KLAC - 4 Factor Dividend Growth Portfolio - Performance Since Launch

2023-08-08 23:31:02 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 2.44% in July, underperforming the S&P 500 by 0.77%. Year-to-date, the portfolio is up 14.72%.
• Since inception, the portfolio is generating 2.75% 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 4 Factor Dividend Growth Portfolio . In a nutshell, the strategy leverages the stock selection process of Schwab U.S. Dividend Equity ETF™ ( Schwab U.S. Dividend Equity ETF™ (SCHD) Stock Price Today, Quote & News ), 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 August 7th, 2023, including each position, the number of shares, current market value, estimated annual dividend, current allocation and target allocation.

July 2023 Results

The portfolio is not faring as well as the S&P 500 ( S&P 500 Index (SP500) Stock Price Today, Quote & News ) in 2023, and it underperformed the index once again in July. 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 maintain a margin of alpha over the S&P 500 and is achieving a very respectable return. Beating the S&P 500 is not a primary objective but it is useful to see how the portfolio fairs compared to the broad U.S. Equity Market.

The portfolio gained 2.44% in July, trailing the S&P 500 by 0.77%. Year-to-date the portfolio is up 14.72% and trailing the S&P 500 by 5.93%. Since inception, the portfolio is up 22.80% and outperforming the S&P 500 by 2.75%.

In August thus far, the portfolio has a negative return, but one that is better than the S&P 500. Through August 7th, the portfolio is down 1.14% compared to a loss of 1.52% for the S&P. With less than 3 months to go in the first year, I am optimistic the portfolio can maintain its above average return and possibly finish ahead of the S&P 500.

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 July of +1.39% 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 1.47% last month. It was stocks 11-20 that posted the best returns last month, and really stocks 16-20 were the clear winners. Stocks 11-20 had an average gain of 6.35%, with stocks 16-20 posting an even more impressive average gain of 7.69%.

The average gain in July for all 30 holdings was 3.19%, and the strategic asset allocation led to a negative outcome since the portfolio finished the month with a gain of just 2.44%.

Since inception the actual allocation has drifted away from the target allocation, at the moment the absolute drift is 8.76%. This is the second time the drift has shrunk compared to the prior month when the absolute drift was 9.41%. 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 two of the top seven holdings enjoyed a strong return last month when compared to the S&P 500. AbbVie ( ABBV ) posted a strong return of 12.25% which was a welcome sight after a poor start this year, and Home Depot ( HD ) enjoyed a nice gain of 7.47%. Notable gains also came from Automatic Data Processing ( ADP ) +12.50%, Paychex ( PAYX ) +12.16%, Lam Research ( LRCX ) +11.76% and T. Rowe Price Group ( TROW ) +10.03%.

7 out of the 30 stocks in this portfolio saw a negative return last month but only 3 stocks remain in the red since inception.

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 only 23.78% of the gain in July, which is below par since they make up nearly 47% of the portfolio. It was stocks 16-20 that picked up some of the slack for the largest positions and helped push the portfolio return higher.

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

With several stocks seeing strong gains in July we now have 23 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 3 months of the first fiscal year. Here are the best performers:

1. LRCX +79.26%
2. AMAT +72.97%
3. MPWR +65.80%
4. KLAC +64.08%
5. TSM +63.56%

The average return of the top 7 holdings is 25.78% compared to an average return of 26.31% for all 30 positions in the portfolio. This is the first point in time where the portfolio as a whole is faring better than the top 7 positions. This also means that now the strategic asset allocation that is top heavy is no longer favorable to an equal weight allocation.

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

1. INFY -9.85%
2. LMT -6.49%
3. ROL -1.99%

The target allocation for these 3 positions is 6.69%, and their inclusion is costing the portfolio approximately 0.50% 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%).

Quarter 3 is not off to a great start either, through August 7th the portfolio is trailing the S&P 500 by 0.38% (1.27% to 1.64%). 2023 has been a tough year for equities with only a handful of stocks driving index returns. If you own these positions you're doing great, if not, you are likely trailing. Fortunately this strategy got off to a great start in late 2022 and built up a little cushion that has slowly been dwindling in 2023. Like I mentioned earlier, beating the S&P 500 is not the primary objective. What I would like to see from this strategy is a strong total return (12% CAGR) over a long period of time, say 5 to 10 years.

Since inception, the portfolio has been generating alpha over the S&P 500. After July the alpha shrunk to 2.7% from 3.56% a month ago. If I include the partial return for August the alpha increases to 3.17%. I think that is still a comfortable cushion going into the final 2.5 months of fiscal year number 1. Since inception the portfolio is up 21.40% (through August 7th) which for me is an excellent return.

My hypothesis for the 4 factor stock selection strategy is that it can produce an annualized total return of at least 12% and generate a growing passive dividend stream along the way.

Future Outlook

Currently, the portfolio has a forward dividend yield of 2.08%, which is down from the 2.16% dividend yield a month ago. This is a direct result of the positive return we observed in July, offset by some dividend growth. The portfolio generated $3.85 in dividend income during the month of July, these dividends were reinvested in a way to reduce the allocation drift. The total dividend income generated in 2022 was $6.08, and $25.26 in 2023 through month end July.

The projected dividend income for the next 12 months is $45.71; this figure has decreased from $46.18 a month ago as a result of changes in dividend rates. The portfolio has exposure to a few foreign positions whose dividend stream is subject to currency fluctuations. That is a 1.01% drop 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 dividend growth and dividend reinvestment.

The average dividend increase in the portfolio has been 11.77%, or 5.61% at the portfolio level factoring in individual stock weights and 0% increases for the stocks that have not raised their dividend yet. This figure is highly likely to increase over the next 2.5 months and it'll be interesting to see where we finish at the end of the first fiscal year.

Observations Made During First 9 Months

I updated my long term return figures for all 30 chosen stocks through July, extending the amount of data to 9 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 2.52% to 3.36%.

If you happened to read my past updates, 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 July 2023 the average total return for the 15 highest ranked stocks using the 4 factor stock selection process was 32.71%. Whereas the next 15 stocks (positions 16-30) had an average return of just 19.91%. If we break these average returns down further, the top 5 ranked stocks had an average gain of 31.95%, the stocks ranked 6 through 10 had an average gain of 17.19% and the stocks ranked 10 through 15 had an average gain of 48.25%. Given that this is based on just 9 months of rather volatile market activity this could simply be a coincidence, however the same patterns continues to develop month after month.

The next re-constitution for this strategy is coming up pretty quickly, at the end of October I will run the 4 factor stock screener again to see which stocks will be part of next year's portfolio. I have decided to make the following changes to the structure of the portfolio for fiscal year 2. Instead of selecting the top 30 stocks I will trim the list to just the top 20 stocks. Additionally I will no longer use the capped float adjusted market capitalization to set the initial asset allocation. Instead I will use an equal weight approach with each stock representing a 5% allocation in the portfolio. I am also debating about rebalancing the portfolio on a monthly basis. Seeing how the actual portfolio is held in a Roth IRA account, there would be no tax consequences from such a rebalancing schedule.

New 4 Factor List

Since month-end May, I have been running the 4 factor stock screener on a monthly basis and tracking the list of top ranking stocks. I want to accumulate this data to run additional tests on more frequent rebalancing and to document how much the list changes from month to month.

The top 20 ranked stocks at the end of May had an average return of 9.40% in June and 5.24% in July. This was better than the S&P 500 that posted a return of 6.61% in June and 3.21% in July.

The top 20 ranked stocks at the end of June also would have gotten off to a better start than the S&P 500, with a return of 5.24% in July.

It'll be interesting to see if this pattern continues and if a more frequent rebalancing can achieve even better long term results.

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 July 31st and 133 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 20 ideas. The list is presented below with data shown as of July 31, 2023.

For further details see: