Tuesday, February 11, 2014

ABCs of Dividend Investing: How to Navigate the Current Sell-off

Since the beginning of the year, stocks have fallen by about 5%.  The modest pullback has many investors wondering whether a full out “correction” (drop in prices by 10% or more) is on its way.  

When the inevitable fluctuations in stock prices come, investors are all left with the same question: What should I do with my portfolio?

At Donaldson Capital Management, we have a particular strategy for handling market upswings and downswings.

What Is An ABC Portfolio?

As many of you are familiar, we invest only in dividend-paying stocks but we break down our portfolios into three types of dividend-paying stocks.  For those of you who are not familiar, we structure our portfolio into A, B and C stocks.  

Below is a summary of each sub-portfolio and it’s specific characteristics.  You can read about each sub-portfolio in more detail here.

Our primary investment model (“Rising Dividend-Cornerstone”) is comprised of all three types of dividend stocks.  

Regardless of what type of market we are in, a portfolio of A, B and C dividend stocks will have at least one group that performs better-than-expected.  This type of portfolio significantly outperforms
in bear markets (our Cornerstone portfolio has a Beta of around 0.7), while also allowing for growth in bull markets. 

From a management perspective, a portfolio comprised of A, B and C stocks allows for flexibility in allocation to each of these sub-sectors.  Each sub-portfolio each has its own characteristics that determine how well they tend to do in different types of markets.

When we anticipate good future economic growth or rising interest rates, we will “tilt” our portfolio towards some of the more growth-oriented A stocks.  In times where the market appears to be overvalued or we expect interest rates to remain flat or fall, we will lean more towards the B and C stocks - which helps reduce volatility when market downturns come and provide income for investors as bond yields decrease.

ABC Performance

When viewing the current sell-off from these three sub-portfolios, you get a very different picture than what is occurring in the overall market. 

B Stocks

Since the beginning of the year, the interest rate on the 10-year Treasury Note has fallen from 3.0% down to below 2.7%.  The emerging market crisis has ratcheted up fears of an economic slowdown.  

Since B stocks provide higher dividend yields and are less dependent upon earnings growth, they tend to perform better in these types of environments.  Many of the B stocks in our portfolio have done very well. 

C Stocks

The C stocks have also performed well relative to the market, but for different reasons.  Many of these stocks are “vexed”, which causes them to trade at low price-to-earnings (P/E) ratios.  Since they are trading significantly lower than the average stock, most of the C stocks have not sold off in any great way. 

A Stocks

In our portfolios, the only stocks that have really sold off as much as the market are the A stocks - which is exactly what you would expect.  Since they are more leveraged to growth expectations, they tend to get hit the hardest when a negative external event occurs (such as the emerging market crisis).  

In the midst of a downturn in prices, investors often overreact driving the prices of A stocks below their fair value.  So far in 2014, many of the A stocks that have been doing the best fundamentally have been hit the hardest (down 12-15%) in 2014.  

We believe this sell-off in the A stocks is likely profit taking and completely unjustified from a fundamental perspective.  The average A stock in our portfolio had 15%+ dividend growth last year.  Those stocks are now trading at discounts to where they were to begin the year with virtually no changes to their 3-5 year dividend growth estimates.

What Portfolio Changes to Make?

As an investor, how you weight your portfolio between A, B, and C stocks depends on your outlook. 

At DCM, we anticipate economic growth is not likely to be impacted by the emerging market crisis.   Economic growth should continue to improve, which should push interest rates slightly higher at the end of the year than where they are now.  If that is the case, A stocks are currently on sale and are poised for another solid year.

As for specific portfolio changes, we’re probably not going to be doing anything with our C stocks.  Our B stocks have done very well and we do not anticipate adding any positions there.  Over the coming weeks, we will look to cut back on some B stocks in favor of A stocks, which we believe will be the best performers as economic growth picks up and interest rates tick higher.

DISCLAIMER: Clients, owners, and employees of Donaldson Capital Management own shares of UTX, JPM and WMB.