Creating The Optimal Dividend Growth Portfolio

This post describes how to create the optimal dividend growth (ODG) portfolio, high quality stocks that will provide a robust and growing income stream over the long haul.

  • Use a simple screen to help select dividend growth stocks.
  • Focus on a few key criteria.
  • Create a regular income stream in retirement to supplement pensions, social security, part-time work, and withdrawals.

If you are retired as I am and are looking for a regular income stream to supplement pension and social security benefits, part-time work, annuities, and investment withdrawals you might want to consider creating a diversified portfolio of dividend growth stocks of companies with a long history of steadily increasing payouts, that are growing earnings, are reasonably valued, have low debt levels, and offer a relatively high current yield.

The guidelines presented herein are based upon my 30+ plus years of investing experience and research and are what I call my “rules for an optimal dividend growth portfolio”, which will compliment the portfolio of dividend stocks I already own.

The six (6) main selection categories are:

1. dividend and earnings growth history over the previous five (5) years (or longer)

2. current valuation,

3. yield,

4. payout ratio,

5. debt,

6. Other factors (including diversification, industry outlook, recent news).

Dividend/earnings growth/longevity
Companies with a long history of growing earnings and boosting payouts to shareholders will probably continue to do so going forward, all other things being equal. For example, members of the S&P500 Dividend Aristocrats have increased the dividend every year for at least 25 consecutive years. Some companies have boosted the payout annually for more than a half century. Unless something dramatic occurs these companies will continue to pay and increase dividends.

For the ODG portfolio I decided to use fifteen (15) years as the minimum criteria for number of consecutive annual increases. Twenty-five (25) years is better and fifty (50) years is best.

In addition, a retiree will probably expect that the payouts stay ahead of inflation. Using data from the U.S. government, one measure of inflation, the Consumer Price Index , has increased 81% over the last 25 years, or at a compounded 2.4% per year.

For the ODG portfolio, earnings per share (EPS) and dividend payments should have an annual growth rate two times the CPI, i.e. at least 5% right now, with higher values even better, over the previous five and, optimally, ten years.

The second consideration for the ODG portfolio is valuation. Buying stocks that are reasonably priced will result in an increased likelihood of positive overall returns (dividend plus capital gains) over the long term, especially in this current environment of “frothy” valuations.

Three (3) parameters will be examined within this category:

1. Price/earnings, P/E,

2. Price/sales, P/S,

3. Price-to-book, P/B.

Current values will be compared to the overall market, the industry that the company competes in, and for the previous half decade for each stock.

For example, if Stock ABC has averaged a P/E of 18 over the last five years, its industry currently averages a P/E of 22, and the overall market has a P/E of 23 then an optimal buy point for the stock might be a current P/E of 18 or less. A current P/E of 23 might be enough to hold off on making a purchase.

To get a jump on creating a meaningful initial income stream, and with the added goal of the payouts increasing over time, I recommend stocks that have a relatively high current yield that can’t be easily obtained elsewhere, say through bonds, money market accounts, or other run-of-the-mill stocks.

I picked three criteria for this parameter:

  1. The U.S. Treasury 10-year note is one baseline to compare to the stock’s dividend yield. As of Jan. 18, 2019, the T-note currently yields about 2.79%.
  2. The second is the 1.5x the yield available on the S&P500 stock index, which as of Jan. 18, 2019 is 2.01%.
  3. The third is that the yield for the stock must be larger than its 5-year average.

Therefore,  the yield chosen for ODG portfolio stocks must be at least 3.02% (1.5 x 2.01) and higher than the 5-year average for the stock.

Payout ratio
Companies that have stocks with relatively low payout ratios, the current dividend divided by the trailing 12-months earnings per share or the free cash flow per share, have more flexibility to raise shareholder payments in the event of lower future earnings and without having to borrow.

Stocks with payout ratios between 40% and 60% will be considered for the ODG portfolio. By law REITs and MLPs pay out a significant portion (90%) of earnings (funds from operations in the case of REITs) so this metric won’t apply to those types of investments.

The last category is debt. Corporations that do not have to stretch to service long-term debt can use some of its excess cash earned to grow the dividend.

The criteria to be used for evaluating debt will be the long term debt-to-equity ratio. The optimal portfolio should contain stocks with long-term debt/equity < 1.0 (and the closer to zero the better). If the debt to equity ratio is showing a constant upswing over the recent past it might be cause for concern.

The final selection metric includes various intangible items.

Any recent bad news or trends regarding a particular stock might be enough to kick it out of the portfolio.

The optimal portfolio should be well diversified (20-30 stocks) and spread out among all market sectors (so around two stocks per sector). The prudent investor won’t want to be concentrated in a few industries (think about the recent oil industry crash).

A relatively simple screening method can be used to help select stocks for an optimal dividend growth portfolio that might compliment other retirement income sources such as pensions and social security benefits.