 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 June 9th, 2023 including each position, the number of shares, current market value, estimated annual dividend, current allocation and target allocation.

May 2023 Results

The portfolio is not faring as well as the S&P 500 (SP500) in 2023, but May did bridge some of the gap. 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 1.84% in May, outperforming the S&P 500 by 1.40%. Year-to-date the portfolio is up 6.66% and trailing the S&P 500 by 2.99%. Since inception, the portfolio is up 14.16% and outperforming the S&P 500 by 5.06%.

June is thus far seeing another positive return for the portfolio, albeit lower than what the S&P 500 is delivering. Through June 9th, the portfolio is up 1.80% compared to 3.15% for the S&P. With 4.5 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 poor average return in May of +0.56%, and were not the primary drivers of underperformance. The 10 largest holdings make up 64.82% of the target allocation and had an average gain of 2.30% last month. It was positions 8-10 and some of the mid-level holdings that resulted in the above average performance during the month. The smallest positions in the portfolio performed the worst in May with the smallest 10 stocks seeing an average loss of 0.73%.

The average gain in May for all 30 holdings was 1.51%, and the strategic asset allocation led to a positive outcome since the portfolio finished the month with a gain of 1.84%.

Since inception the actual allocation has drifted away from the target allocation, at the moment the absolute drift is 9.74%. This is another pretty significant increase from the absolute drift a month ago which was 8.70%. 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 May for each holding. In the table below you can see the ticker symbol for each holding, the target allocation weight, the total return for March and the respective allocation return in the portfolio.

You will notice that only two of the top seven holdings enjoyed a strong return last month when compared to the S&P 500. ASML Holdings ( ASML ) posted a strong gain of 13.84% and Taiwan Semiconductor ( TSM ) posted an even higher gain of 16.95%. Notable gains also came from Applied Materials ( AMAT ) +18.24%, Lam Research (LRCX) +17.67%, KLA Corporation ( KLAC ) +14.99% and Accenture ( ACN ) +9.14%.

17 out of the 30 holdings in this portfolio posted losses in May and it was really the technology exposure that delivered a positive return for the portfolio last month.

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 15.5% of the gain in May despite making up nearly 47% of the portfolio weight. And the top 20 holdings accounted for the entire gain and even offset some of the loss from the smallest 10 positions.

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

Despite the positive return in May, only 15 out of the 30 positions in this portfolio have thus far generated double digit total returns, one less than a month ago. I think that is still pretty great. The best performers are:

1. TSM +61.94%
2. ASML +54.29%
3. LRCX +53.44%
4. AMAT +52.10%
5. MPWR +44.90%.

The average return of the top 7 holdings is 19.92% compared to an average return of just 15.00% for all 30 positions in the portfolio.

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

1. INFY -14.78%
2. ADP -12.61%
3. PAYX -9.36%
4. LMT -7.00%
5. ROL -5.62%
6. ABBV -3.98%
7. HD -2.31%.

The target allocation for these 5 positions is 24.95%, with the worst holding, Rollins, having a target weight of just 0.37%.

Long-Term Performance

The portfolio trailed the S&P 500 by 0.19% in Quarter 1 (7.31% to 7.50%). Quarter 2 is not off to a better start, after May the portfolio trails the S&P 500 by 2.61% in Quarter 2 (-0.61% to 2.00%).

Through June 9th my portfolio has a gain of 1.80% compared to a gain of 3.15% for the S&P 500. This means that the portfolio is unlikely to catch up to the S&P in Quarter 2. 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 losses 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 May the alpha increased to 5.06% from 3.64% as of May 15th. If I include the partial return for June the alpha drops to 3.68%. I think that is still a comfortable cushion going into the final 4.5 months of year number 1. Since inception the portfolio is up 16.22% 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 2.19%, which is down from the 2.27% dividend yield a month ago. This is a direct result of the gains we saw in May. The portfolio generated $3.90 in dividend income during the month of May, these dividends were reinvested in a way to reduce the allocation drift. The total dividend income generated in 2022 was $6.08, 2023 has already surpassed this amount with total dividend income of $17.79 after April.

The projected dividend income for the next 12 months is $46.06; this figure has increased from $45.83 a month ago as a result of dividend increases and dividend reinvestment. That is a 0.50% 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.

First Insight - Update

I updated my long term return figures for all 30 chosen stocks through May, extending the amount of data to 7 months. The base case for adopting an equal weight allocation opposed to using a capped float adjusted market cap allocation still stands, but the margin of difference has decreased from 0.90% to 0.63%.

If you happened to read my update two 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 were performing better. And perhaps adopting the allocation methodology of SCHD was not the optimal route to take.

Between November 2022 and May 2023 the average total return for the 15 highest ranked stocks using the 4 factor stock selection process was 20.91%. Whereas the next 15 stocks (positions 16-30) had an average return of just 9.09%. If we break these average returns down further, the top 5 ranked stocks had an average gain of 18.82%, the stocks ranked 6 through 10 had an average gain of 10.15% and the stocks ranked 10 through 15 had an average gain of 33.77%. Given that this is based on just 7 months of rather volatile market activity this could simply be a coincidence, but nevertheless I will be monitoring this going forward. I am leaning more towards adjusting the number of holdings in this portfolio to just the top 20 in year number 2, and adopting an equal weight allocation (5% per position).

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 May 31st 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 date shown as of May 31, 2023.

For further details see: