SPY - 4 Factor Dividend Growth Portfolio: Year One Is On The Books

2023-11-06 10:37:48 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 fell by 3.07% in October, underperforming the S&P 500 by 0.97%. Year-to-date, the portfolio is up 3.61%.
• Since its inception, the portfolio has generated 1.35% of alpha over the S&P 500, on an annualized basis.

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™ (SCHD), or rather its underlying index, the Dow Jones 100 Dividend Index (DJUSDIV), 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.

October 31, 2023, marked the end of fiscal year one for this portfolio, the results will be summarized in the next section. On November 1, 2023 I rebalanced this portfolio with 25 newly selected stocks using the 4-factor strategy.

Here is a snapshot of the actual portfolio as of November 3rd, 2023, including each position, the number of shares, current market value, estimated annual dividend, current allocation, and target allocation.

October 2023 Results

The final month of fiscal year one wasn't the best as the portfolio declined by 3.07% and underperformed the S&P 500 Trust ETF (SPY) by 0.97%. However, this loss wasn't enough to tip the one-year return in favor of SPY, with the portfolio outperforming its benchmark by 0.75% in fiscal year one. The final return for year one was 10.90%, another significant decline from the prior month when the return stood at 14.41%. Beating the S&P 500 is not a primary objective but it is useful to see how the portfolio fares compared to the broad U.S. Equity Market.

The newly rebalanced portfolio with fewer stocks and a balanced allocation is off to a promising start for fiscal year two. During the first three days of November, the portfolio is up 4.56% and outperforming SPY by 0.63%.

Year-to-date the portfolio is up 8.33% and trailing the S&P 500 by 6.71%. The entirety of the alpha generated by this strategy in fiscal year one came in the last two months of 2022 as the portfolio outpaced the index by 7.53%. I'll be curious to see if a similar pattern develops in fiscal year two, where the portfolio performs best early on.

The average loss for all 30 holdings in this portfolio during October was 3.41%, meaning that the strategic asset allocation worked out beneficially for the portfolio last month.

Near the end of fiscal year one the actual allocation drifted approximately 10% away from the target allocation, in absolute terms. Since the portfolio was rebalanced only 3 days ago the current allocation drift is minimal, 1.87%. During fiscal year two the portfolio will be rebalanced to its target weights on a monthly basis, in addition, the small dividend stream this portfolio has will be used to manage the allocation drift intra-month.

Individual Returns and Variations

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

23 out of the 30 stocks in this portfolio saw a negative return last month which was better than what we observed in September. However prior to October, only 3 stocks were sitting with a negative fiscal return, following October we now have 11 stocks with negative annual returns.

Here is a breakdown of the portfolio by the 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.

We can see that the top 7, or the core holdings, performed much better than the portfolio as a whole, albeit still with an overall negative return. The average returns became progressively worse with each further iteration of the top "X" holdings, with the bottom 10 holdings performing the worst, on average.

Here are the combined returns for each holding between November 2022 and October 2023.

Despite more volatility last month, we still have 14 out of the 30 stocks seeing double-digit total returns. That's just one fewer than a month ago. This is still pretty exceptional given the correction we have seen in the market during the last 3 months. Here are the best performers:

1. AMAT +51.34%.
2. KLAC +50.35%.
3. LRCX +47.21%.
4. TSM +43.11%.
5. FERG +40.43%.

The average return of the top 7 holdings is 14.90% compared to an average return of 12.04% for all 30 positions. So the largest 7 positions continue to outperform the portfolio as a whole. Once again suggesting there may be some merit to the strategic asset allocation that was used.

11 holdings finished fiscal year one with an overall negative return. The losers are:

1. UPS -12.69%.
2. TROW -10.92%.
3. INFY -10.02%.
4. ROL -9.42%.
5. TXN -8.82%.
6. ADP -7.76%.
7. LMT -4.31%.
8. PAYX -3.39%.
9. BLK -2.46%.
10. HD -1.26%.
11. LOW -0.19%.

The target allocation for these 11 positions is 36.15%, and their inclusion is costing the portfolio approximately 2.03% in total return. Despite 11 stocks seeing negative returns, the approximate loss in return was not that significant.

Long-Term Performance

In prior updates I shared quarterly returns based on calendar quarters, today I'd like to restate them as fiscal quarters. Quarter 1 being November 2022 through January 2023, quarter 2 being February 2023 through April 2023, and so forth.

During quarter 1 the portfolio outperformed SPY by 7.89% (+13.65% vs. +5.76%). During quarter 2 the portfolio underperformed SPY by 4.08% (-1.36% vs. +2.72%). During quarter 3 the portfolio underperformed SPY by 0.97% (+9.54% vs. +10.51%). And during quarter 4 the portfolio underperformed SPY by 1.44% (-9.69% vs. -8.25%). It's pretty interesting to see that just one winning quarter was enough to push this portfolio to outperform SPY during fiscal year one.

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. Fiscal year one came up a little short of this threshold but I remain optimistic for the future.

Since its inception, the portfolio has been generating alpha over the S&P 500. After October the alpha decreased from 1.90% a month ago to 0.75%. This was enough to give the portfolio a notch in the "W" column against SPY for fiscal year one. Since inception, the portfolio is up 14.65% through November 3rd, on an annualized basis, and as of right now remains ahead of my 12% annualized target rate of return.

Dividend Review

Currently, the portfolio has a forward dividend yield of 2.53%, which is up from the 2.27% dividend yield a month ago. This is primarily driven by the recent rebalancing that was completed on November 1st, 2023. The portfolio generated $3.41 in dividend income during the month of October, these dividends were reinvested in a way to reduce the allocation drift. The total dividend income generated in 2022 was $6.08, and $36.13 in 2023 through month end October. This brings the final dividend income for fiscal year one to $42.21. Fiscal year two should generate considerably more dividend income given its higher starting dividend yield.

The projected dividend income for the next 12 months is $57.45; this figure has increased from $46.41 a month ago as a result of the recent rebalancing. 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.

Based on the projected annual dividend income for the next 12 months I can expect 36% growth in year-over-year dividends. With dividend increases and dividend reinvestment, this figure could increase marginally. However, the monthly rebalancing to target weights may impact overall dividend growth.

Observations Made During The First Year

I updated my long-term return figures for all 30 chosen stocks through October, extending the amount of data to 12 months. The base case for adopting an equal weight allocation as opposed to using a capped float-adjusted market cap allocation still stands, but the margin of difference has marginally decreased from 1.97% to 1.35%.

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 October 2023, the average total return for the 15 highest-ranked stocks using the 4-factor stock selection process was 13.37%. Whereas the next 15 stocks (positions 16-30) had an average return of just 10.71%. If we break these average returns down further, the top 5 ranked stocks had an average gain of 9.32%, stocks ranked 6 through 10 had an average gain of 6.51% and stocks ranked 11 through 15 had an average gain of 24.29%.

The average return of the top 20 ranked stocks during fiscal year one was 13.27% which is about 3.5% higher than the return of the actual portfolio. Not only would investing in 20 stocks be easier, but adopting an equal weight allocation would also be simpler.

During the reconstitution of the portfolio for fiscal year two, I ended up trimming the number of chosen stocks from 30 to 25. I also moved away from using the capped float-adjusted market capitalization to set the initial weights for each stock. Instead, I adopted an equal allocation with each stock representing 4% of the portfolio. This was far easier to implement in my brokerage account and it'll be much simpler to track going forward. As of right now, the plan is to rebalance this portfolio at the end of each month. Since this portfolio sits in a Traditional IRA there is no immediate tax consequence from such a frequent 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.

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.

I will be sharing the performance results of that list as well as the three other 4 Factor Strategies I am tracking in a separate series. But I will continue sharing the top 25 chosen stocks for this strategy each month in this series.

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 October 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 25 ideas. The list is presented below with data shown as of October 31, 2023.

For further details see: