4 Factor Dividend Growth Portfolio - Firing On All Cylinders

Summary

• The 4-factor dividend growth portfolio is a strategy that leverages the stock selection process of Schwab U.S. Dividend Equity ETF with a few minor twists.
• The portfolio returned 6.99% in February, outperforming the S&P 500 by 1.65%.
• Since its inception, the portfolio has generated 5.02% of alpha over the S&P 500 and 22.54% of alpha over SCHD on an annualized basis.

4-Factor Dividend Growth Portfolio

The 4-factor dividend growth portfolio was launched on November 1st, 2022. You can read about the strategy, stock selection process, and portfolio construction in this 4-Factor Dividend Growth Portfolio article. In a nutshell, the strategy leverages the stock selection process of Schwab U.S. Dividend Equity ETF (SCHD), or rather its underlying index, the Dow Jones US Dividend 100 Index (DJUSDIV), with a few minor modifications.

The first major difference is the starting universe of stocks, I chose to create my own investable universe focused on high-quality companies that have a history of above-average dividend growth.

The second major difference is the modification to the ranking criteria, instead of using the return on equity, as the DJUSDIV, I chose to replace it with the return on capital. I personally believe that return on capital is a superior metric to return on equity.

On November 1, 2023, I rebalanced this portfolio with 25 newly selected stocks using the 4-factor stock selection process laid out in the original article.

These stocks will be held for a duration of 12 months and the portfolio will be rebalanced back to equal weight (4% per stock) at the end of each month. The portfolio is held in a traditional IRA and therefore has no tax drag from being rebalanced frequently.

Here is a snapshot of the actual portfolio as of March 1, 2024, including each position, the number of shares, current market value, estimated annual dividend, current allocation, and target allocation.

February 2024 Results

The portfolio made a comeback in February, fully erasing the losses it saw in January. The S&P 500 returned 5.34% last month, SCHD returned just 1.84%, and my portfolio posted a strong gain of 6.99%. This 1.65% win over the S&P and 5.15% win over SCHD propels the portfolio further ahead of both benchmarks. For fiscal year 2 (Nov 2023 - Oct 2024), my portfolio maintains a healthy level of alpha over both the S&P 500 (+5.71%) and SCHD (+12.67%). Since its inception, on November 1, 2022, the portfolio has a CAGR of 29.98% and is outperforming the S&P 500 by 5.02% and SCHD by 22.54%.

Beating the S&P 500 or SCHD is not a primary objective, but it is useful to see how the portfolio fares compared to alternative options. The goal is for this portfolio to deliver a long-term (5+ years) CAGR of at least 12%. Thus far, 16 months in, the portfolio is sitting comfortably ahead of this goal. Outperforming the S&P 500 and SCHD is just icing on the cake.

The average gain for all 25 holdings in February was 7.12%. The reason for the slight difference in return between the portfolio and the average return for all holdings is that it is very difficult to bring this portfolio back to equal weight. The rebalancing happens while the market is open and also causes some fluctuations in the final monthly return measured against the benchmark.

Individual Returns and Variations

Here are the individual returns for February for each holding. In the table below you can see the ticker symbol for each holding, the target allocation weight, the total return in February, and the respective allocation return in the portfolio.

23 out of the 25 stocks had a positive return last month, and 8 of them posted double-digit gains.

Here are the best performers:

1. WSM +21.79%
2. MPWR +19.47%
3. SQM +18.18%
4. MAS +14.52%
5. LRCX +13.70%

The average cumulative return for all 25 stocks for the period November 2023 to February 2024 is 27.66%, slightly lower than the actual portfolio return (+27.92%). 21 out of the 25 chosen stocks have double-digit returns, with only 1 stock currently sitting in the red (EOG).

Here are the top 5 performers in fiscal year 2:

1. MPWR +63.27%
2. LRCX +59.94%
3. ASML +59.60%
4. WSM +57.45%
5. AVGO +55.29%

Breaking down the returns by the original ranking of the top 25 holdings chosen for inclusion in the portfolio, we can see that it's the mid-ranked stocks (6-20) that continue to generate the highest returns. Prior to February, the top 5 ranked stocks were performing the worst, this flipped last month with the top 5 stocks overtaking the bottom 5 stocks. What's interesting though is that the 2 highest-ranked stocks are the two worst performing stocks thus far.

In fiscal year one, there was a clear correlation that higher-ranked stocks performed better than their lower-ranked counterparts. Thus far, this trend has not held true in fiscal year 2.

Since there are 25 stocks included in the portfolio, there is no easy way to divide it into two equal halves. If I eliminate the middle stock, the 13th best-ranked stock, the top 12 stocks have an average return of 26.36% thus far, while the bottom 12 stocks have an average return of 29.80%. The top 12 stocks performed better in February relative to the bottom 12 stocks, let's see if this trend sees the long-term trend flip in the coming months.

Long-Term Performance

The portfolio achieved a 10.90% return in fiscal year one, outperforming the S&P 500 by 0.75%. The return for fiscal year two (Nov. 1, 2023 - Feb 29, 2024) is 27.92% and puts the portfolio 5.71% ahead of the S&P 500. Since inception, Nov. 2022, on an annualized basis the portfolio has a return of 29.98% versus 24.96% for the S&P 500, resulting in 5.02% of annualized alpha over the index.

Given that the inspiration for this strategy and portfolio was SCHD, it's only fair that I compare the returns the portfolio attains to those of SCHD. SCHD did not perform well in 2023, with the exception of the last two months. The return for SCHD during fiscal year one (Nov. 2022 to Oct. 2023) was -4.51%, my portfolio outperformed SCHD by 15.41%. SCHD's return for the period November to February 2024 is 15.25%, and my portfolio is outperforming the fund by 12.67%. Since its inception, my portfolio has been beating SCHD by 22.54% on an annualized basis.

What I would like to see from this strategy is a strong total return (12% CAGR) over a long period of time, say 5 to 10 years. Fiscal year one came up a little short of this threshold, but things are back on track in fiscal year two.

Dividend Review

Currently, the portfolio has a forward dividend yield of 2.10%, which is down from the 2.22% dividend yield a month ago. This is primarily driven by the positive gains last month. The portfolio generated $3.24 in dividend income during the month of February, the dividends were reinvested in a way to reduce the allocation drift. February 2024 dividend income was 10.99% lower than February 2023 dividend income. The total dividend income generated in 2022 was $6.08, and $49.08 in 2023. Dividend income in fiscal year one was $42.21, fiscal year two should be significantly higher. Four months in and the dividend income for fiscal year 2, $20.01, is already more than 47% of fiscal year 1's total dividend income.

The projected dividend income for the next 12 months is $58.71; this figure has increased from $58.24 a month ago as a result of the recent rebalancing. I'll be curious to see what impact the monthly rebalancing will have on potentially missed dividend income. 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 dividend growth and dividend reinvestment.

New 4 Factor List

Since June 2023, I have been running the 4-factor stock screener on a monthly basis and tracking the list of top-ranking stocks. I want to accumulate this data to run additional tests on more frequent rebalancing and to document how much the list changes from month to month.

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.

Thus far, starting this strategy during any month between June 2023 and March 2024 would have led to a better return than SCHD all the time, and a better return than SPY 9 out of 10 times. Here's a breakdown of the total returns.

The returns in the table above are through 3/1/24. Granted, the March selections are based on a single trading day, but nevertheless the 4 Factor selections are off to a better start than both SPY and SCHD. Thus far, only the January 2024 selections are trailing SPY, this is primarily tied to a poor return in January.

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 February 29 and 113 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 25 ideas. The list is presented below, with data shown as of February 29, 2024.