To The Moon

Summary

• I propose leveraging the stock selection criteria from the underlying index of SCHD to build a portfolio with a subset of Dividend Aristocrats.
• I am tracking two portfolios built using this process and comparing the results to NOBL and SCHD.
• Both portfolios started out trailing their benchmarks, December yielded positive results but the new year has started out pretty rough.

DNY59/E+ via Getty Images

Quick Recap

On October 18, 2022 I published anarticle that covered the stock selection methodology used by the Dow Jones US Dividend 100 Index, the underlying index for Schwab's U.S. Dividend Equity Fund (SCHD). In that article I proposed a theory, to leverage this stock selection process and apply it to the Dividend Aristocrat universe of stocks. On November 1st, 2022, I launched two mock portfolios doing just that, one is an exact replication of stock selection process and the other has a slight twist that I will get to a little bit later.

Both portfolios were built using the criteria laid out in the original article. A total of 30 dividend aristocrats were chosen for each portfolio based on their ranking using the 4 factor stock selection process for the DowJones US Dividend 100 Index. The asset allocation was generated using a float adjusted market capitalization, with the maximum allocation capped at 6.67% (twice the equal weight allocation). Initially I intended to launch these portfolios on January 1st, 2023, but given that NOBL the most popular Dividend Aristocrat ETF was launched in November of 2013, I decided to launch my portfolios in November as well. Both portfolios will reinvest all dividends back into the issuing stock based on the market open price for the day following the dividend payment, and the asset allocation will remain unchanged for 1 full year. On November 1st, 2023, I will re-run the stock selection process for each portfolio and re-allocate based on the results. The intention is to see whether there is any merit to such a stock selection strategy, both portfolios will be measured against NOBL and SCHD to see if they can generate superior total returns. I will also be tracking the dividend income each portfolio generates to provide additional color on yield and growth measures. Each portfolio was funded with $10,000 of hypothetical money and no further contributions will be made.

Here are the results for both portfolios thus far.

First Portfolio - Exact Replication

This portfolio followed the exact criteria used by the Dow Jones US Dividend 100 Index. The criteria were.

1. Free Cash Flow to Total Debt Ratio
2. Return on Equity
3. Forward Dividend Yield
4. 5 Year Dividend Growth Rate

Here is a snapshot of the portfolio as of February 21st, 2023.

As you can see not all of the 30 chosen aristocrats are performing well thus far and collectively the portfolio has started to fall behind the two benchmarks. The best selections thus far have been.

1. Caterpillar (CAT) +$51.50 +10.64%
2. Nucor (NUE) +$35.08 +21.52%
3. AbbVie (ABBV) +$31.15 +4.67%
4. Procter & Gamble (PG) +$30.40 +4.56%
5. Abbott Labs (ABT) +$30.32 +4.55%

Here are the monthly returns of this portfolio (labeled LFDAS), NOBL and SCHD.

The portfolio got off to a slow start with a gain of 4.9% in November which was worse than NOBL that gained 6.28% and SCHD that gained 6.03%. During December, the portfolio weathered the market pullback much better, losing only 1.79% versus a loss of 4.12% for NOBL and 3.44% for SCHD. Unfortunately this streak has not extended into January, the portfolio finished the month with a loss of 0.23%, compared to a gain of 3.23% for NOBL and a gain of 2.08% for SCHD. February started out on a similarly sour note but the portfolio has leveled off more recently. Through February 21st the portfolio is down 2.04% compared to a loss of 2.03% for NOBL and a loss of 2.15% for SCHD.

The combined since inception return places the portfolio 2.35% behind NOBL and 1.56% behind SCHD. So it has quite some ground to make up in the coming months.

Here is a breakdown of the dividend income thus far as of February 21st, 2023.

My portfolio did not capture most of the dividends from November and missed out on October income as well. Therefore this initial dividend income comparison is not really apples to apples. The portfolio has moved ahead of NOBL in lifetime dividend income but that lead will likely flip as NOBL pays out its quarterly dividend next month.

As of right now my portfolio has a dividend yield of 2.83% compared to 1.91% for NOBL and 3.39% for SCHD.

Since inception the portfolio has drifted away from its starting allocation by 5.98%, which is a slight deviation from the absolute drift a month ago (5.61%). The table below shows the absolute drift for each individual position. I imagine that after 12 months the total drift could be much higher. There are two schools of thought on rebalancing a portfolio to its target allocation. On the one hand you can forego rebalancing and let your winners run, on the other hand you can capture short-term gains and reallocate them to worse performing positions in the hope that they will perform better down the road. I have opted to forego rebalancing this portfolio on a fixed schedule or at a specific drift target. The portfolio will be rebalanced after the first full year comes to an end and new aristocrats are selected using the original stock selection method.

Second Portfolio - My Modification

This portfolio modified the criteria used by the Dow Jones US Dividend 100 Index, replacing one of the factors. The criteria use was:

1. Free Cash Flow to Total Debt Ratio
2. Return on Capital
3. Forward Dividend Yield
4. 5 Year Dividend Growth Rate

The one factor that was changed was the return on equity, and it was replaced with the return on capital. I personally like this metric better as I think it does a better job of measuring profitability.

Here is a snapshot of the portfolio as of February 21st, 2023.

As you can see the modified portfolio is thus far performing a little better than the first portfolio. The best selections thus far have been.

1. Caterpillar +$50.12 +10.64%
2. Linde plc (LIN) +$47.39 +7.14%
3. S&P Global (SPGI) +$38.14 +8.10%
4. Nucor +$34.21 +21.52%
5. AbbVie +$31.15 +4.67%

The best selections are similar to the first portfolio with the exception of the inclusion of Linde plc and S&P Global in this portfolio, whereas the first portfolio had Procter and Gamble and Abbott Labs amongst the top 5.

Here are the monthly returns for this portfolio (labeled LFDAM), NOBL and SCHD.

This portfolio got off to a much better start, gaining 6.05% in November, outperforming SCHD and only slightly trailing NOBL. The portfolio fell in December but finished the month better than NOBL and SCHD, losing only 2.45% compared to losses of 4.12% and 3.44%, respectively. This portfolio weathered January much better than the first portfolio, picking up a gain of 1.04%. It still trailed both benchmarks by quite a bit and is also struggling a bit more in February thus far.

Comparing both portfolios the second strategy is 1.04% ahead of the first.

Here is a breakdown of the dividend income by month as of February 21st, 2023.

This portfolio got off to a better start compared to the first portfolio, generating more dividend income in partial 2022 ($31.85 vs. $29.18). But since it has a lower dividend yield it was only a matter of time before the first portfolio moved into the lead. Thus far this portfolio has only generated $30.04 in dividend income this year and is projected to generate less total income this year than both NOBL and SCHD.

What will be interesting to see is which portfolio will achieve a better dividend growth rate and how dividend reinvestment will differ between the two portfolios.

Since inception the portfolio has drifted away from its starting allocation by 6.16%, which is a minor deviation from a month ago (5.57%). The table below shows the absolute drift for each individual position. Compared to the first portfolio the absolute drift here continues to be smaller and it will be interesting to see how this trend changes in the future, and what impact it may have on the long term return. The same rebalancing rules will be applied to this portfolio as to the first portfolio.

Portfolio Differences

Now that we have taken a closer look at each portfolio let's go over the differences between them and what impact these differences have made.

First up let's go over the 8 unique aristocrats found in each portfolio. The first portfolio owns the following unique aristocrats.

On average these 8 aristocrats are up 2.68% since November 1st, which is a big improvement from a month ago (down 1.37%). Their combined starting allocation in the portfolio was 26.71% and as a result their impact on the overall portfolio return thus far has been a loss of 0.05%. Albeit the 8 unique aristocrats have a strong average return, it's really propped up by Cincinnati Financial (CINF) that is the smallest of the unique holdings.

Here are the 8 unique aristocrats in the second portfolio.

We can clearly see these 8 aristocrats on average have performed better than the 8 unique aristocrats in the first portfolio. They also made up a slightly larger initial allocation of the portfolio and as a result played a more significant role in the overall return, +0.99%.

I believe these 16 aristocrats will be the main drivers of the long term difference between these two portfolios. Of course there are more allocation differences between the common aristocrats shared by both portfolios and that will play a role as well.

Dividend Increases

A total of 8 dividend aristocrats included in these 2 portfolios have increased their dividend rate since November 1, 2022. The first portfolio, LFDAS, has seen 7 increases while the second portfolio, LFDAM, has only seen 4. The average dividend growth rate for LFDAS has been 5%, while the average dividend growth rate for LFDAM has been a slightly better 5.18%.

Future

The long term goal is to determine whether this stock selection strategy has merit. This will be measured by whether or not either of these portfolios can achieve and sustain long term alpha over NOBL. I am also comparing the results to SCHD but since this ETF uses a different universe of stocks it isn't really a fair benchmark in this test. I would like to see both portfolios outpace NOBL and remain competitive when measured against SCHD. I'll be providing updates throughout the year and when the time comes to select new constituents for each portfolio.

$Schwab US Dividend Equity ETF(SCHD)$  $ProShares S&P 500 Aristocrats ETF(NOBL)$

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