LIN - Selecting Dividend Aristocrats Using SCHD's Methodology - Initial Results

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.
• Initial results for November were below par, but both portfolios are showing promise in December, suggesting the strategy may have merit.

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 US 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 initial results for both portfolios.

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 midday December 28th, 2022.

As you can see not all of the 30 chosen aristocrats are performing well thus far but collectively the portfolio is doing just fine. The best selections thus far have been.

1. Procter & Gamble ( PG ) +$90.47 +13.56%
2. AbbVie ( ABBV ) +$73.72 +11.05%
3. Air Products and Chemicals ( APD ) +$59.76 +22.99%
4. Abbott Labs ( ABT ) +$59.66 +8.94%
5. Caterpillar ( CAT ) +$49.50 +10.23%

Here are the partial returns for 2022 by month for this portfolio (labeled LFDAS), NOBL and SCHD.

As you can see the portfolio got off to a slow start with a gain of 4.9% in November which was worse than NOBL that gained 6.28% and SCHD that gained 6.03%. But the portfolio is performing much better in December thus far and not only has it recovered the loss from November, it added some alpha as well. As of midday December 28th, 2022 this portfolio is up 3.15% compared to a gain of 1.55% for NOBL and 2.11% for SCHD. The one caveat here is that SCHD has already paid out its Q4 dividend, while NOBL is slated to pay its dividend on December 30th. This will improve the return for NOBL but it should still remain lower than my portfolio.

Here is a breakdown of the dividend income for partial 2022 as of December 28th 2022.

NOBL is projected to pay a dividend of $67.54 on December 30th. Also keep in mind that both SCHD and NOBL pay quarterly dividends while my portfolio will generate dividends every month. Given that this portfolio was started on November 1st, it 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 an apples to apples comparison.

As of right now my portfolio has a dividend yield of 2.71% compared to 2.64% for NOBL and 3.40% for SCHD. As such the portfolio should slightly outpace NOBL in terms of dividend income but will likely come up short of SCHD, at least in the initial year.

Since inception the portfolio has drifted away from its starting allocation by 6.38%. The table below shows the absolute drift for each individual position. I imagine that after 12 months the total drift will 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 were.

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 midday December 28th, 2022.

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

1. Procter & Gamble +$90.47 +13.56%
2. AbbVie +$73.72 +11.05%
3. Air Products and Chemicals ( APD ) +$58.15 +22.99%
4. Abbott Labs ( ABT ) +$59.66 +8.94%
5. Linde PLC ( LIN ) +$55.23 +8.23%

The best selections are very similar to the first portfolio with the exception of the inclusion of Linde PLC in this portfolio, whereas the first portfolio had Caterpillar as the 5th best aristocrat.

Here are the partial returns for 2022 by month for this portfolio (labeled LFDAM), NOBL and SCHD.

This portfolio got off to a much better start, gaining 6.05% in November, outperforming SCHD and only slightly trailing NOBL. In December it is not doing as great as the first portfolio with a loss of 2.3% compared to a loss of 1.68%. However it is still outpacing NOBL and SCHD during the month and generating some positive alpha.

Here is a breakdown of the dividend income for partial 2022 as of December 28th 2022.

This portfolio has generated a little more dividend income than the first portfolio ($30.64 v. $27.94). However this should change in the near future, this portfolio has a current dividend yield of 2.4% which is much lower than the first portfolio's yield of 2.71%. I'm actually projecting that this portfolio will generate the least amount of dividend income in year number one. 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.

Since inception the portfolio has drifted away from its starting allocation by 5.64%. The table below shows the absolute drift for each individual position. Compared to the first portfolio the absolute drift here has been smaller and it will be interesting to see how this trend changes in the future, and what impact it may have on the long term return. 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 talk about 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 0.41% 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 0.11%.

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, +0.56%.

For further details see: