4-Factor Dividend Growth Portfolio - Half-Year Mark

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 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 May 15th, 2023 including each position, the number of shares, current market value, estimated annual dividend, current allocation and target allocation.

April 2023 Results

The portfolio started the year trailing the S&P 500 total return by 11 basis points in January, albeit it still offered a strong gain of 6.17%. Nearly half of these gains were lost in February as the portfolio shed 2.78% and trailed its benchmark by 34 basis points. In March things started to look up, the portfolio added 3.97% and outperformed the benchmark by 29 bps. April, however, proved to be a sour ending to the first half of the fiscal year, the portfolio lost 2.41% and trailed its benchmark by 3.97%.

The final 6-month return (Nov. 2022 to Apr. 2023) was 12.10% compared to 8.63% for the S&P 500 Total Return. A 3.47% lead half way through the first year sounds very good but the lackluster return during April is a little worrisome.

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 April of -0.26%, but were not the primary drivers of underperformance. The 10 largest holdings make up 64.82% of the target allocation and had an average loss of 2.24% last month. It was positions 7-10 and some of the mid-level holdings that resulted in the below average performance during the month. The smallest positions in the portfolio performed the best in April with the smallest 10 stocks seeing an average gain of 0.08%.

The average loss in April for all 30 holdings was 1.81%, and the strategic asset allocation led to a negative outcome since the portfolio finished the month with a loss of 2.41%.

Since inception the actual allocation has drifted away from the target allocation, at the moment the absolute drift is 8.70%. This is a pretty significant increase from the absolute drift a month ago which was 6.66%. 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 March 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 three of the top seven holdings enjoyed a strong return last month when compared to the S&P 500. Merck (MRK) posted a gain of 8.53%, adding 0.57% to the portfolio return. Mastercard (MA) posted a gain of 4.74%, adding 0.32% to the portfolio return. And Visa (V) posted a gain of 3.22%, adding 0.21% to the portfolio return. Notable gains also came from Rollins (ROL) +12.58%, Ferguson plc (FERG) +5.29%, Snap-on (SNA) +5.07%, Lowe's (LOW) +4.46% and Expeditors International of Washington (EXPD) +3.38%.

There were many losers last month but 3 holdings fell by more than 10%. Infosys (INFY) fell by 10.89%, Skyworks Solutions (SWKS) fell by 10.24% and Texas Instruments (TXN) fell by 10.11%.

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 5.5% of the loss in April. And the top 20 holdings accounted for the entire loss, with the bottom 10 holdings providing very minimal support.

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

Despite the poor showing in April 16 out of the 30 positions in this portfolio have thus far generated double digit total returns, I think that is pretty great. The best performers are:

1. TSM +38.47%
2. MPWR +36.63%
3. ASML +35.53%
4. FERG +30.42%
5. LRCX +30.40%

The average return of the top 7 holdings is 18.09% compared to an average return of just 12.68% for all 30 positions in the portfolio.

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

1. INFY -17.02%
2. ADP -8.02%
3. PAYX -5.88%
4. LMT -3.37%
5. ACN -0.49%

The target allocation for these 5 positions is 17.58%, with the worst holding, Rollins, having a weight of just 2.45%.

Long-Term Performance

After the two month losing streak was broken in March, the portfolio starts Quarter 2 on a very sour note. However, despite yet another setback the portfolio maintains a healthy cushion on the S&P 500 Total Return.

Through May 15th my portfolio has a loss of 0.53% compared to a loss of 0.71% for the S&P 500. This is a gain of 18 basis points of alpha, which is a positive sign that perhaps the quarter may not be a complete loss. The gained alpha from partial May pushes the cumulative return for my portfolio to 11.51% compared to 7.86% for the S&P 500. As a result, the alpha of 3.47% following the prior month increases to 3.64% as of May 15th.

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

2023 just started, and my portfolio finished quarter 1 trailing the S&P by 19 basis points. Quarter 2 is off to a poor start but I remain optimistic and long on this strategy.

Currently, the portfolio has a forward dividend yield of 2.27%, which is up from the 2.21% dividend yield a month ago. This is a direct result of the losses we saw in April. The portfolio generated $3.37 in dividend income during the month of April, 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 $13.89 after April.

The projected dividend income for the next 12 months is $45.83; this figure has increased from $45.66 a month ago as a result of dividend increases and dividend reinvestment. That is a 0.37% 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 April, extending the amount of data from 5 to 6 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 increased from 0.49% to 0.90%.

If you happened to read my update last month 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 April 2023 the average total return for the 15 highest ranked stocks using the 4 factor stock selection process was 15.61%. Whereas the next 15 stocks (positions 16-30) had an average return of just 9.76%. If we break these average returns down further, the top 5 ranked stocks had an average gain of 13.61%, the stocks ranked 6 through 10 had an average gain of 9.13% and the stocks ranked 10 through 15 had an average gain of 24.07%. Given that this is based on just 6 months of rather volatile market activity this could simply be a coincidence, but nevertheless I will be monitoring this going forward. Perhaps there is merit to dropping the original allocation methodology and trimming the number of positions in the portfolio to just the top 15 or 20 stocks.

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 12th 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 30 ideas. The list is presented below with date shown as of May 12, 2023.