I Just Bought Shares Of These 2 Stocks For My Dividend Growth Portfolio (DGP)

I have been running a real-money Dividend Growth Portfolio (DGP) since 2008. It is a demonstration of dividend growth investing in action.

I report on the DGP every month. You can access the reports by using the “Dividend Growth Investing” drop-down menu at the top of every page on this site:

When the menu appears, the link to the DGP is the 5th one down:

Under the business plan for the DGP, I review the portfolio once or twice per year. I recently completed such a review.

While the DGP is generally a buy-and-collect enterprise with very little turnover, it is not an inert buy-and-ignore portfolio with no management whatsoever.

Indeed, one of the things I try to illustrate through the DGP is thoughtful portfolio management.

There are specific circumstances that call for possibly trimming a position.

One example is whenever a stock bubbles or becomes seriously overvalued.

A few weeks ago, I wrote an article that identified three stocks that are, in fact, seriously overvalued:

• McDonald’s (30% over fair value at the time of the article)
• Realty Income (28%)
• Procter & Gamble (23%)

All three of those stocks are in the DGP. Their overvalued condition makes them risky, and it has also caused their yields to fall.

Examining the Riskiest Positions in the DGP

I focused my attention on those three stocks plus Alliant Energy, which has grown into the portfolio’s largest position. I figured that the most risk – and greatest opportunity – comes from those four stocks.

Here’s how they stack up as of the end of April.

Here’s more detail about them:

Alliant Energy (LNT)

Alliant is the largest position, and its 3.1% yield is below the portfolio’s overall yield of 3.3% as a result of its price advances over the years. I’ve owned it since 2010.

I ran LNT through my usual valuation process (see DGI Lesson 11: Valuation), and I found that it is 10% overvalued.

When considered along with its reduced yield and large size, the overvaluation leads me to decide to trim it back. To bring it down to 7.5% of the portfolio requires selling about $2800 worth of shares.

McDonald’s (MCD)

McDonald’s is 30% overvalued, and its yield of 2.4% is well below the portfolio’s average. I’ve owned it since 2008 (with additional purchases in 2009 and 2011).

To reduce it to 7.5% of the portfolio requires the sale of $1800 in shares.

Realty Income (O)

Realty Income is way overvalued (28% too high), and it also accounts for more than 10% of the DGP’s income, so I will trim it. I first bought it in 2008 and again in 2017.

Its 3.7% yield is above the portfolio average, but the large position in an overvalued stock represents a risk that I’d like to cut back.

To cut it to 7.5% of the portfolio requires trimming about $950 in shares.

Procter & Gamble

While it is way overvalued (by 23%), PG is a smaller position at 4% of the portfolio. Its yield at 2.9% is below the portfolio average, but because it’s such a small position, I decided to leave it alone.

Summary

You probably noticed from the three YCharts that each stock to be trimmed presents a similar picture. They all have price gains that have far outstripped their dividend growth, even though they are all terrific dividend growth stocks.

The result is that they all have yields that are below their historical averages. That’s on top of becoming risky from a price perspective.

Their reduced yields also mean that I am paying an opportunity cost: I am making less in dividends than I could make if the money were invested in higher yielding stocks of similar quality elsewhere.

What to Buy?

Other than accumulating dividends awaiting reinvestment, I don’t hold cash in the DGP. It’s always fully invested. So I need to identify stocks to buy with the proceeds of the trims.

I always say to invest like you’re the CEO of your own business. (See DGI Lesson 12: Run Your Investing Like a Business.)

Perhaps the most important decisions a business owner makes are about how to allocate capital.

That’s what I am doing: Allocating capital. I am removing some capital from overpriced, lower-yielding, riskier stocks, and moving it to better-valued, higher-yielding stocks.

If I apply the following criteria, there are four purchase candidates already in the portfolio:

• Yield > the portfolio’s average of 3.4%.
• Undervalued.
• Not larger than 7% of the portfolio now.

To those, I add these two other potential candidates, based on articles I have recently written about them (click here for Dominion Energy (D) or Abbvie (ABBV):

That gives me six candidates for two purchases. My main selection requirements are company quality and valuation.

While I want to raise the yield of the DGP, I won’t chase yield. Anything I buy has to be of high quality.

Therefore, I constructed the following Quality Snapshot of the six candidates. In the right-hand column, I created a simple quality score based on 5-4-3-2-0 points for each stock’s ratings, which are indicated by color. Green is good (5-4), yellow is neutral (3), and orange is below average (2).

The top four candidates all scored 23 points, so I’ll eliminate the other two. That leaves me with two tobacco companies and two utilities.

Next I value them using my usual methods.

Final decision: I decided to increase my small stake in Altria and to open up a new position in Dominion.

Selling and Buying

I executed the following transactions within a few minutes of each other on Wednesday, May 8, 2019. There are three sales (LNT, MCD, and O) followed by two buys (D and MO). The numbers are net of commissions.

The proceeds from the three sales totaled $5579. The total cost of the two purchases was $5536. The $43 left over goes into my reinvestment cash kitty to await my next dividend reinvestment, which will be later this month.

Dominion (D) becomes the 25th position in the DGP and clocks in at 2.2% of the portfolio. Altria’s size increases from 0.8% to 3.0% of the portfolio. Both stocks will appear in next month’s portfolio review.

Portfolio Before and After

Here is a snapshot of the portfolio prior to the swaps:

And here is the same information after the swaps.

Note the impact on the portfolio’s income:

• Income goes up by $138 per year, or about 3.3% more.
• Current yield rises from 3.35% to 3.46%.
• Dividend safety score and dividend growth rate go up nominally.

Closing Thoughts

There is an adage among many investors: Let you winners run. The three stocks I sold are all winners. So why trim them?

Because my central focus is on building the income stream. Trimming these three positions raised the annual income stream by more than 3%.

And I didn’t do it at the cost of taking on more risk. The new stocks are of the same high quality that is typical of the portfolio, and eliminating some overvalued shares should actually decrease the DGP’s price risk over the long haul.

This exercise in portfolio management represents less than 5% of the portfolio turning over. In the past few years, annual turnover in the DGP has been under 7%. Assuming these are the only sales I make this year, that will also be true this year.

I rarely sell anything, but when I do, I am always trying to improve the portfolio and cut down on its risk. The risk with all three stocks selected for trimming came from overvaluation and position size. I was also paying an opportunity cost of accepting lower dividend payouts than I can get elsewhere from better-valued stocks with higher current yields.

These swaps help redress some of those factors. The DGP is now better-balanced, better-valued, and higher-yielding. Hopefully, that means it will perform better in relation to its main goal, which is to build a reliable, steadily increasing dividend stream over many years.

— Dave Van Knapp

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