LIN - Selecting Dividend Aristocrats Using SCHD Methodology - May Update

2023-05-17 22:07:02 ET

Summary

• I propose leveraging the stock selection criteria from the underlying index of SCHD to build a portfolio with a subset of Dividend Aristocrats.
• I am tracking two portfolios built using this process and comparing the results to NOBL and SCHD.
• Thus far, both portfolios trail NOBL but are ahead of SCHD.
• This month's update includes the top 30 dividend aristocrats selected as of May 16th, 2023.

Quick Recap

On October 18, 2022 I published an article on Seeking Alpha that covered the stock selection methodology used by the Dow Jones US Dividend 100 Index, the underlying index for Schwab's U.S. Dividend Equity Fund ( SCHD ). In that article I proposed a theory, to leverage this stock selection process and apply it to the Dividend Aristocrat universe of stocks. On November 1st, 2022, I launched two mock portfolios doing just that, one is an exact replication of stock selection process and the other has a slight twist that I will get to a little bit later.

Both portfolios were built using the criteria laid out in the original article. A total of 30 dividend aristocrats were chosen for each portfolio based on their ranking using the 4 factor stock selection process for the Dow Jones US Dividend 100 Index. The asset allocation was generated using a float adjusted market capitalization, with the maximum allocation capped at 6.67% (twice the equal weight allocation). Initially I intended to launch these portfolios on January 1st, 2023, but given that [[NOBL]], the most popular Dividend Aristocrat ETF, was launched in November of 2013, I decided to launch my portfolios in November as well. Both portfolios will reinvest all dividends back into the issuing stock based on the market open price for the day following the dividend payment, and the asset allocation will remain unchanged for 1 full year. On November 1st, 2023, I will re-run the stock selection process for each portfolio and re-allocate based on the results. The intention is to see whether there is any merit to such a stock selection strategy, both portfolios will be measured against NOBL and SCHD to see if they can generate superior total returns. I will also be tracking the dividend income each portfolio generates to provide additional color on yield and growth measures. Each portfolio was funded with $10,000 of hypothetical money and no further contributions will be made.

Here are the results for both portfolios thus far.

First Portfolio - Exact Replication

This portfolio followed the exact criteria used by the Dow Jones US Dividend 100 Index. The criteria were.

1. Free Cash Flow to Total Debt Ratio
2. Return on Equity
3. Forward Dividend Yield
4. 5 Year Dividend Growth Rate

Here is a snapshot of the portfolio as of May 16th, 2023.

As you can see the portfolio is performing better than SCHD but still trailing NOBL, with some components seeing more favorable returns than others. The portfolio return has fallen since last month's update and the gap to NOBL has widened. SCHD has performed very poorly during the past few weeks and has fallen quite a lot compared to my portfolio and NOBL. The best selections thus far have been.

1. Procter & Gamble ( PG ) +$113.99 +17.09%
2. Abbott Laboratories ( ABT ) +$72.37 +10.85%
3. Pepsi ( PEP ) +$55.13 +8.27%
4. West Pharma ( WST ) +$47.29 +54.35%
5. Coca-Cola ( KO ) +$45.59 +6.84%

Since inception the portfolio is up 0.79% compared to 2.91% for NOBL and -5.45% for SCHD. This means the portfolio is trailing NOBL by 2.12% but beating SCHD by 6.24%.

Here is a breakdown of the dividend income thus far as of May 16th, 2023.

My portfolio did not capture most of the dividends from November and missed out on October income as well. Therefore this initial dividend income comparison is not really apples to apples. The portfolio currently has generated more dividend income than NOBL but trails SCHD. Given that SCHD has a higher dividend yield its unlikely the portfolio will ever generate more dividend income than the ETF.

As of right now my portfolio has a dividend yield of 2.91% compared to 1.93% for NOBL and 3.82% for SCHD.

Since inception the portfolio has drifted away from its starting allocation by 9.42%, which is an increase of nearly 2 percent from the absolute drift a month ago (7.64%). The table below shows the absolute drift for each individual position. I imagine that after 12 months the total drift could be much higher. There are two schools of thought on rebalancing a portfolio to its target allocation. On the one hand you can forego rebalancing and let your winners run, on the other hand you can capture short-term gains and reallocate them to worse performing positions in the hope that they will perform better down the road. I have opted to forego rebalancing this portfolio on a fixed schedule or at a specific drift target. The portfolio will be rebalanced after the first full year comes to an end and new aristocrats are selected using the original stock selection method.

Second Portfolio - My Modification

This portfolio modified the criteria used by the Dow Jones US Dividend 100 Index, replacing one of the factors. The criteria use was:

1. Free Cash Flow to Total Debt Ratio
2. Return on Capital
3. Forward Dividend Yield
4. 5 Year Dividend Growth Rate

The one factor that was changed was the return on equity, and it was replaced with the return on capital. I personally like this metric better as I think it does a better job of measuring profitability.

Here is a snapshot of the portfolio as of May 16th, 2023.

As you can see the modified portfolio is thus far performing better than the first portfolio and both benchmarks. The best selections thus far have been.

1. Linde plc ( LIN ) +$140.90 +21.22%
2. Procter & Gamble +$113.99 +17.09%
3. Abbott Laboratories +$72.37 +10.85%
4. McDonald's ( MCD ) +$58.02 +8.70%
5. S&P Global ( SPGI ) +$51.00 +10.83%

Since inception the portfolio is up 1.86% compared to 2.91% for NOBL and -5.45% for SCHD. After a tough few weeks the portfolio trails NOBL by 1.05% but remains ahead of SCHD by 7.31%.

Comparing both portfolios the second strategy is 1.07% better than the first.

Here is a breakdown of the dividend income by month as of May 16th, 2023.

This portfolio got off to a better start compared to the first portfolio, generating more dividend income in partial 2022 ($31.85 vs. $29.18). But since it has a lower dividend yield it was only a matter of time before the first portfolio moved into the lead.

This portfolio does have a dividend yield that is higher than NOBL so it should outpace the ETF in dividend income in the long run. It is also more growth oriented and should bridge the gap in dividend income with the first portfolio over a very long time frame.

What will be interesting to see is which portfolio will achieve a better dividend growth rate and how dividend reinvestment will differ between the two portfolios. Thus far the portfolio is slightly ahead of NOBL in lifetime dividend income but considerably behind SCHD.

This portfolio also trails the first portfolio in terms of dividend income by about $23.

Since inception the portfolio has drifted away from its starting allocation by 10.04%, which is an increase of exactly 200 bps from a month ago (8.04%). The table below shows the absolute drift for each individual position. This is the first time since inception where this portfolio has a higher absolute drift than the first portfolio. The same rebalancing rules will be applied to this portfolio as to the first portfolio.

Portfolio Differences

Now that we have taken a closer look at each portfolio let's go over the differences between them and what impact these differences have made.

First up let's go over the 8 unique aristocrats found in each portfolio. The first portfolio owns the following unique aristocrats.

On average these 8 aristocrats are up 6.48% since November 1st. Their combined starting allocation in the portfolio was 26.71% and as a result their impact on the overall portfolio return thus far has been a gain of 1.71%. Overall the return of these 8 holdings has improved from a month ago when it was 1.13%

Here are the 8 unique aristocrats in the second portfolio.

We can clearly see these 8 aristocrats on average have performed better than the 8 unique aristocrats in the first portfolio. They also made up a slightly larger initial allocation of the portfolio and as a result played a more significant role on the overall return, +2.72%. However, since last month's update the overall return has declined from 2.83% to 2.72%, while the first portfolio's unique holdings have seen their average return improve.

I believe these 16 aristocrats will be the main drivers of the long term difference between these two portfolios. Of course there are more allocation differences between the common aristocrats shared by both portfolios and that will play a role as well.

Dividend Increases

Since the last update 5 more dividend aristocrats have announced higher dividend rates, bringing the running total to 20 since inception. The first portfolio, LFDAS, has seen 15 increases while the second portfolio, LFDAM, has seen 14. The average dividend growth rate for LFDAS has been 4.46%, while the average dividend growth rate for LFDAM has been a slightly better 4.85%.

Top 30 Dividend Aristocrats Today

Since it has been more than 6 months since I originally selected these lists I felt it would be interesting to run the same analysis once more and see which aristocrats rank the best today. I ran the second screener only with the return on capital factor instead of the original return on equity. Therefore this new list is more of a comparison to LFDAM than LFDAS. Here are the top 30 selected aristocrats along with their metrics.

Comparing this list to LFDAM there are 7 changes. The following stocks have dropped off: Air Products and Chemicals ( APD ), Brown-Forman ( BF.B ), Genuine Parts Company ( GPC ), Hormel ( HRL ), Linde plc ( LIN ), McDonald's ( MCD ) and S&P Global ( SPGI ). They are replaced by: C.H. Robinson Worldwide ( CHRW ), Cincinnati Financial ( CINF ), Clorox ( CLX ), Kimberly-Clark ( KMB ), Nordson ( NDSN ), Pepsi and Sysco ( SYY ).

Comparing this list to LFDAS there are only 5 changes. The following stocks drop off: Air Products and Chemicals ( APD ), Colgate Palmolive ( CL ), Hormel ( HRL ), Coca-Cola and Medtronic ( MDT ). They are replaced by: Cardinal Health ( CAH ), C.H. Robinson Worldwide ( CHRW ), Grainger ( GWW ) and Lowe's ( LOW ).

C.H. Robinson Worldwide and Nordson both were not on the dividend aristocrat list when I made my initial selections.

Future

The long-term goal is to determine whether this stock selection strategy has merit. This will be measured by whether or not either of these portfolios can achieve and sustain long term alpha over NOBL. I am also comparing the results to SCHD but since this ETF uses a different universe of stocks it isn't really a fair benchmark in this test. I would like to see both portfolios outpace NOBL and remain competitive when measured against SCHD. I'll be providing updates throughout the year and when the time comes to select new constituents for each portfolio.

For further details see: