Model Dividend Portfolio for 2018 to 2019

Overview

Many people invest in high dividend-paying stocks to take advantage of their steady streams of income. Since many dividend-paying companies are older, well-established and financially stable, the stock prices of these companies tend to be more stable and less subject to erratic price swings. Many dividend-paying stocks are also consistent growers, which allows shareholders to enjoy periodic dividend payments as well as capital gains. In addition, many of these companies are market leaders and are able to continually raise their dividends over time.

To accommodate the interests of our dividend-focused readers, we have created a Model Dividend Portfolio using the Gurufocus All-In-One Screener and a proprietary optimization model. This portfolio consist of 25 of the top-performing dividend-paying stocks in our coverage universe. The portfolio is intended to help investors identify high-quality dividend-paying companies based on independent analysis, helping them achieve solid investment results without having to put in the time theselves.

The model portfolio generated below is aimed at delivering moderate risk-adjusted returns and should be in line with the needs of many different types of investors and, in particular, risk-averse and older investors. The portfolio has been carefully constructed with an assortment of best-in-class American and Canadian stocks, which should deliver solid income over the short, medium and long term.

Rebalancing Schedule

The portfolio structure was finalized on Oct. 9 based on close-of-business prices. The portfolio should be re-balanced annually or unless otherwise warranted due to any significant upward or downward price changes in any given position.

Market Coverage

The model dividend portfolio consists of stocks belonging to the following indexes:

1. United States: S&P 500
2. Canada: S&P/TSX (TSXV excluded)

Methodology

The first step in the portfolio development process was selecting a set of sector exposures that can be used as building blocks for a dividend-heavy portfolio. The best dividend-paying stocks are typically found in the consumer staples, financial, utility and telecom sectors, with a few other high dividend achievers in the tech and industrial sectors.

When selecting stocks for the model portfolio, we looked for companies that:

1. Are well-established, have strong sustainable competitive advantages and have produced stable cash-flows for a long period of time.
2. Have not rejected or reduced their dividends at any point in time over the last few economic cycles.
3. Have a history of repeatedly raising dividends.
4. Are liquid and have easily manageable short-term and long-term debt loads.
5. Earn high returns on invested capital.
6. Pay out an acceptable percentage of earnings and free cash-flows as dividends, cushioning them against economic downturns.
7. Are approximately fairly priced or moderately underpriced.
8. Are in, or are entering, a horizontal or upward sloping trend channel.

We try to avoid companies that do not have strong sustainable competitive advantages or that offer dividend yields below 2%. We also tend to avoid companies offering yields above 8% as many of these firms are in serious trouble and will likely have to cut their dividends in the near future.

Stock selection strategy

The selection of each stock for the dividend portfolio is a function of the stock’s volatility-level. To determine the optimal stock holding for various volatility levels, we follow a variation of a methodology developed by Nobel Prize winning economist Harry Markowitz called Mean-Variance Optimization (MVO).

MVO is a mathematical framework that is used by many institutional and sophisticated investors. By using MVO, we can find the optimal combination of stocks that maximize dividends for each level of risk. The inputs to MVO are expected dividend yields, payout ratios, standard deviation of returns, and correlation of dividends and total returns of stock with each other.

Yields, payout ratios, standard deviation and correlation of stock returns are calculated from annual data for the last 20 years, with greater weights applied to more recent years.

We have developed various models to forecast expected yields for each of the stocks in our coverage universe. For instance, our models look at current and historical dividend yields, growth in earnings per share, free cash-flow growth projections, operating margins, returns on capital, and historical and forward price multiples.

To account for the volatility in dividends and total expected returns of our stocks, and to reduce the optimization’s sensitivity to input parameters, we simulate thousands of possible return scenarios within the constraints of the stock’s expected returns, standard deviations and correlations.

For each scenario, we calculate an optimal portfolio consisting of 25 stocks. We then use a bootstrapping technique to combine the results of each simulation to arrive at our recommended dividend portfolio. This process is often called Resampled Mean Variance Optimization in the financial industry.

The model portfolios that we arrive at using this method are less sensitive to changes in discount rates and growth assumptions, and are expected to deliver solid income over the medium to long term.

Final Portfolio Construction

Because of the risk-return trade off, investors must be aware of their personal risk tolerance when following an investment strategy. Taking on some risk is the cost of generating returns and, if you want to make money, you can't eliminate all of your risks. Using the GuruFocus screener and optimization methodology described above, our optimal 25 stock dividend portfolio is shown below. Based on the portfolio’s holdings, we expect to earn an average annual compound rate of return of 9.5%. We have also calculated that there is a 75% probability of making money on the portfolio next year and a 10% probability of making more than 15%.

Disclaimer: We currenty hold long postions in Walmart and Power Corporation of Canada.