Our Dividend Growth “ETF”: Business Plan

In the first article about this Dividend Growth “ETF” project, I outlined the basic goal: To create a general dividend growth portfolio at Motif Investing that anyone can use as a basic or starter portfolio.

We’ve chosen Motif Investing, because anyone will be able to access the portfolio, change it, invest in it, or just track it. The motif – the portfolio – that we create will be available for anyone to purchase, with or without modifications as they see fit. The launch target date is January 1, 2017.

You don’t have to purchase anything if you simply want to follow along or play around with it.

Business Plan
Before we start picking stocks, we need a business plan. Three Lessons in the Dividend Growth Investing Lessons series are directly relevant. Lesson 12 Part I and Part II cover the importance of planning your investing. Lesson 13 provides some specific suggestions.

Remember the benefits of having a written plan.

• First it guides you in getting started. You don’t feel rudderless when you push off from shore. You know where you want to go and how to get there.
• More important, when market conditions are ambiguous, or your emotions are getting out of control, you can refer back to your plan to recall how you viewed issues when you were thinking straight.

I won’t repeat here the basics of business planning. Please go to the lessons cited above for that kind of background.

Here, we will get right to writing our business plan. If we don’t get everything right the first time, that’s OK. Planning is an iterative process. If we make a mistake now, we can correct it later. That’s the beauty of being your own boss.

Name
The name of this plan is the same as the name that I have already given to the portfolio itself: DVK’s Dividend Growth Investing “ETF.”

Here is a screenshot of the portfolio in progress on the Motif site.

captureThis display has more detail than the one shown in the first article. That is because I placed 3 of stocks into the portfolio for illustration. That caused Motif to compute the backwards-looking performance for the portfolio, as if it had existed a year ago.

Just to show what the portfolio displays will look like, here is a screenshot of the stocks I put into the portfolio for fun. These may not be in the final portfolio when it comes out on January 1, 2017.

captureYou can see the 3 stocks are AT&T (T), Welltower (HCN), and Johnson & Johnson (JNJ). Motif separates them by sector, shows their weight (1/3 each), and trailing 1-year return.

One thing I noticed is that Motif’s sectors are not the standard GICS sectors that one usually sees.

captureWelltower is a REIT (real estate investment trust), which has its own GICS sector classification. Motif shows it as a Financial. That’s OK, it is not a big issue in creating a portfolio.

Goal
What do we want to accomplish? What is our desired result?

As I stated in the first article, the broad goal is to create a generalized dividend growth “ETF.” That means that the portfolio could be suitable for:

– someone just getting started
– someone who wants to back away from the time and effort required to sift through individual stocks, portfolio management decisions, and so on
– someone who wants a basic core starter portfolio that can be modified, embellished, or personalized.

Please note that our broad portfolio will not necessarily meet the needs of any particular investor. Dividend growth (DG) investors have a variety of personal goals. They are not a monolithic herd of boxed-in thinkers with identical objectives.

Nevertheless, I believe that it is possible to create a basic dividend growth portfolio, with a decent yield and satisfying growth rate, that fulfills many of the goals that DG investors have in mind when they adopt the strategy.

By setting it up on Motif Investing, individuals can personalize it however they wish – a desirable attribute that is not available with any mutual or exchange-traded fund.

The dividend growth strategy, at its simplest, is based on this concept: Identify, accumulate, and manage a portfolio of stocks that reliably send growing amounts of cash back to the investor.

With that general goal in mind, here are some specific targets that I will use for this portfolio. Remember, these targets apply to the portfolio as a whole, not necessarily to every stock in it.

• Initial yield, on the launch date, of about 3.5%. (For comparison, the largest dividend ETF in the world, Vanguard’s Dividend Appreciation Fund (VIG), yields about 2.2%.)
• Median dividend growth rate in the 8% per year range for the whole portfolio.
• Total return (including dividends) that will be competitive with the S&P 500 over the long term.
• Emphasis on high-quality companies with proven records of annual dividend increases.

“ETF”
I keep putting “ETF” in quotes. Why is that?

Because the portfolio will not be a real ETF. ETFs are complex financial instruments regulated by the Securities and Exchange Commission (SEC) under the Securities Act of 1933. Real ETFs trade on exchanges. Our “ETF” will not.

Our “ETF” will instead be a motif portfolio at Motif Investing. Using their services, our creation will be investable by anyone, modifiable, or just trackable for those who have no desire to buy it.

And it will have a few advantages over actual ETFs:

• Low cost structure
• Modifiable by anyone for their own personal needs
• Manageable by anyone
• Not influenced by money inflows or withdrawals by the public.

That last point is a significant advantage. When you own a fund, its managers must buy or sell stocks as the fund’s investors add to or withdraw money from the fund. This may impact valuations or even generate capital gains or losses that you do not want. You have no control over these decisions. They are inherent in the fund structure.

The motif “ETF,” on the other hand, is controllable by each investor. Stocks are not purchased unless you add money and make that decision. No stocks are sold unless you want to. Thus you personally are not affected by decisions that other investors may be making about the same portfolio.

Picking Stocks
Obviously, the degree to which our goals are met will depend largely on what stocks we pick (and how we manage the portfolio later on).

A real ETF is usually described as passive, because the ETF follows an index, which is most often provided by a different party from the fund provider.

For example, the Vanguard ETF mentioned earlier, VIG, is based on an index from Nasdaq, as Vanguard’s literature about VIG makes clear.

captureNote that Vanguard states that it follows a passive replication strategy. In other words, they buy and sell stocks so as to copy the index.

But note, they do not state whether the index itself is active or passive. And the index is where the real decisions are made, because Vanguard just replicates it. While most indexes are constructed using rigid rules or algorithms, a few (like the S&P 500 itself) are based on human judgements.

Here in our project, there is no index. We will hand-select all stocks directly for the portfolio.

We must do this carefully, keeping our goals in mind at all times. That means that we need to figure out which companies are good at making money, can do it for a long time, and have the ability and intent to send growing streams of their profits to shareholders.

Our stock selection will follow guidelines. It is not based on whimsy or random selection. Here are the guidelines for stock selection.

Yield and Dividend Growth Rate

I stated above that the goal for this portfolio is to have an initial yield of around 3.5% with a DGR around 8% per year.

That does not mean that every stock in the portfolio will meet those parameters. Instead we will diversify, with different yields and growth rates. The whole portfolio will meet the parameters.

Stocks that are selected will fall within the following ranges:

• Yield of at least 1.0%.
• Dividend growth rate of at least 2% per year, measured over the past 5 years.
• Dividend increase streak of at least 5 consecutive years. (See DGI Lesson 3: The 5-Year Rule.)

Clearly, if only stocks that meet the minimums were included, the portfolio could not meet its goals.

So in order to hit the portfolio’s guidelines, it will need to contain:

• stocks with high yields (4%+) that may have lower growth rates;
• stocks with low yields (1%+) that have higher growth rates; and
• stocks in between, with moderate yields and moderate growth rates.

Dividend Safety

Nobody can perfectly predict the future, but we want companies whose dividends are safe.
Dividends come from profits. More specifically, dividends come from the cash flow that a company generates. (See DGI Lesson 1, What Is a Dividend?)

I have come to have great respect for Simply Safe Dividends, a service that rates dividends for safety based on a variety of factors.

captureThey use a grading scale of 0-100 for safety. (For information on how they arrive at the grades, please click here.)

captureI had at first thought that stocks for this portfolio would have dividend safety grades of at least 60. But after examining a bunch of candidates, I have decided to bump up the requirement to at least 70. We won’t lose any great candidates, and we will end up with a safer portfolio.

Other Factors

The main characteristic we are looking for is high quality. Companies in many industries can qualify, but to me high quality means:

• Good credit rating. We will not consider any company that lacks an investment grade rating of BBB- or better from S&P.
• A moat – that means it has sustainable competitive advantages. Morningstar publishes moat ratings.
• Good “quality” rankings from independent sources.
• Reasonable debt levels.
• Preference for low price volatility. I would like the portfolio as a whole to have a beta (volatility compared to the S&P 500) of 0.8 or less. That would mean the portfolio is 80% or less volatile as the S&P 500.

I am combing through a variety of lists and sources for the best companies for this portfolio. I am also creating a scoring system. Here is an example of an early version of the scoresheet that I will use, illustrating Johnson & Johnson, a company that almost certainly will be in the final portfolio.

captureAs I often do, I am using a color scheme to grade the various factors. Dark green is the best, yellow is OK, orange is marginal, and red is bad. JNJ has no orange or red. It is a great company.

Overall, there are more than 700 stocks with 5+ year of dividend increases in David Fish’s Dividend Champions, Contenders, and Challengers. I have already pared that number down to about 100 that are serious semi-finalists for the portfolio.

In the next article, we will take a look at specific candidates. The final cut to 30 or less will come just before launch on January 1.

Diversification

This portfolio is meant to be an all-around dividend growth portfolio, suitable for a broad swath of dividend growth investors. Thus the portfolio needs to be well-rounded.

Therefore, it will contain a diverse group of companies selected from the gamut of dividend growth companies. Most economic sectors will be represented.

It will also contain companies of various sizes. It is a myth that all dividend growth companies are large-cap or mega-cap stocks. Many utilities and REITs, for example, are not huge companies.

And as discussed earlier, it will contain stocks from across the spectrum of different yields and growth rates.

Valuation

Paying too much for even a great company is not a good way to invest. As discussed in DGI Lesson 11, Valuation, you want to buy companies when they are fairly priced, or better still when they are on sale.

As you may have read, many stocks became overvalued in 2016 after the nearly uninterrupted bull market that we have had since March, 2009.

Whether that will still be true at the end of the year remains to be seen.

In building your own portfolio, you can work around bad valuations.

That is what I normally do, simply refusing to buy stocks that are overvalued.

But in creating this portfolio, we may not be able to follow that practice completely.

The portfolio needs to be ready on its launch date. We probably won’t have the luxury of restricting ourselves to only undervalued stocks. Some of the absolute best dividend growth companies may have overvalued stocks when we need to place them in the portfolio.

That said, I don’t want the portfolio to be encumbered by widespread overvaluation. That would hurt returns forever after. Therefore, I intend to reduce the impact of overvalued stocks:

• I won’t necessarily fill all 30 slots at the beginning. That will leave some space for great dividend growth companies that may fall to better valuations in the months and years to come.
• I will shoot for an overall “fair” valuation for the whole portfolio. Thus any overvalued stocks will be balanced by stocks that I think are undervalued.
• I will use valuation as a tiebreaker. If two stocks are essentially similar in quality, yield, DGR, dividend safety, and the like, I will select the one that is better valued.

Number of Stocks
Most ETFs contain 50 or more stocks, often numbering in the hundreds. The ETF VIG, mentioned earlier, has 185 stocks.

Our motif portfolio will be restricted to 30 stocks, because that is how many can be in a motif. As just mentioned, a few slots will probably be empty on the launch date.

Portfolio Balancing
At inception, I will simply equal-weight the stocks for simplicity. In the Motif display earlier, you can see that each of the 3 stocks has a weight of 33.3%.

Over time, position weightings will go out of whack as the result of price changes in the market.

I am currently undecided whether to rebalance the portfolio periodically back to equal weightings. That incurs costs that may exceed the benefits.

There will be plenty of time to answer that question later. Plus, with Motif, each individual can answer the question for himself or herself.

Tracking
Once it is up and running, our Dividend Growth “ETF” will be tracked by Motif Investing. You will be able to access it online. The information will be public. You do not have to invest in the portfolio to track it.

I will supplement Motif’s tracking with occasional articles that emphasize its income performance. Unfortunately, Motif is like the fund companies in that they only focus on total returns when they discuss performance. We need to improve on that for our own purposes.

Personalization
Motif offers pre-built portfolios. Ours will be one of them. There are already a couple of dividend portfolios. Here is one created by Motif in 2012:

captureMotif allows personalization of pre-existing portfolios. That’s an advantage over an ETF. Here is one of their FAQs on the subject:

captureThat’s how you will be able to customize our DG “ETF” if you want to do it. Anyone can alter a motif to suit themselves.

Conclusion
So that is the basic business plan to get us started. Later on, we will flesh out the plan to cover portfolio management, selling policies, and other issues.

In the next article, we will explore the stock ranking system. As they are scored in different categories, you will see how some stocks break away from the pack. Those will become serious candidates for the Final 30. Other stocks will fall out of the running.

I like to eliminate less-worthy stocks. It relieves us from wasting time on companies that have no chance of being in the portfolio. It is a Darwinian process necessary to create a great portfolio.

Let Me Hear Your Feedback!
As we build this portfolio, I would like to hear your ideas. If you want to give me some input, please email the editors at DailyTradeAlert. Let them know your thoughts, and they will pass them along to me. Who knows, you might ask a key question or offer a great idea that influences the final portfolio in a significant way!

— Dave Van Knapp

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